Question

A given increase in autonomous investment will, in general, cause an increase in income larger than the initial increase in investment. Why? Explain in detail.

Answer 1

Yes, a given increase in autonomous investment generally causes a more than proportional increase in income due to the multiplier effect, a fundamental concept in Keynesian economics.

Autonomous investment is the portion of total investment that is independent of income or output levels. It is influenced by factors such as:

• Government spending on infrastructure,
• Technological innovations,
• Business expectations,
• Social or policy objectives.

This type of investment doesn't change with the level of national income and is considered an injection into the circular flow of income.

The answer lies in the concept of the investment multiplier. This explains how an initial increase in investment leads to a chain reaction of increased consumption and hence, a multiplied increase in aggregate income.

1. Initial Investment: Suppose the government invests ₹100 crore in road construction.
2. Income Generation: The workers and suppliers involved earn income from this project.
3. Increased Consumption: These income earners spend a portion of their earnings on goods and services.
4. Further Income Generation: The recipients of this spending now earn income and spend a portion of it again.
5. Repetition: This process continues in multiple rounds, each time smaller than the previous one due to leakages like savings, taxes, and imports.

The marginal propensity to consume (MPC) determines the strength of the multiplier. The formula is:

Multiplier (K) = `1/(1-MPC)`

MPC is the fraction of additional income that households consume rather than save.

Example:

If MPC = 0.8, then:

K = `1/(1-0.8)`

= `1/0.2`

= 5

So, an increase of ₹ 100 crore in autonomous investment leads to:

ΔY = K × ΔI 

= 5 × ₹ 100 crore

= ₹ 500 crore