Question
Explain the concept of investment (or output) multiplier.
or
Explain working of investment multiplier with the help of a numerical example.
or
Explain how an increase in investment affect level of income.
Solution
Meaning. Multiplier (K), is the ratio of increase in national income (ΔY) due to an increase in investment (ΔI). Put in symbols:
Where K = Investment, ΔY = Change in income, ΔI = Change in investment.
Increase in investment causes increase in income. But increase in income is not to the same extent as in investment rather it increases by a multiple of increase in investment. The number of times by which income increases as a result of increase in investment is called investment multiplier. In other words, investment multiplier shows a relationship between initial increment in investment and the resulting increment in national income. Suppose if an increase in investment of र 50 crores causes an increase in national income of र 300 crores, then value of multiplier would be 6 (=,300/50), This equals increase in income divided by increase in investment The implication of K = 6 is that for any level of change in investment in the economy, income will change 6 times of investment amount.
Investment multiplier indicates the multiplying effect of investment on income.
Working of Multiplier, Let it be known that multipler works through consumption. How? The concept of multipler is based on the fact that from economics point of view expenditure of one person is another person's income, e.g., expenditure of A is income of B; B's expenditure is income of C; C's expenditure is income of D and so on until expenditure becomes zero. Suppose government invests र 100 crores more in expansion of a fertilizer factory. The first impact of this additional investment will be that the income of employees engaged in this factory will go up by र100 crores. If their marginal propensity to consume (MPC) is 3/4 or 75%, they will spend र 75 crores (3/4 of 100) on new consumption goods. This is not the end of story. The consumption expenditure will give an extra income of र 75 crores to the producers of these goods who, in turn, will spend र 56.25 crores (3/4 of 75) on consumption expenditure. So this process will go on with each round of expenditure being 3/4 of the previous round till consumption expenditure becomes nil In other words, the process of increase in income stops when change in income (ΔI) becomes equal to change in saving (ΔS), i.e., ΔI = ΔS. This process of working of multiplier is further clarified in the following table. This is based on the assumption that initial increase in investment = र 100 crores and MPC = 7.5% (or 3/4).
The above table clearly shows that initial increase in investment of र 100 crores has resulted in an increase of additional income of र 400 crores, i.e., resultant increase in income is multiple of initial increase in investment. Thus here multiplier (K) = 400/100 = 4 or
(Multiplier acts also in reverse direction as decrease or withdrawal of investment, causes a multiple decrease in income.)
Graphic Representation of Multiplier. The effect of multiplier can be illustrated with the help of the adjoining graphical Fig. 8.9. Here OX measures national income and OY saving and investment. Saving curve SS intersects original investment curve II at E. At the equilibrium point of E, saving and investment are equal and income is र 300 cores. But when investment is increased by र 10 crores, the new investment curve IT intersects saving curve SS at E1. At the new equilibrium point E', national income is र 340 crores. This shows that with investment increase of र 10 crores, national income has increased by र 40 crores. The increase in investment is shown by a small arrow whereas increase in national income by a long arrow. This indicates that national income has increased by four times the
increase in investment, i.e., value of K is
Where K = Investment, ΔY = Change in income, ΔI = Change in investment.
Increase in investment causes increase in income. But increase in income is not to the same extent as in investment rather it increases by a multiple of increase in investment. The number of times by which income increases as a result of increase in investment is called investment multiplier. In other words, investment multiplier shows a relationship between initial increment in investment and the resulting increment in national income. Suppose if an increase in investment of र 50 crores causes an increase in national income of र 300 crores, then value of multiplier would be 6 (=,300/50), This equals increase in income divided by increase in investment The implication of K = 6 is that for any level of change in investment in the economy, income will change 6 times of investment amount.
Investment multiplier indicates the multiplying effect of investment on income.
Working of Multiplier, Let it be known that multipler works through consumption. How? The concept of multipler is based on the fact that from economics point of view expenditure of one person is another person's income, e.g., expenditure of A is income of B; B's expenditure is income of C; C's expenditure is income of D and so on until expenditure becomes zero. Suppose government invests र 100 crores more in expansion of a fertilizer factory. The first impact of this additional investment will be that the income of employees engaged in this factory will go up by र100 crores. If their marginal propensity to consume (MPC) is 3/4 or 75%, they will spend र 75 crores (3/4 of 100) on new consumption goods. This is not the end of story. The consumption expenditure will give an extra income of र 75 crores to the producers of these goods who, in turn, will spend र 56.25 crores (3/4 of 75) on consumption expenditure. So this process will go on with each round of expenditure being 3/4 of the previous round till consumption expenditure becomes nil In other words, the process of increase in income stops when change in income (ΔI) becomes equal to change in saving (ΔS), i.e., ΔI = ΔS. This process of working of multiplier is further clarified in the following table. This is based on the assumption that initial increase in investment = र 100 crores and MPC = 7.5% (or 3/4).
The above table clearly shows that initial increase in investment of र 100 crores has resulted in an increase of additional income of र 400 crores, i.e., resultant increase in income is multiple of initial increase in investment. Thus here multiplier (K) = 400/100 = 4 or
(Multiplier acts also in reverse direction as decrease or withdrawal of investment, causes a multiple decrease in income.)
Graphic Representation of Multiplier. The effect of multiplier can be illustrated with the help of the adjoining graphical Fig. 8.9. Here OX measures national income and OY saving and investment. Saving curve SS intersects original investment curve II at E. At the equilibrium point of E, saving and investment are equal and income is र 300 cores. But when investment is increased by र 10 crores, the new investment curve IT intersects saving curve SS at E1. At the new equilibrium point E', national income is र 340 crores. This shows that with investment increase of र 10 crores, national income has increased by र 40 crores. The increase in investment is shown by a small arrow whereas increase in national income by a long arrow. This indicates that national income has increased by four times the
increase in investment, i.e., value of K is
