Investment Multiplier

Its working and leakages, Importance and critique

ASSIGNMENT

Himachal Pradesh National Law University

Submitted By Submitted To
Ayush Thakur Dr Hari Chand Thakur
1020202137 Economics Professor

BA LLB Sem 2nd

 Acknowledgements

I wish to take this opportunity to offer my sincere gratitude to

my academic supervisor, Dr Hari Chand Thakur, Professor
(Economics), Himachal Pradesh National Law University,
Shimla. Without his kind direction and proper guidance, this
study would have never come to fruition.
I am also greatly indebted to Himachal Pradesh National Law
University’s e-library resources for providing me with the
necessary online subscriptions in order to conduct this
research which helped me in making this assignment,
especially in these trying times when the physical resources of
the library are inaccessible.
Last but not the least; I would want to thank everyone who
guided me throughout the process of making this study a
successful venture.
 INDEX

1) Concept of Investment Multiplier

2) Relationship between Multiplier and MPC

3) Assumptions of Investment Multiplier

4) Working of Investment Multiplier

5) Leakages or Limitations of the Investment Multiplier

6) Importance of the Investment Multiplier

7) Case Study
 Concept of Investment Multiplier

Keynes in his theory of income determination made the prediction

that change in autonomous expenditure caused by an alteration in any
desired expenditure function will cause a change in national income.
The change in income is larger than or a multiple of the initial change
in expenditure.
Following Keynes, we may now consider a change in investment
expenditure, which gives rise to the famous multiplier concept.
Multiplier expresses the relationship between an initial increment in
investment and the resulting increase in aggregate income. It tells us
how many times the income of the consumer increases as a result of
an increase in the investment.
The multiplier concept that Keynes developed goes by the name
investment multiplier. It is the number by which the change in
investment (∆I) has to be multiplied to find out the resulting change in
national income (∆Y)

M = ∆Y/∆I = Change in income/change in investment

 Relationship between Multiplier and MPC

The concept of multiplier is based on the fact that the expenditure of

one person is an income of another person. When investment
increases, it also increases income of people.
People spend a part of their increased income on consumption and it
depends upon MPC.
There exists a direct relationship between MPC and multiplier. Higher
the MPC, more will be the value of multiplier and vice-versa.

Let us understand the logic behind the direct relationship between

MPC and multiplier. It runs like this:
• Additional investment (del I) means additional expenditure in the
economy; additional expenditure means additional income (del Y)
in the economy.
• Thus, if del I = 100, then del Y = 100, as soon as investment
expenditure is incurred.
• Let us take this del Y as increase in income in the round-1.
• This del Y (=100) would be split into del C and del S. Because a
part of income is spent and a part of it is saved.
• In round-2, del C would be converted into del Y (because del C is
expenditure and expenditure cause income).
Here, comes an important point:
Higher value of MPC would mean higher del C.
Example: If MPC = 0.4, then del C = 0.4(100) = 40.
If MPC = 0.6, then del C = 0.6(100) = 60.
Accordingly, del Y in round-2 (which is equal to del C) would depend
on the value of MPC. Higher MPC would mean higher del Y.
• Conversion of del C into del Y continues in various rounds. And,
in all the rounds, higher MPC would cause higher del C and
therefore, higher del Y.
• Hence the conclusion that, higher the value of MPC, higher is the
generation of income caused by a given increase in investment. Or
that, higher the MPC, higher is the value of investment multiplier.1

1
T.R. Jain and Dr. V.K. Ohri, Introductory Macroeconomics 225-227 (Edition: 2020-21).
 Assumptions of Investment Multiplier

i. Autonomous Investment:
It comes into operation for any autonomous change in spending, viz.,
investment, government spending, export and consumption.

ii. Lump-Sum Taxes:

Taxes are presumed to be lump sum only. If a percentage of increased
income is taxes away at every phase of income generation the
multiplier effect will be smaller.

iii. Availability of Consumption Goods:

Another significant assumption in multiplier theory is that there is
overcapacity in the consumer goods industry, so as demand increases,
more quantities of consumer goods can be produced to meet that
demand. If there is no excess capacity in consumer goods industries,
the increase in demand as a result of an initial increase in investment
will lead to an increase in prices rather than an increase in real
income, output and employment.

iv. Continuity of Investment:

To realize the full effect of the multiplier it is absolutely essential that
the various augmentations in investment are repeated at periodic
intervals.

v. Positive Net Investment:

we have presumed that there is a net increase in investment in a
period and that there are no further indirect effects on investments in
this period or, if they occur, have been taken into account in such a
way that there is a given net increase in investment.

vi. Stability of MPC:

We have presumed that the marginal propensity to consume remains
constant over several consumption rounds as income rises. However,
the marginal propensity to consume may differ in several rounds of
consumer spending. But, this consistency of marginal propensity to
consume is a realistic assumption. This is assumed because all
available experiential evidence shows that the marginal propensity to
consume is very stable in the short term.

