Question

Explain investment multiplier. If MPS = 0.04, what is the value of multiplier? If the value of MPS = 0.4, how would the level of income be affected?

Answer 1

The investment multiplier refers to the ratio of the change in national income to the initial change in investment. It explains how a small increase in investment results in a multiple increase in income through repeated rounds of spending and consumption.

The formula for the multiplier (K) is:

K = `1/(1 - MPC)` or K = `1/(MPS)`

Where

MPC = Marginal propensity to consume

MPS = Marginal propensity to save

K = Multiplier

There is a direct relationship between MPC and the multiplier and an inverse relationship between MPS and the multiplier. That is a higher MPC or lower MPS gives larger multiplier

Given: MPS = 0.04

K = `1/(MPS)` 

= `1/0.04`

= 25 

So, if MPS is 0.04 the value of the multiplier is 25.

This means any increase in investment will increase income 25 times that amount.

If MPS = 0.4

K = `1/(MPS)` 

= `1/0.4`

= 2.5

This means the multiplier is now only 2.5, so the increase in income will be much smaller for the same amount of investment.

Conclusion: When MPS increases (from 0.04 to 0.4), the multiple decreases (from 25 to 2.5). As a result, the level of income will be affected negatively. i.e., the increase in income due to investment will be much smaller.