Investment Multiplier: Definition, Logic and Assumptions

Suppose marginal propensity to consume of the people is 4/5 or 80%. Now, let us explore another crucial part of investment multiplier—its relationship with MPC. It is important for people to note that there exists a directly proportional relationship between MPC and investment multiplier value. This is because how a community consumes and saves has a direct bearing on the investment multiplier. This economic concept is rooted in the economic theories of John Maynard Keynes, the renowned economist who is considered the father of modern macroeconomics. The investment multiplier is among the many multipliers used in economics and finance.

The propelling force behind the multiplier effect is the consumption function. As a result of an increase in investment outlay, income initially increases in the same magnitude, but as income increases, consumption also increases. If their marginal propensity to consume is 3/4th or 75%, they will spend Rs 75 crore (3/4th of 100) on new consumption goods. When investment increases by a certain amount, aggregate income increases by a multiple of that investment. If the government taxes away a certain portion of the extra income generated in the economy the value of the multiplier will fall. So like savings, taxes also act as a leakage from the circular flow.

It can be concluded that an initial investment of ₹200 crores has resulted in a total increase of ₹1,000 crores in income. Keynesian multiplier is an important economic concept that John Maynard Keynes introduced. The basic tenet of this multiplier is that the more a country’s government spends, the more its economy will flourish. In the following sections we have simplified the concept of investment multiplier and how it works with apt examples. Examples other than investment multiplier include fiscal multiplier, earnings multiplier , and equity multiplier. Simultaneously, saving some part of the total income due to Marginal Propensity to Save (MPS).

Investment Multiplier Assumptions

An increase in bank lending should translate to an expansion of a country’s money supply. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. When the reserve requirement decreases, the money supply reserve multiplier increases, and vice versa. It we ultimately come to a halt when the last increase in consumption spending is not sufficient to generate a fresh income. However, at the end, the total rise in expenditure, and hence in national income, will be more than the rise in autonomous expenditure by the amount of the rise in induced consumption spending.

This would translate to more income for workers, more supply, and ultimately greater aggregate demand. So the initial and direct effect of an increase m autonomous investment of Rs. 1000 crores implies an equivalent increase of employ­ment and income of-factors of production employed in those industries. But the process of income gener­ation cannot continue indefinitely. The producers of these goods will have an extra income of Rs 75 crore. If MPC of producers is also 3/4th, they in their turn will spend Rs 56.25 crore (3/4 of 75). So, this process will go on, with each round of expenditure being 3/4th of the previous round and in this way the production and national income will go on increasing round after round.

Here, the marginal propensity to consume, commonly referred to as MPC, plays an important role, which will be explored later. All in all, this theory explains the impact of injecting investments on income and output. If banks are lending more than their reserve requirement allows, then their multiplier will be higher, creating more money supply.

Logic of the Investment Multiplier:

An imaginary economy is in equilibrium with no foreign trade or government activity. The aver­age propensity to consume and the marginal propensity to consume are both 8/10, the actual level of consumption expenditure being Rs. 16,000 in each year. In an interde­pendent economy one man’s expenditure is another man’s income. Now those who receive this Rs. 800 crores, in turn, spend an extra Rs. 640 crores a year (4/5 of Rs. 800 crores). The process will continue for some time and at any stage of the process each successive set of recipients of new income spend 4/5 of their new income and save the rest. Let us now suppose that due to new investment of Rs. 1000 crores there is an increase in injections.

From this proposition Sir John Hicks developed the concept of super-multiplier. In re­ality any multiplier increase in income hardly gets distributed evenly throughout the popula­tion. It shows the amount by which aggregate demand must be what can be the maximum value of investment multiplier reduced initially to prevent any excess of de­mand over supply that will cause prices to rise. It is often observed that a major portion of the new income gen­erated in the economy is utilised to buy old bonds and securities from others.

For this reason, the investment multiplier increases with the increase in the MPC. The last impact (induced impact) highlight the true benefit of multiple effects. Although a single individual received a tax benefit, many companies and their employees benefited. For example, imagine the individual dined at a restaurant and left a tip.

