Question

Define investment multiplier. What is the relation between investment multiplier and marginal propensity to consume?

Hint:

The investment multiplier shows how much income will increase with an increase in investment. A higher MPC leads to a larger multiplier effect.

Answer 1

Step 1: Defining Investment Multiplier:
The investment multiplier refers to the ratio of change in national income to the initial change in investment. It shows how much income or output will increase as a result of an initial increase in investment. A higher multiplier means that the economy will experience a larger increase in income for a given increase in investment.
Step 2: Formula for Investment Multiplier:
The investment multiplier is given by the formula: \[ \text{Investment Multiplier} = \frac{1}{1 - \text{MPC}} \] Where \(\text{MPC}\) is the marginal propensity to consume. The formula shows that the multiplier effect depends on how much of additional income is consumed.
Step 3: Relation Between Investment Multiplier and MPC:
- The marginal propensity to consume (MPC) is the fraction of any additional income that is spent on consumption. A higher MPC means that consumers are spending a larger portion of their income, leading to a larger multiplier effect.
- The investment multiplier increases as the MPC increases. If people spend more of their income (higher MPC), the increase in consumption leads to a larger increase in income, amplifying the effect of investment on the economy.
Step 4: Final Conclusion:
The investment multiplier and the marginal propensity to consume are closely related. A higher MPC leads to a larger multiplier effect, as it indicates that more of the additional income will be spent, stimulating further economic activity.