INVESTMENT MULTIPLIER

What is an 'Investment Multiplier'?

An investment multiplier refers to the concept that any increase in public or private investment spending has a
more than proportionate positive impact on aggregate income and the general economy. The multiplier attempts
to quantify the additional effects of a policy beyond those immediately measurable. The larger an investment's
multiplier, the more efficient it is at creating and distributing wealth throughout an economy.
BREAKING DOWN 'Investment Multiplier'
The investment multiplier tries to determine the financial impact for a public or private project. For instance,
extra government spending on roads can increase the incomes of construction workers as well as the incomes of
the suppliers of the materials necessary for the project. These people may spend some of this extra income in
the retail sector, also boosting incomes of workers there as well. Furthermore, workers and businesses stand to
gain from access to better roads.
Logic of Investment Multiplier
 Numerical Approach

 Graphical Approach
Formula for Calculation of Multiplier
1 1 ∆
( )= = =
1− ∆
Features of Investment Multiplier
1. It is associated with change in Investment.
2. Size of Multiplier depends upon size of MPC.
3. Multiplier works in both Forward and Backward Direction
4. Value of Multiplier varies from Unity to Infinity.
Assumptions of Investment Multiplier
i. Autonomous Investment:
It comes into operation for any autonomous change in spending, viz., investment,
government spending, export and consumption.

ii. Lump-Sum Taxes:

Taxes are assumed to be lump sum only. If a portion of increased income is taxes away
at every stage of income generation the multiplier effect will be smaller.

iii. Availability of Consumption Goods:

The process of income-propagation is largely conditioned by a steady flow of mass
consumption goods.

iv. Continuity of Investment:

For the realisation of the full effect of the multiplier it is absolutely essential that the
various increments in investment are repeated at periodic intervals.

v. Positive Net Investment:

For realizing the full value of the multiplier, it is not enough for gross investment to be
positive. Gross investment to the extent of depreciation always take place in any
economy. But net investment or net addition to society’s stock of capital has to be
positive.

vi. Stability of MPC:

For the concept of the multiplier to be meaningful it is also necessary to argue that there
is no change in MPC at frequent intervals, i.e., at least during the process of income-
generation.

vii. Closed Economy:

We assume a closed economy having no trading relation with the rest of the world.

viii. No Time Lag Between Successive Expenditures on Consumption Goods:

It is argued the income changes are immediately reflected in consumption changes.
There is no lag between receipt of income and expenditure on consumption.

ix. Unemployed Resources:

Finally, Keynes argued that the multiplier principle becomes effective only when there
are unemployed resources in the economy. In other words, there must exist involuntary
idleness of resources including manpower.
Importance of Investment Multiplier
The concept of multiplier is a major contribution of Keynes to the theory of income and employment. It helps to
explain fluctuations in business activates and facilitates formulation of appropriate policies.

(1) Trade Cycle: Multiplier explains the occurrence of business fluctuations resulting from increase and
decreases in investment. An increase in investment causes revival, and a decrease in it, contraction in business
activities.

(2) Acceleration of Economic Growth: The rate of economic growth is measured in terms of increase in GDP.
Multiplier helps the state to decide the additional investment expenditure that should be undertaken to achieve
desired increase in GDP.

(3) Deficit Financing: During depression when a low rate of interest fails to revive business activities the
government can resort to deficit financing. The resources generated through deficit budget can help generate
additional employment and income in the economy.

(4) Public expenditure: The state can play an important role in promoting business activities through
additional spending, particularly when the private sector suffers from pessimism and not willing to undertake
investment
Limitations/Leakages of Investment Multiplier

(Time Lag)