Understanding the Multiplier Effect

The multiplier effect is an economic term, referring to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of capital. In effect, Multipliers effects measure the impact that a change in economic activity—like investment or spending—will have on the total economic output of something. Keynes’ theory of investment multiplier is con­sidered to be an important and permanent contribu­tion to economic theory.

• The multiplier is, therefore, the ratio of increment in income to the increment in investment.
• This means that the multiplier effect was 2 ($200,000 / $100,000).
• The portion they save (i.e., do not spent) disappears from the circular flow, thus reduc­ing the value of the multiplier.
• A change in the pattern of in­come distribution, for instance, will alter the value of MPS and thus the value of the multiplier in the pro­cess.
• The white bar in each period shows how much income has been generated in the previous period.

The average propensity to consume is the mathematical average of these. The marginal propensity to consume relates to the pro­portion of additional income that people spend. Keynes stated that the size of the multiplier is determined by the MPC. It is because the slope of the saying schedule is the MPS and the reciprocal of the slope of the saving schedule gives us the value of the mul­tiplier. Therefore, the flatter the saving schedule, the larger must be the increase in income, before saving rises to equal the new level of investment.

What Is the Keynesian Multiplier?

In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price. The multiplier can also be shown graphically using the AD and AS approach. 8.7, income is taken on the X-axis and aggregate demand on the Y-axis. Marginal propensity to consume is the proportion of a raise that is spent on the consumption of goods and services, as opposed to being saved. Spending directed toward investment, by the MPI, may have a multiplier effect that boosts the economy, but this effect might vary or possibly even be negative if crowding out occurs. A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or that assesses the ability of a company to meet financial obligations.

The theory of the multiplier was developed in the midst of the depression of the 1930s by Richard (later Lord) Kahn. He observed the millions of unemployed and suggested that if more men are employed they would spend their wages. The de­crease in equilibrium income is Rs. 200, Rs. 100, Rs. 80 and Rs. 40 for the four values of MPC.

Importance of the Investment Multiplier:

The money multiplier involves the reserve requirement set by the Federal Reserve, and it varies based on the total amount of liabilities held by a particular depository institution. If there is an output lag, i.e., if producers do not immediately increase output to meet an increase in total demand and allow their stocks of goods to run down, the multiplier effect will be partly lost. The same thing happens if there is consumption lag, i.e., if households who receive an increase in their income take time to adjust their consumption habits. The multiplier can be used by governments and by businessmen to forecast the overall effect of a public expenditure programme. Thus real con­sumption spending (which determines the value of the multiplier) will fall. In other words, a major por­tion of increased money income will be neutralised by price inflation, instead of stimulating consumption and creating jobs and incomes in the process.

This means that for every Rs.1 invested by the government, there will be an income of Rs. 2. John Maynard Keynes was a ground-breaking British economist who is considered the father of modern macroeconomics. His book, The General Theory of Unemployment, Interest, and Money, was published in 1936 and is the foundation for Keynesian economics. Let us suppose that an investment of Rs.5000 Cr is made in an economy. Unlike Static in Dynamic Multiplier, there exists a time lag during the process.

(b) Relationship of K with MPC and MPS:

Or, in other words, it must be greater than zero but less than one. The numerical values of the multiplier in these three cases are 2.5, 5 and 7.5, respectively. This shows that the flatter the saving schedule, the larger the value of the multiplier. If MPS is high, K will be low but if MPS is low, K will be high as proved in the following examples. This means that any change in income (ΔY) will therefore equal (ΔC+ΔI). This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable.

The concept of the multiplier to be meaningful M PC must be greater than zero but less than one. This is so because there are various leakages from the circular flow of income. Due to these leakages the process of income genera­tion slows down. If a portion of increased income is taxes away at every stage of income generation the multiplier effect will be smaller. The time taken for the multiplier process to work itself out through the various ’rounds’ of spending may vary. Thus, the multiplier, ∆Y/∆S, is the reciprocal of the slope of the saving function.