Investment Multiplier Meaning, Working and Formula with Examples
Investment multiplier is an integral part of economic theories as propounded by John Maynard Keynes, a British economist. He illustrated this concept with the help of a country’s GDP (Gross Domestic Product) and its investments. According to the investment multiplier concept, a rise in investments will cause income generation in multiples.
In the following sections we have simplified the concept of investment multiplier and how it works with apt examples.
What is an Investment Multiplier?
The investment multiplier is a key concept in Keynesian economics, according to which, an increase in public or private investments will cause a country’s GDP to increase by a value more than the original investment amount. Such investments can be made through private consumption spending or government spending in the economy.
If one has to define it investment multiplier in simple words, it is the increase in a country’s aggregate income as a result of increased investments.
The extent of the investment multiplier depends on the decisions taken by households with respect to spending and saving. Here, the marginal propensity to consume, commonly referred to as MPC, plays an important role, which will be explored later.
How Does Investment Multiplier Work?
The basic premise upon which the investment multiplier works is that one individual’s expense is another person’s income. When governments spend money, a chain of consumption and expenditure increases the total income many times its original investment.
Given below are some points that will explain more clearly the working of the investment multiplier:
- When governments spend money on things like public works, it makes a large-scale expenditure, which is paid to labourers, suppliers selling raw materials, etc. Thus, this investment becomes the income for people who will spend most of the money on consumer goods.
- These consumers spend their income on consuming or buying various products or services. But, they do not end up spending the total income. Instead, as per the general practice, they save a portion of their income.
- When people spend their income to buy products, the money flows to the sellers, who in turn spend their income to purchase products and services and reserve a portion of it as savings.
- These processes create a loop of investment, expenditure, consumption and income. It continues, and as a result, the overall income keeps increasing.
- However, after every round, one will notice that income from consumption will decrease because of people’s propensity to save. This propensity is referred to as the Marginal Propensity to Save (MPS).
This process will continue until there remains no scope for further consumption and savings. After this, one can calculate the number of times the income is multiplied to know the investment multiplier.
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Investment Multiplier Assumptions
Listed below are the assumptions that were taken into account to describe the investment multiplier working above:
- First, the common assumption was that the prices of goods remained constant.
- Second, the assumption was that the economy was closed, so exports and imports were not considered.
- Third, marginal propensity to consume (MPC) was assumed to remain unchanged in the entire process.
- While explaining the working of investment multiplier, it was assumed that time lags did not occur between the increase in income and investment.
- It was assumed that industries could meet the demand instantly.
Importance of Investment Multiplier
Listed below are the reasons why the concept of investment multiplier is significant in economics:
- Investment multiplier illustrates the importance of government investments in creating employment in a country.
- This concept helps people better understand a trade cycle’s different phases.
- In addition, it plays a vital role in policy formulation.
- According to economic experts, an investment multiplier can become a remedial therapy for recovery from depression.
- It analyses the effect of investments on savings.
- It explains the wider economic impact of public projects such as the building of roads, ports and other infrastructure projects.
Investment Multiplier Formula
The most common formula that people use to calculate investment multiplier is as follows:
Investment multiplier = (Change in national income) / (Change in investment)
Note that there are other formulas to arrive at an investment multiplier using MPC and MPS.
- The formula using MPC (Marginal Propensity to Consume) is as follows:
Investment multiplier = (1) / (1-MPC)
- The formula for investment multiplier using MPS is as follows:
Investment multiplier = (1) / (MPS)
Investment Multiplier Example
This concept is illustrated with the help of an example:
Suppose a state government has invested Rs.500 crore to construct a public library. They will have to hire engineers, suppliers and labourers. This investment will lead to employment opportunities for many people. As a result, they will receive income from which they will consume, which would distribute the money among more people.
These suppliers have an MPC (Marginal Propensity to Consume) of 0.5. It means that for every Rs.1 earned, suppliers can spend Rs.0.50. In such a situation, investment multiplier is as follows:
Investment multiplier = (1) divided by (1-MPC) = 1 / (1 – 0.5) = 2
This means that for every Rs.1 invested by the government, there will be an income of Rs. 2.
Now, suppose that labourers have an MPS (Marginal Propensity to Save) of 0.2., In that case, investment multiplier would be:
Investment multiplier = 1 / MPS = 1 / 0.2 = 5
One can use the value of MPC or MPS to arrive at the total increase in income from the initial investment. We know that, investment multiplier = (change in income) / (change in investment). We also know that investment multiplier = 1 / MPS.
So, from the above example, we can say that an initial investment of Rs. 500 crore will generate the following income:
Change in income / 500 = 1 / 0.2
Change in income = 500 / 0.2
= Rs.2500 crore
As shown by this calculation, an initial investment of Rs.500 crore will generate an income of Rs.2,500 crore.
What Is the Keynesian Multiplier?
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 aftermath of the great economic depression, Keynes realised that supply may not always create demand. A lack of aggregate demand was the primary reason for the economic depression. Furthermore, Keynes noted that investments by the government generate a multiplier effect as it increases demand.
What is an Equity Multiplier?
It is a risk indicator that evaluates the portions of a company’s assets funded by the stockholder’s equity. To calculate the equity multiplier, one has to divide a company’s total asset value by total shareholders’ equity.
A high equity multiplier is indicative of the fact that a company has a higher level of debt. In contrast, a low equity multiplier means that it relies less on credit. Moreover, this multiplier is also referred to as financial leverage ratio.
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Relationship between Investment Multiplier and Marginal Propensity to Consume (MPC)
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.
Investment multiplier = 1 / 1 – MPC
A higher value of MPC will correspond to a higher value of investment multiplier and vice versa.
Final Word
Renowned economist John Maynard Keynes introduced the concept of investment multiplier. This integral part of economic theory states that an increase in investments will increase income.
People use their income to consume and save. As a result, the concepts of MPC (Marginal Propensity to Consume) and MPS (Marginal Propensity to Save) are intertwined with this multiplier.
FAQs
Ans: The minimum value of investment multiplier may be 1 when a one-time change occurs in income. On the other hand, there is no upper limit to the maximum value of the multiplier. It can be infinite when there are infinite changes in income or when MPC is 1.
However, this is theoretical, and in the real world, the marginal propensity to consume is always less than 1 and more than 0.
Ans: Leakages are diversions that hold the potential to weaken the multiplier effect of income. One of the most important leakages happens to be savings. This is because the higher the marginal propensity to save, the lower the income stream.
Ans: The continuous availability of consumer goods is the primary requisite of income generation, a major challenge in underdeveloped countries. If consumer goods are unavailable, people will not be able to spend their income.
Ans: Taxation plays an important role in the multiplier process. An increase in the level of taxation negatively affects people’s income stream, resulting in a decrease in this multiplier.
Ans: An increase in investments in one sector should not be offset by a decrease or disinvestments in a different sector. In such a situation, there will be a negative impact on income generation. As a result, the overall increase in an economy’s investment will be zero or very low.
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