INVESTMENT MULTIPLIER

Keynes believed that an initial increment in investment increases the final income by many times. Multiplier (K) is the ratio of increase in national income (Y) due to an increase in investment (I).

Symbolically, K = Y / I

Multiplier and MPC

There exist a direct relationship between MPC and the value of the multiplier, higher the MPC, more will be the value of the multiplier, and vice-versa. The reason for this is:

In the case of higher MPC, people will spend a large proportion of their income on consumption. In such case, the value of multiplier will be more.

In case of low MPC, people will spend lesser proportion of their increased income on consumption. In such case, value of multiplier will be comparatively less.

Algebraically, since, Y = C + I

Therefore change in Y = change in C + change in I

Dividing both sides by Y

Y/Y = C/Y + I/Y

1 = MPC + I/K (: Y/Y = 1, C/Y = MPC, I/Y = I/K)

1 – MPC = I/K

K= I /1-MPC or I / PC (: I - MC = MPS)

Multiplier is directly related to MPC and inversely related to MPS

The above statement can be easily proved through the following table:-

It is clearly seen in the above table that as MPC is increasing, Multiplier is also increasing which shows positive relationship whereas it is increase with fall in MPS, which shows negative relationship.

The maximum value of the multiplier can be infinity when MPC is I and MPS is Zero whereas the minimum value of the multiplier can be I when MPC is 0 and MPS is 1.

Working of Multiplier

The working of multiplier is based on fact that ‘One person’s expenditure is another person’s income’. When an additional investment is made, then income increased many times more than the increase in investment. Let us understand this with the help of an example:-

  1. Suppose the government for some infrastructural activities makes an additional investment of Rs.1000 crores. This will generate an extra income of Rs.1000 crores in the first round. However, this is not the end of the story.
  2. If MPC is assumed to be 0.80, then the recipient of this additional income will spend 80% of Rs.1000 crore i.e. Rs 8000 crore as consumption and remaining amount will be saved. It will increase the income by Rs. 800 Crore in second round.
  3. In next round, 90% of additional income of Rs.8000 crore i.e. Rs. 640 crore will be spent on consumption and the remaining amount will be saved.
  4. This multiplier process will go on and consumption in every round will be 0.80 times of additional income received from the previous round.
  5. Here value of Multiplier(K) =Y/I = 5000/1000=5 times Or I/MPS (I/I-MPC) =1/0.20 = 5 times
  6. Therefore, an initial increase in investment by one unit will increase total national income by 5 times.

Diagrammatic presentation of Multiplier:

https://www.learncbse.in/wp-content/uploads/2019/09/NCERT-Solutions-for-Class-12-Macro-Economics-National-Income-Determination-and-Multiplier-Q3.png