Q. 235.0( 1 Vote )

How an initial in

Answer :

It is the multiplier effect the initial investment will affect the level of income of the economy. The value of the multiplier is determined by the marginal propensity to consume. The higher the marginal propensity to consume higher will be the multiplier. Investment multiplier shows the relationship between the change in investment and the change in income. It shows how a small change in the investment will cause multiple changes in the level of income. It was introduced by J M Keynes.


The investment multiplier shows the number of times the income will get multiplied with a small initial change in the investment. According to Keynes, when there is an increment of investment, income will be increased by an amount that is K times the increase in investment. Thus, K is the investment multiplier.


The value of the investment multiplier is determined by the value of Marginal Propensity to Consume (MPC). The size of the multiplier directly varies with the value of MPC. Higher the MPC, higher will be the size of the multiplier and vice-versa. Its value can range between 1 and infinity.


Suppose investment expenditure by the government is equal to Rs. 100 crores.


The total cost will amount to Rs. 100 crores. The spending of the government will increase the incomes of the people equal to Rs. 100 crores. The people who receive Rs. 100 crores will spend a good part of them on consumer goods. Assume that marginal propensity to consume of the people in the economy is 0.8 which is 80% of the total income.


Then out of Rs. 100 crores they will spend Rs. 80 crores on consumer goods, which would increase incomes of those people who supply consumer goods equal to Rs. 80 crores. But those who receive these Rs. 80 crores will also, in turn, spend these incomes, depending upon their marginal propensity to consume. Since marginal propensity to consume is 0.8, then they will spend Rs. 64 crores on consumer goods. Thus, this will further increase incomes of some other people equal to Rs. 64 crores.


This process will continue to the income of the people in the economy is increased. Therefore with the initial investment 100crore, the income of the economy has been multiplied to the greater volume because of MPC.


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