Investment Multiplier At a Glance

The working of the Multiplier assumes the following process:

multipler-process

Change in investment causes change in income. As a result, consumption changes. Consumption expenditure of one person is an income of the other.

Hence, change in consumption leads to change in income. This process continues till ∆C falls to zero.

MPC is the core factor in the process of income generation. Higher the MPC, greater is the conversion of income into consumption expenditure. Accordingly, greater is the generation of income. As, it is expenditure that is converted into income.

Expenditure is the injection into the income generation process, saving is the leakage.

For Detailed Study -

1. Investment Multiplier

2. Graphic Presentation of Multiplier

How Multiplier Mechanism Works

Let us understand the logic behind the direct relationship between MPC and multiplier through Multiplier Mechanism. It runs like this:

1) Suppose AB industry limited spends Rs. 100 crore in setting up a new plant i.e  ∆I = Rs. 100 crore.

This will lead to creating more demand for goods and services required for the setting up of this new plant. There will more demand for machinery, raw materials, labour etc.

This will generate income for all those people who are associated with the setting up this plant and leading to more output and income.

As a result national income in the first will increase by an amount equal to amount of investment i.e  ∆Y = Rs. 100 crore

2) This ∆Y = Rs. 100 crore would be split into ∆C and ∆S as a part of income is spent and a part of it is saved.

3) In round – 2, ∆C would be converted  into ∆Y as people who receive this new income (Rs. 100 crore) directly from the building of the factory will spend some of it on consumer goods like food, clothing, TV, cars, etc.

Here comes an important point:

The exact amount of additional consumption expenditure depend on the MPC(c).

Suppose MPC is 0.8, then 

MPC = ∆C / ∆Y (as discussed in consumption function)

∆C = MPC (∆Y)

∆C = 0.5(100)

     = Rs. 50 crore

If  MPC is 0.4, then

∆C = 0.4(100)

     = Rs. 40 crore

Derivation of Investment Multiplier Formula

The multiplier formula can be derived by using the simple equilibrium condition for the two sector model i.e  

Y = C + I 

When there is an increase in investment by (∆I), it will lead to increase in income (∆Y) and this induces increase in consumption (∆C) i.e

∆Y = ∆C + ∆I 

Since, change in total consumption (∆C) equals change in income multiplied by MPC (marginal propensity to consume, “c”)

∆Y = c∆Y + ∆I

∆Y - c∆Y = ∆I

∆Y(1-c) = ∆I

∆Y = ( 1 / 1-c)  ∆I 

∆Y/ ∆I = 1 / 1-c

Tabular explanation of Consumption function

Consumption function depends on income. It is directly related to the level of income. It increases as income increases. However, there is always some minimum level of C (consumption) irrespective of level of Y. Also, increase in C tends to lag behind the increase in Y. Because, after certain level of Y is reached, people start saving a part of Y. As shown below:

Y(Rs)	C (Rs)
0 20 40 60 80 100 120	30 35 40 45 50 55 60

The above table shows:

1) 30 is the minimum level of C even when Y = 0. Survival requires that C be at least 30 even with zero income. The level of consumption at zero level of income is called autonomous consumption.

Consumption Function

The amount of money spent by the people on the purchase of goods and services in order to satisfy their wants directly is called consumption expenditure. 

Consumption function or propensity to consume shows the relationship between total desired consumption spending by the households and the factors that determine it. The factors that can affect consumption of a person are income, rate of interest, wealth, liquid assets, future expectation about income, consumer credit, distribution of income, etc.

However among all the factors mentioned above Income is considered to be a major factor of propensity to consume.

Keynesian theory of consumption function, therefore, shows the functional relationship between the desired consumption expenditure and income.

Propensity to consume has two aspect:

1) Average propensity to consume

2) Marginal propensity to consume