Economic Application of Investment Multiplier

There are many types of people with a vested interest in quantifying the investment multiplier of a particular
project, including government officials, investors, financial analysts, real estate developers and neighbourhood
groups. Total output and job creation tend to be highest when dealing with commercial and real estate
investments because investment costs are overshadowed by a wave of economic activity. Business cycle
analysts, central bankers and policy planners study investment multipliers on an aggregate level to observe the
general flow of wealth in an economy and to better understand certain variables such as employment, prices and
the velocity of money supply. The concept of a multiplier effect is applied in many other areas, such as
unemployment benefits and tax policy.
Practical Application of Investment Multiplier
i. The Calculation of the Aggregate MPC:
It is difficult to calculate aggregate MPC. It can be calculated for changes in the level of income in the past. But
projection of the aggregate consumption function based on past data is unrealistic because the behaviour of the
people may change.

ii. A Change in the Distribution of Income:

In reality any multiplier increase in income hardly gets distributed evenly throughout the population. So, a
redistribution of income is likely. This may affect the aggregate MPC.

Thus, if a new investment project takes place in a village, where, because incomes in general have been low for
some time, the average MPC is high, the multiplier effect will be greater than if the same investment is made in
Calcutta where the MPS is high.
iii. An Induced Change in Consumption:
A multiplier increase in income may create expectation of further rises and so cause people to spend more out
of a given income and will set off further multiplier effects

iv. Induced Changes in Investment:

If we consider induced investment also, income change will be greater. A multiplier effect which increases con-
sumption and brightens investment prospects will induce increases in investment.

This, in its in turn, will lead to further multiplier process. That is, if investment like consumption depends on
income or its change, the multiplier effect will be stronger. From this proposition Sir John Hicks developed the
concept of super-multiplier.

v. An Output Lag:
If there is an output lag, i.e., if producers do not immediately increase output to meet an increase in total
demand and allow their stocks of goods to run down, the multiplier effect will be partly lost. The same thing
happens if there is consumption lag, i.e., if households who receive an increase in their income take time to
adjust their consumption habits.

vi. Business Saving:

Finally, if companies do not distribute the major portion of their profits to shareholders in the form of dividends
and increase their reserves of undistributed profits the aggregate MPS will rise and the size of the multiplier is
reduced.

Illustration
Investment multiplier (or Keynesian multiplier) is the idea that an initial investment of ₹100, will cause the total
income in the entire economy to increase by more than ₹100. Here’s an illustration of how this happens (at least
in theory).
First, assume that when people receive an increase in income of ₹100, they will spend some of the additional
income, and save the rest. For our example, let’s say people spend ₹90 out of the ₹100 of additional income.
The following is the series of events that will happen in this model.
The initial investment of ₹100 is paid to someone (let’s call her Alice), so total income in the economy
increases by ₹100.
Alice is now ₹100 richer. Based on our assumption, she will spend 90% of it, which is ₹90. Again, national
income increases by another ₹90. This ₹90 is paid to someone (let’s call him Bob), who receives it as additional
income.
Bob is now ₹90 richer and spends 90% of his additional income (₹81). He pays this to Charles who…
This goes on forever and ever.
If we add up the total increase in national income, we get
National Income=₹100+₹90+₹81+₹72.9+...
This is what mathematicians call a geometric series and there are formulas for finding the answer. This will add
up to ₹1000. So, in this case, our initial investment of ₹100 is multiplied 10 times, causing the national income
to increase by ₹100×10=₹1000.
MPC was assumed to be 0.9. Therefore, using formula also we get 10 times:
1 1 1
= = = = 10
1− 1 − 0.9 0.1
Conclusion
The effect is almost certain to be an estimate of the marginal propensity to consume out of current income than
would be obtained from a function that makes consumption dependent on current income alone. To put it in
other terms: it means that current consumption is interpreted as autonomous and dependent on current income
and hence, through the multiplier process, on investment. The result is investment multiplication, and an
inherently cyclically more stable system.

Bibliography
Websites:
 economicsdiscussion.net
 investopedia.com
 theglobaltutors.com
Books:
 Macroeconomics, Class 12 by I.D. Mangala
 Macroeconomics, Class 12 by Sandeep Garg
 Macroeconomics, Class 12 by T. R. Jain and V.K. Ohri
Expert Advice of:
 Mrs. Kusum Batra
 Mr. Sushil Bhandari
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