Investment Multiplier and its Mechanism

Investment multiplier is an important part of economic theories suggested by notable economist John Maynard Keynes. According to this concept, in the event of an increase in the investment activities either public or private which can be in the form of private consumption spending, government spending in an economy, there is a corresponding increase in the Gross Domestic Product (GDP) of the economy by a value more than the amount invested.

In simple words, investment multiplier refers to the increase in the aggregate income of the economy as a result of an increase in the investments done by the government in the form of new projects.

The size of the investment multiplier is determined by the decisions of the households in an economy in the areas of spending (which is known as marginal propensity to consume) or saving (known as marginal propensity to save).

The multiplier can be represented by the following formula.

K = ΔY / ΔI

Where,

ΔY = Increase in GDP or National Income

ΔI = Increase in Investment

Also,

k = 1/ 1- MPC

Where k = Investment Multiplier

MPC = Marginal Propensity to Consume

And, k = 1/ MPS

Where k = Investment Multiplier

MPS = Marginal Propensity to Save

Therefore, it can be concluded that

K = 1/ 1- MPC = 1/ MPS

It can be said that in order to find the value of the investment multiplier, either the value of MPC or MPS should be determined or the value of the multiplier can be determined if MPC or MPS values are provided.

Let us understand the mechanism of investment multiplier with an example.

Suppose the government has made an investment of 100 crores in a road construction project. This will lead to hiring of labourers, engineers and suppliers of raw materials, logistics. In short such an investment will lead to job opportunities for many people. It will result in income generation, which will result in their tendency to consume and save.

Let’s say the MPC of the labourers is 0.5, that means that for every 1 rupee earned they spend 0.50 rupees in consumption of goods and services.

Therefore, the investment multiplier will become,

K = 1/ 1-MPC

K = 1/ 1-0.5

K = 1/0.5

K = 2

It means that for every 1 rupee invested by the government, it will generate an income of 2 rupees.

Similarly, we can find the value of multiplier when MPS = 0.2

K = 1/MPS

K= 1/0.2

K= 5

Therefore, it can be seen that if the MPS value is less than the multiplier, value increases and when the value of MPC is more than the investment multiplier becomes more.

The value of MPS or MPC can be used to find the total increase in income obtained from the initial investment by using the following formula

K = ΔY / ΔI

and, K = 1/MPS

Therefore, in the above example an investment of 100 crores will bring total income of

ΔY / ΔI = 1/MPS

ΔY / 100 = 1/0.2

ΔY / 100 = 5

ΔY = 500

Therefore, the total increase in income will be 500 Crores.

This concludes our article on the topic of Investment Multiplier and its Mechanism, which is an important topic in Economics for Commerce students. For more such interesting articles, stay tuned to BYJU’S.