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.
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.
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:
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.
Listed below are the assumptions that were taken into account to describe the investment multiplier working above:
Listed below are the reasons why the concept of investment multiplier is significant in economics:
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.
Investment multiplier = (1) / (1-MPC)
Investment multiplier = (1) / (MPS)
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.
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.
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.
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.
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.
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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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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