Question

Explain and illustrate Keynes’ investment multiplier. Use suitable diagram.

Answer 1

The concept of the investment multiplier can also be illustrated with the help of a diagram. In this figure, income is represented on the X-axis, while desired aggregate expenditure (i.e., consumption plus investment) is shown on the Y-axis.

Initially, the economy is in equilibrium at point E₀, where the aggregate expenditure curve AE₀ intersects the 45° line (which represents points where income equals expenditure). The corresponding level of income is OY₀.

When there is an increase in autonomous investment (ΔI), the aggregate expenditure curve shifts upward from AE₀ to AE₁. This upward shift is equal to the increase in investment. At the original income level Y₀, the new desired spending is now higher due to this added investment. As a result, income begins to rise.

A new equilibrium is established at point E₁, where the new aggregate expenditure curve AE₁ intersects the 45° line. The new equilibrium level of income is OY₁.

Thus, an increase in investment by ΔI (equal to E₁M) leads to an increase in income from Y₀ to Y₁ (equal to E₁N). As shown in the diagram, the increase in income (E₁N) is larger than the initial increase in investment (E₁M). This demonstrates that the multiplier is greater than one, meaning that a small change in investment leads to a larger change in national income.

Thus, 

K = `(DeltaY)/(DeltaI)=(E_1N)/(E_1N)>1`

This indicates that a specific autonomous increase in investment results in a larger increase in income than the initial amount invested.