vii. Closed Economy:

We assumed a closed economy, that is, we did not consider imports
and exports. If our economy were an open economy, some of the
increase in consumer spending would be due to imports of goods from
abroad. This would have caused an increment in income in foreign
countries rather than within the country. This will decrease the value
of the multiplier. Imports are a big leak from the multiplier process,
and we ignored them for the sake of simplicity.

viii. No Time Lag Between Successive Expenditures on Consumption

Goods:
We have also assumed that there is no time lag between the increase
in investments and the resulting increase in income, that is, the
increase in income occurs immediately due to the increase in
investments.2

2
M. Agarwal, Multiplier Keynesian: Its Working, Operation, Importance and Criticism, Investopedia,
https://www.economicsdiscussion.net/keynesian-economics/multiplier-keynesian/multiplier-keynesian-its-
working-operation-importance-and-criticism/7806 .
 Working of Investment Multiplier

(i) The table above shows that as a result of initial increase in

investment by Rs 100 crore, there is increase in income by Rs 100
crore in round-1. Our assumption is that MPC is 0.5. Hence, because
of the increase in income by Rs 100 crore, consumption will increase
by Rs 50 crore and remaining Rs 50 crore will be saved.

(ii) In round-2, because of expenditure of Rs 50 crore on

consumption, there will be an increase in income by Rs 50 crore.
Now, del Y (= Rs 50 crore) would be split into del C = Rs 25 crore
and del S = Rs 25 crore.

(iii) On account of increase in consumption expenditure by Rs 25

crore, there will be increase in income by Rs 25 crore in round-3.
Now, AV (= Rs 25 crore) would be split into AC = Rs 12.5 crore and
AS = Rs 12.5 crore. Accordingly, in round-4 income will increase by
Rs 12.5 crore.
(iv) In different time periods, as shown in the table, income will go on
increasing as a result of increase in consumption expenditure. Total
increase in income = Rs 200 crore.
Since, increase in investment (AI) = Rs 100 crore, and increase in
income (AV) = Rs 200 crore, it follows that multiplier = 2.

Obviously, higher MPC would have caused greater increase in

income, implying a higher value of multiplier. 3

3
Supra 1, from 228 – 229.
 Leakages or Limitations of the Investment
Multiplier

1. Paying off debts:

The first leakage in the multiplier process befalls in the form of
payment of debts by the people, especially by businessmen. In the real
world, all income received by the people as a result of some increase
in investment is not consumed. A part of the increment in income is
used for paying back the debts which the people have taken from
moneylenders, banks or other financial institutions.
The incomes used for paying back the debts do not get spent on
consumer goods and services and therefore leak away from the
income stream. This reduces the size of the multiplier. Of course,
when incomes received by the moneylenders, banks or institutions are
again lent back to the people, they come back to the income stream
and enhance the size of multiplier. But this may or may not happen.

2. Holding of idle cash balances:

When people keep some of their income growth as idle credit and not
use it for consumption, they also represent a leak in the multiplier
process. As we have seen, people keep some of their income to satisfy
their reasons for caution and speculation. Money saved for such
purposes is not consumed and therefore does not appear in successive
rounds of consumer spending, thus reducing the increase in total
income and production.

3. Imports:
In our previous analysis of how the multiplier process works, we took
the example of a closed economy, that is, an economy with no foreign
trade; When the economy is open, as is so often the case, part of the
increase in income is also spent on importing consumer goods. The
importation of consumer goods will generate income in other
countries and will not help to increase income and production in the
national economy.
Therefore, imports constitute another important leakage in the
multiplier process.
Suppose marginal propensity to save of an open economy is 1/4, i.e.,
marginal propensity to consume is 3/4.
Further, that marginal propensity to import is 1/4, the size of the
multiplier without imports will be equal 4 to equal to 4 but the size of
the multiplier with the marginal propensity to import equal to 1/4 and
the marginal propensity to consume equal to 3/4 will be smaller.
Multiplier in an Open Economy = 1/ 1 - (MPC-MPI) = 1/1 - MPC +
MPI where MFC stands for marginal propensity to consume and MP1
for marginal propensity to import.
In our example quoted above, where marginal propensity to consume
is equal to 3/4 and marginal 3/4 propensity to import is equal to 1/4,
the multiplier is: K = 1/1- (3/4 – 1/4) = 1/1/2 =2
We, therefore, see that the size of multiplier instead of being equal to
4, as it would have been in the case of a closed economy, is equal to 2
in the open economy with — as the marginal propensity to import.

