Question

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

Answer 1

Investment Multiplier refers to increase in national income as a multiple of a given increase in Investment. Its value is determined by MPC. It is denoted by 'K' where, ∆y = additional income generated ∆I = additional Investment.

Multiplier= 1/(1-MPC) = 1/MPS;where MPC= Marginal Propensity to Consume MPS = Marginal Propensity to save.

Suppose increase in investment is Rs 1000 and MPC = 0.8. The increase in national income is in the following sequence: (i) Increase in investment raises income of those who supply investment goods by Rs 1000. This is the first round increase. (ii) Since MPC = 0.8, the income earners spend Rs 800 on consumption. This raises the income of the suppliers of consumption goods by Rs 800. This is second round increase. (iii) In the similar way, the third round increase is Rs 640 = 800 × 0.8. In this way, national income goes on increasing round after round. (iv) The total increase in income is Rs 5000.