Question

Explain the determinants of size and working of the investment multiplier.

Answer 1

1. Marginal propensity to consume (MPC): This is the most important determinant of the multiplier. A higher MPC means people spend a larger portion of any additional income, resulting in a greater multiplier effect. Conversely, a low MPC means more savings and less spending, reducing the multiplier. The multiplier is calculated using the formula: 
   Multiplier (K) = `1/(1-"MPC")`
2. Availability of consumer goods: If goods and services are readily available in the economy, increased income leads to more consumption and hence, a higher multiplier effect. However, if there is a shortage of goods, even people with higher income may not be able to spend more, which limits the multiplier.
3. Existence of excess capacity: If industries have spare capacity, they can increase production when demand rises, which strengthens the multiplier. However, if the economy is already at full capacity, increased demand leads only to higher prices (inflation), not more output, reducing the multiplier’s effect.
4. Leakages from the income stream: Leakages are portions of income not spent on domestic goods and services, such as savings, taxes, imports, and hoarding. These reduce the flow of money in the economy and weaken the multiplier effect. Greater leakages lead to a smaller multiplier.
5. Time lags in spending: If there are delays in spending, the multiplier works slowly. Immediate spending leads to faster and stronger effects.
6. Inflationary conditions: If prices are rising rapidly, the real value of income falls, and the multiplier’s impact on real output and employment weakens.