4. Taxes:
Taxes are another important factor in the multiplier process. As a
result of the increase in investment, some of them are also used to pay
taxes, so the money used to pay taxes does not appear in successive
rounds of consumer spending in the multiplier process and the
multiplier is reduced to that extent. However, when the government
spends the money raised through taxes, the tax loss is offset by
increased public spending. However, it is not required that all of the
money raised through taxes be spent by the government, as is the case
with a budget surplus. Undoubtedly, increasing government spending
by a taxable amount would not have an adverse effect on the tax
increase. Income and investment and that way there would be no
leakage in the multiplier process.

5. Price increase:
Price inflation is another important leak in the real multiplier process;
the multiplier only works in real terms if, as a result of an increase in
money income and overall demand, the production of goods also
increases. If the production of consumer goods cannot easily be
increased, then part of the increase in monetary income and aggregate
demand increases the prices of the goods, not their production, so that
the multiplier is reduced by the amount of price inflation. As in India,
the additional income and demand is mainly spent on food crops, the
production of which cannot be easily increased.
Hence, increases in demand raise the prices of goods more than
increases in their production. In India, there is hardly any
overcapacity in many consumer goods industries, particularly
agriculture and other wage industries. As a result of an increase in
investments, it generally makes these goods more expensive than their
production and thus weakens the real functioning of the multiplier.
This is why it has often been claimed in the past that the Keynesian
multiplier theory is of little relevance for the conditions in developing
countries like India.
However, we will argue later that this old view of how the Keynes
multiplier works is not entirely true. The various previous leaks
reduce the multiplier effect of the investment made. If these leaks are
plugged, the impact of the change in investment on income and
employment would be greater.4

4
Supra 2.
 Importance of the Investment Multiplier

The introduction of multiplier analysis to income theory is one of

Keynes' seminal contributions as it not only enriched economic
analysis, but also profoundly influenced economic policy. “It is true
that Keynes did not discover the multiplier that the honour belongs to
Mr. Kahn, but he gave it the role it plays today by moving it from an
instrument for road construction analysis to an instrument for analysis
converted the "income building".
We now have a theory, or at least a solid start, on income generation
and spreading that is great and easy. It has blown a breath of fresh air
through the structure of economic thought. "From the above
qualifications and limitations, it should never be concluded that the
concept of the multiplier is of little use. Despite the structures, the
multiplier was of great importance for both economic theory and
politics as the most important dynamic element of the economy, not
only pointing to direct job creation, but also showing that income is
being generated throughout the system like a rock making waves in a
lake.
On the practical economic policy side, this is of the utmost
importance as the case of public investment has been further
strengthened with the introduction of this concept. tells us that a small
increase in investment leads to a large increase in investment and
employment. Knowing the multiplier is crucial in the course of
business cycle studies and for its accurate prediction and control. A
tool for pursuing an adequate employment policy. So, we find that the
multiplier theory has revolutionized the thinking of economists and
political decision-makers almost virtually. With this concept, the
approach has radically shifted from hands-off to public sector growth
in virtually every country in the world.
 Case Study

Estimable Fiscal Multipliers for India

Fiscal multiplier, defined as a ratio of a change in output to an

exogenous change in a fiscal variable (viz., government
expenditure/taxation or both), measures the short-term impact of
discretionary fiscal policy on output.

Analysis
It is important to note that revenue expenditure multipliers for the
central and state governments are less than unity. If revenue
expenditure is increased by one rupee, government final consumption
expenditure also increases by one rupee, which increases the output
by the same amount, provided capital expenditure remains
unchanged. This also induces a positive impact on consumption
demand.
Empirical estimates, however, suggest that there exists a negative
relationship between revenue and capital expenditure, given the
budget constraint. Consequently, an increase in revenue expenditure
by the central and state governments reduces capital expenditure
which, in turn, impacts private investment negatively, offsetting the
positive effects emanating from the consumption channel and
eventually increasing output only by 45 paise and 82 paise,
respectively.
In contrast, the capital expenditure multiplier is well above unity for
both the central and state governments: 3.25 for the central
government and 2.0 for state governments. This indicates that an
increase in capital expenditure by the central and state governments
by one rupee each crowds in private investment, induces a more than
proportionate increase in investment in the economy, and leads to an
increase in output by 3.25 rupees and 2.0 rupees, respectively. 5

References
1) T.R. Jain and Dr. V.K. Ohri, Introductory Macroeconomics 225-227 (Edition: 2020-21).

2) M. Agarwal, Multiplier Keynesian: Its Working, Operation, Importance and Criticism, Investopedia,
https://www.economicsdiscussion.net/keynesian-economics/multiplier-keynesian/multiplier-
keynesian-its-working-operation-importance-and-criticism/7806 .

3) RBI. (2019). Monetary Policy Report – April 2019. Mumbai: RBI.

5
RBI, Government of India, Monetary Policy Report – April 2019, available at
https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=18941#3CPB31, last seen on 31/5/2021.
 Plagiarism Report

Plagiarism – 20% + 15% / 2 = 17.5%