In common practice, working of the multiplier is affected by a larger number of dynamic factors which work over time. Multiplier not goes on raising income indefinitely. This is because of there are several leakages from the income-stream as a result of which the process of income propagation is slowed down as time passes. All the income of the people is not fully used in consumption expenditure. Therefore, marginal propensity to consume is not 100%, i.e., 0<MPC<1.
The incomes of people are influenced by various factors limiting the process of multiplier. That is, due to leakages in income flow, the effect of multiplier reduced. leakages are the potential diversions from the income-stream which tend to weak the multiplier effect of new investment. Given the marginal propensity to consume, the increase in income in each round declines due to leakages in the income-stream and ultimately the process of income propagation to gradually becomes smaller. Due to the leakages, the national income does not increase fully. So, leakages in various forms are the leakages of multiplier. The following are the important leakages:
Saving is the most important leakage of the multiplier process of income propagation. Since the marginal propensity to consume is less than one, the whole increment in income is not spent on consumption. A part of it is saved which gradually becomes smaller of the income stream and the crease in income in the next round declines. Thus, the higher the MPS, the smaller the size of multiplier and the greater the amount of leakage out of income-stream, and vice-versa. For instance, if MPS=1/6, the multiplier is 6, according to the formula K=1/MPS; and the MPS of 1/3 gives a multiplier of 3.
(2) Strong Liquidity preference:
If people prefer to hoard the increased income in the form of idle cash balances to satisfy a strong liquidity preference for the transaction, precautionary and speculative motives, that will act as a leakage out of the income stream. As income increases people will hoard money in inactive bank deposits and the multiplier process is checked.
(3) Purchase of old stocks and securities:
If a part of the increased income is used in buying old stocks and securities instead of consumer goods, the consumption expenditure will fall and its cumulative effect on income will be less than before. In other words, the size of the multiplier will fall with a fall in consumption expenditure when people buy old stocks and shares.
(4) Debt cancellation:
If a part of increased income is used to repay debts to banks, instead of spending it for further consumption, that part of the income peters out of the income stream. In case, this part of the increased income is repaid to other creditors who save or hoard it, the multiplier process will be slowed down.
(5) Price Inflation:
Price inflation constitutes another important leakage from the income stream of an economy. If due to increased investment the inflation increases then most part of the increased income will be used to pay for the increased price. This will affect the multiplier. Increase in the price of goods decreases the real consumption of the people. The price inflation is also one of the main leakages of multiplier.
(6) Net Imports:
If increased income is spent on the purchase of imported goods, it acts as a leakage out of the domestic income stream. Such expenditure fails to effect the consumption of domestic goods. This argument can be extended to net imports when there is an excess of imports over exports thereby causing a net outflow of funds to other countries.
(7) Undistributed Profits:
If profits accruing to joint-stock companies are not distributed to the share-holders in the form of dividend but are kept in the reserve fund, it is a leakage from the Income stream. Undistributed profits with the companies tend to reduce the income and hence further expenditure on consumption goods thereby weakening the multiplier process.
Taxation Policy is also an important factor in weakening the multiplier process. Progressive taxes have the effect of lowering the disposable income of the tax payers and reducing their consumption expenditure. Similarly, commodity taxation tends to raise the prices of goods, and a part of increased income may be dissipated on higher prices. Thus, increased taxation reduces the income stream and lowers the size of the multiplier.
All these factors constitute potential leakages from the income stream resulting from an expansion of new investment. The new income under such circumstances, does not give rise to secondary consumption expenditures as much as it should.