TOPIC : THE INVESTMENT MULTIPLIER

PRESENTED BY : SURBHI SHARMA ROLL NO. : 47 (SEM-3, BBM-IB) SUBJECT : INTERNAL ASSIGNMENT FOR SEM- 2 BACKLOG.

..When we noted that consumption plus investment together determine the level of equilibrium output, we implied that a change in either of the two (C and I) would cause a change in income-level. The investment multiplier tells us how much would the change in total out put be following a given change in investment. Let us examine the process in detail..

p.t.o

..Viewed from the macro point of view, one mans expenditure is another mans income. The person who gets the income dose not spend the entire sum, but saves a part of it. So the income of the other person depends on the marginal propensity to consume of the person who gets the income. For example, let us assume that the equilibrium of the economy is at less than the full-employment level and the government decides to construct a dam under the employment guarantee scheme during a given period of time, let us assume that the government spends Rs. 10 crores (by printing new notes), on such a project. This is a new investment undertaken by the government. The money spent, in this example Rs. 10 crores, will go to the labourers in the form of wages and will be earned by others who supply cement, sand and other material required by the government for the construction of the dam. This may be in the form of commission, rent, profile, etc. this , in other words, means that the total income earned by the society as a whole has increased by Rs. 10 crores. As a result, the people who will be getting additional incomes will be spending much more than their previous expenditure.

This process of income propagation is shown in table 5.2 with the initial investment of Rs. 10 crores, the income of the people increases by the same amount immediately. During the first multiplier period, 80% of 10 crores i.e. 8 crores is spent and subsequently, the income increases bye the same amount. Thus, in the second period again 80% of 8 crores i.e. 6.40 crores, are spent. This process continues and at the end of the fifth period, the total increases in the income thus generated, would be equal to Rs. 36.892 crores. This process will continue further :INITIAL INVEST. 1 10 crores 8.O THE MULTIPLIER PERIOD 2 6.40 3 5.12 4 4.096 5 3.276 TOTAL 38.892

(THE MPC IS TAKEN TO BE = O.8) THE PCOCESS OF INCOME PROPOGATION.

..We can find out the ultimate total increase in the income of the people, at the end of the multiplier period, with the help of simple mathematics. The investment multiplier is used to fine out this ultimate increase in the income. the multiplier is the ratio of the final change in income to the initial change in investment. The multiplier gives the extent of this change. In the above example, the marginal propensity to consume was taken to be 0.8 . If it was taken to be 0.7 , the rate of increase in the income, at the end of the multiplier period, would have been less. This means that the ultimate increase in income depends on the marginal propensity to consume. The value of the multiplier therefore depends on the marginal propensity to consume.. The formula of the multiplier is as follows:

K = 1 /( 1 -

C/

Y)

The change in the investment * multiplier = final change in income In table we have added the increments in income at the end of each round of spending. If this is done till the last unit of money is spent, then the total increase will be equal to Rs. 50 crores. This can be calculated with the help of the formula of the multiplier given above. The initial increase in investment of Rs. 10 crores with different marginal propensity to consume, the value of the multiplier would be different.
MPC * 0 MULTIPLIER 1 CH. IN INITIAL (I) CH. IN INCOME. 10 10.00

0.20
0.50 0.75 0.90 0.99 1.00

1.25
2.00 4.00 10.00 10.00

10
10 10 10 10 10

12.50
20.00 40.00 100.00 100.00

From the table it would be seen that the greater the marginal propensity to consume, the greater would be the value of the multiplier; and the greater the multiplier, the greater would be the increase in the final income. The two extreme possibilities of the marginal propensity to consume are 0 and 1. But generally, the marginal propensity to consume is positive and less than one. If it is more on the side of 1, the value of the multiplier would be greater and vice versa. In the above discussion, we have purposely used the terms change in initial investment and change in income. This implies increase or decrease in the respective quantities. If there is an increase in the initial investment there would be an increase in the final income, this can be obtained by multiplying the initial investment by the multiplier. On the contrary, if there is a decrease in the initial investment, there would be decrease in the final income. This can be obtained by multiplying the initial investment by the multiplier. This
means that the multiplier functions in both directions

Saving & Invest. S 400

300
200 E

E1 I1 I

100
0 - 100 3000 3600 4000 INCOME(Rs. CR.)

..The function of the multiplier brings about a manifold increase in the flow of income. The increase in income brought about by the initial investment goes on increasing at the of every multiplier period. This is so because income generated at the of every round is spent again. But if some income leaks out from the flow of income, the effect of the multiplier is reduced. The flow of water in a pipe may continue to be constant only if there are no leakages. The following are the possible leakages in the income stream:i. Saving : if the marginal propensity to consume equals 1, the value of the multiplier would tend to infinity. This means that if investment increases by just one rupee initially, the same rupee will continue to be invested again and again happen because the people who receive additional income do not spend all of it. A part of it is always kept aside. Thus savings which are kept aside are known as leakages in the flow of income. ii. Repayment of loans : a part of the income, is many times, used for the repayment of loans. This part of the income goes out of the flow of the income because it is not spent on consumers goods.

iii.

Import Surplus : If imports are more than exports, an amount of money equivalent to the difference between the two is to be paid to the foreigners. This amount also goes out of the flow of income. iv. Inflation : If increased income result in an increase in prices and thus it cannot bring about an increase in real income and employment, this results in inflation. v. Hoarding : At times, a part of the increased income is hoarded by the people in the form of money. Obviously, that amount of money goes out of the flow of income. vi. Taxes and the corporate savings : The amount of money collected by the government as taxes and savings which are kept aside before the declaration of dividend by various companies fall out from the flow of income. vii. The purchase of securities : The amount of money used for the purchase of securities, shares, insurance policies, etc., also goes out of the flow of income. The discussion so far, is limited to the effects of the multiplier only. If savings are spent on capital goods, but here we have taken into account the multiplier effect brought about bye the expenditure on consumers goods only. If the multiplier effect is expected to bring about an increase in employment, it is essential to control these leakages.

While discussing the functioning of the multiplier, we have assumed certain conditions and the multiplier function only within the limits of these assumptions. i. Availability of consumers goods : The functioning of the multiplier is possible only if consumers goods are available. On the contrary, if there is scarcity of consumers goods, the prices only would rise. ii. Stability of investment : If the effect of the multiplier is to remain constant, there must be stability of investment. Otherwise, income will fall back to its original level. iii. The period of multiplier : Expenditure once incurred on consumers goods, gives rise to additional income. This additional income is spent on the consumers goods. The time taken for this is known as the period of the multiplier if this period is linger, the effect of the multiplier fades out. iv. Time lags : While measuring the effect of the multiplier, it is always assumed that there is no time-lag between the accruing of income and expenditure of that income. In practice, we see there is always a time-lags between the two the greater the time lag, the smaller the effect of the multiplier of income. v. Involuntary unemployment : Only if there is under-employment output and income. The concept of the investment multiplier serves as an important tools in explaining business cycles as will as a policy for full employment.