Investment Multiplier:

The concept of investment multiplier suggests that the increase in investment will lead to income generation in multiplies.

Prof. Keynes felt that an initial rise in investment multiplies overall income by a large factor. A rise in the amount of desired aggregate expenditure due to increase in desired consumption expenditure (C) or desired investment expenditure (I) will shift the aggregate expenditure curve (AE = C + I) curve upward and therefore result in an increase in equilibrium level of income and output.

Similarly, a fall in desired aggregate spending will shift the AE line downward and will thereby lower the equilibrium level of income and output.

The relationship between an initial increase in investment and the subsequent rise in total income is expressed by the multiplier.

A multiplier explains how many times an increase in investment causes an increase in national income.

Investment Multiplier:

Investment multiplier is defined as “the multiple amount by which income increases as a result of increase in investment expenditure”.

An increase in investment expenditure increases equilibrium level of income by a multiple amount, that is by an amount greater than itself.

The multiplier is the ratio of the change in income to the change in investment.

Thus, K = ∆ Y / ∆ I

Where, K = investment multiplier

∆Y = change in income

∆ I = change in investment

The multiplier provides a measure of magnitude of change in income as a result of change in investment.

Multiplier Mechanism (Process) :

Question: Explain the working of investment multiplier taking a numerical example.

Question : Discuss the mechanism of investment multiplier with the help of a numerical example.

Multiplier Mechanism:

The mechanism of multiplier can easily be understand with the help of an example.

Assume that the economy is in equilibrium and an industry spends Rs 100 crore in setting up a new plant.

This setting up of anew plant will create more demand for land, labour, materials and machinery. This will generate more output and income for all those people who are associated with this establishing of new plant.

As a result, the national income in first round will increase by an amount equal to the amount of investment i.e., investment = Rs 100 crore.

The increase in national income will also induce the increase in consumption spending.

People receiving this increased income (Rs 100 crore) will spend some part of it on consumer goods like – food, clothing, cinema, TV , cars etc. The exact amount of additional consumption expenditure will depend on marginal propensity to consume (MPC or c) , Let MPC = .8 .

Therefore, the rise in consumption expenditure (∆C) in second round will be –

∆ C = c × ∆ Y

= .8 × 100

∆C = 80 crore

Due to this rise in consumption expenditure the demand for consumer goods will give rise to an increase in output and employment and then generate in income for the firms and workers producing these consumer goods. Thus, the increase in income in second round will be Rs 80 crore which is equal to increase in consumption expenditure.

This increase in income will give rise to an increase in consumption expenditure in third round by –

∆C = c × ∆Y

∆C = .8 ×80

= 64 crore .

Therefore, the increase in consumption expenditure in third round = Rs 64 crore.

This will generate an income of equal amount i.e. Rs 64 crore.

This process of increase in income will continue to be repeated in subsequent rounds with income in each round of spending being MPC times the increase in income in the previous round.

This process can not continue indefinitely. The amount of increase in consumption passed on from one round to the next keeps on diminishing. Thus the total income will increase by an amount which is some definite multiple of initial increase in investment. In our example the total increase in income would be Rs 500 crore.

Process of Income Propagation:

Rounds of Spending	Increase in investment spending	Increase in consumption	Increase in income
1	100	–	100
2	–	0.8 *100=80	80
3	–	0.8*80=64	64
4	–	0.8*64=51.2	51.2
. .	. .	. .	. .
. .	. .	. .	. .
		Total increase in consumption=Rs.400 crore	Total increase in income=Rs.500 crore

Graphic Presentation of Multiplier:

Question : Explain and illustrate Keynesian Investment Multiplier. Use suitable diagram.

Investment Multiplier:

The number of times by which income increases because of increase in investment is called investment multiplier.

The multiplier is the ratio of the change in income to the change in investment.

K = ∆Y / ∆ I

Where, K= investment multiplier

∆Y = change in income

∆I = change in investment

Investment multiplier can be explained with the help of a diagram –

Illustration of Multiplier

In the given diagram, income is shown along the X – axis and desired aggregate expenditure (C + I) is indicated along the Y – axis.

The point of intersection of AE0 – line and 45° – Y -line is the initial equilibrium (E0) and the equilibrium income corresponding to point E0 is OY0.

An increase in autonomous investment expenditure (∆I) shifts the desired expenditure upward from AE0 to AE1.
Due to the increase in desired spending the income will also rise.

The new equilibrium is set at the point of intersection of AE1 and Y line which is E1 and the equilibrium level of national income is now OY1.

As a result of increase in investment by ∆I (= E1M), the income rises by Y0 Y1 or E1N. It can be seen from the above diagram the increase in income E1N ( = Y0Y1) is greater than increase in investment, the multiplier is greater than unity.

K = ∆Y / ∆I

= E1N / E1M > 1

It is proved that a given autonomous change in investment will lead to a change in income which exceeds the change in investment.

Derivation of Multiplier Formula :

Question : How is investment multiplier related to marginal propensity to consume ?

Question : Explain the relationship between marginal propensity to save and multiplier.

Question : “The size of multiplier varies directly with the size of MPC and inversely with MPS” elucidate.

Derivation of Multiplier Formula:

We know that the equilibrium level of income in two sectors Keynesian model is given by:

Y = C + I

If the increase in investment is ∆I. Then this will lead to increase in income (∆Y ) and further will induce the increase in consumption (∆C). All this change, will change the equilibrium level of income. Therefore,

∆Y = ∆C + ∆ I ………..equation 1

Since, c = ∆C / ∆Y

Where c = marginal propensity to consume or MPC

So ∆C = c ∆Y

Putting the value of ∆C in the equation 1

∆Y = c ∆Y + ∆I

∆Y – c ∆Y = ∆I

∆Y (1 – c) = ∆ I

Dividing both side by (1 – c)

∆ Y = 1 / (1- c) × ∆I

Dividing both side by ∆I

∆Y / ∆I = 1 / (1- c)

Since, K = ∆Y / ∆I

Therefore, K = 1 / (1- c)

The term 1/ (1-c ) gives the value of investment multiplier.

From the above formula of investment multiplier it is clear that the size of multiplier depends on the marginal propensity to consume (c).

“There is a direct relationship between K and MPC (c).”

The larger the value of the MPC, the larger is the size of multiplier. Here, higher MPC means that the consumption expenditure induced by the initial increase in income is larger at every round, and the final rise in national income is corresponding larger.

Similarly, the smaller the value of MPC, the smaller will be the size of multiplier. The consumption spending induced by the initial rise in income is smaller at every round and the final rise in national income is correspondingly smaller.

Relation of Multiplier with Saving Function:

We know, MPC + MPS = 1

c + s = 1

s = (1 – c)

Therefore, K = 1 / (1- c)

K = 1/ s

Or K = 1/ MPS

It means, the multiplier is reciprocal of marginal propensity to save. There is an inverse relationship between K and MPS.

The greater the value of MPS, the smaller will be the size of investment multiplier and vice versa.

Investment Multiplier : Economics Class 12

Investment Multiplier:

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