Question

Explain the working of investment multiplier with the help of a numerical example

Answer 1

Multiplier is the mechanism through which income gets propagated as a result of added investment. How a new investment brings about a multiple increase in income by increasing consumption, is clear from the following example. This example gives us what may be described as a ‘motion picture’ of income propagation under certain assumptions. Assuming the marginal propensity to consume as 1/2, let us suppose further that there is an investment of Rs. 20 crores in public works. The MPC being 1/2 (multiplier) will be 2 [1/1 ½].

An investment of Rs. 20 crores will increase the total income by Rs. 40 crores. When an original invest­ment of Rs. 20 crores is made, half of it will be spent on consumption by the income recipients (because MPC = y , Rs. 10 crores out of Rs. 20 crores will be spent on consumption in the first round).

In the second round, income shall increase by Rs. 10 crores ; in the third round, income shall expand by Rs. 5 crores ; in the fourth by Rs. 2.5 crores in fifth by Rs. 1.25 crores ; and so on, till it has increased to Rs. 40 crores i.e., 2 times the original investment. Thus, we note that there is an infinite geometric series of the descending variety, viz. Rs. 20 cr. + Rs. 10 cr. + Rs. 5 Cr. +2.5 Cr. + Rs. 1.25 cr……. and soon, adding up to Rs. 40 crores. We see that the multiplier is equal to the ratio of the increase in income to the increase in investment, i.e., Rs. 40 cr. + 20 cr. = 2. In this way, multiplier is having the value 2.



It may, however, be noted that the whole process of income expansion is spread over time as income does not increase to Rs. 40 crores all at once in a single jump. Keynes, however, did not give much importance to time lags involved in the process of income generation. The multiplier effects of investment on income are shown below in the form of a diagram.

In this figure, consumption curve CC is drawn according to the MPC being less than one. E1Y1 gives us the equilibrium level of income since C +1 curve intersects the 40° line at the point E1. Let us suppose that for one reason or the other, investment rise from C + I to C + I + ∆I. The new curve C +1 + ∆I, intersects the 45° line at E2. E2Y2 gives us the new level of income at Y1Y2. This is greater than the vertical distance between C +I and C + I + ∆I curves.

Answer 2

The term "investment multiplier" describes how many times a gain in output or income surpasses an increase in investment. The ratio of changes in income to changes in investment is used to calculate it.

In other words, an investment Multiplier refers to the increase in national income as a multiplier of a given increase in investment. Its value is determined by MPC. It is denoted by ‘k’ where ΔY = additional income generated and ΔI = additional investment.

Multiplier = 1/(1 – MPC) = 1/MPS

Here, MPC = Marginal Propensity to Consume and MPS = Marginal Propensity to Save.

For example:

Suppose the increase in investment is Rs. 1000 and MPC = 0.8. The increase in national income is shown in the following sequence:

(1) A Rs. 1000 rise in investment raises the income of people who provide investment products. This is the initial round of growth.

(2) The income earners spend Rs. 800 on consumption because MPC = 0.8. The income of the producers of consumer goods increases by Rs. 800 as a result. This increase represents the second round.

(3) The third round increase is indeed Rs. 640 (i.e. 800 x 0.8). In this way, the nation's income keeps rising continuously.

(4) The total increase in income is Rs. 5000.

(5) Additional rounds will cost Rs. 2560. It is determined by taking the total rise in income, consumption, and saving and subtracting the values of the first, second, and third rounds.

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