The Investment Multiplier theory was first proposed by economist John Maynard Keynes. An essential concept, it helps us understand how an investing decision significantly changes a country’s overall economic growth. It describes how an initial investment can lead to a more effective return.
Investment Multiplier is a crucial tool for policymakers and investors to make informed decisions on issues such as government spending and tax policy. In this blog, we will take a closer look into the working of investment multipliers, formulas, and examples.
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What is an Investment Multiplier?
An investment multiplier refers to the way in which a change in investment spending can cause a larger change in the overall Gross Domestic Product(GDP). It is a measure of the effect that a change in investment spending can have on overall economic activity.
The Keynesian theory of investment multipliers also states that when companies invest in new businesses it creates income for the workers who work in that business. The income generated can then be invested in other products and services, which will create a huge effect on the economy.
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Working of Investment Multipliers
By understanding how an investment multiplier works, you can gain insights into how changes in investment spending can lead to a magnified effect on economic activity.
The working of investment multipliers can be illustrated in the following steps:
- When a business chooses to invest in new capital goods, such as machinery or equipment, it increases investment spending in the economy.
- The production of these capital goods requires labor and raw materials, which creates income for workers and suppliers in the form of wages, salaries, and profits.
- The workers and suppliers who receive this income can then use it to purchase other goods and services, such as groceries or clothing, and make an impact on the economy.
- The businesses that produce these goods and services also require labor and raw materials. This creates more income for workers and suppliers.
- This process continues in a chain reaction, and each increase in spending creates more income.
- Due to the multiplier effect of additional spending, the overall impact of investment spending is thus significantly more than the initial amount invested.
The size of the investment multiplier depends on several factors, including the Marginal Propensity to Consume (MPC), the fraction of additional income spent on consumption, and the marginal tax rate.
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Investment Multiplier Formula
The investment multiplier formula is used to calculate the total impact of changes in investment spending on the overall economy.
The formula of an investment multiplier is mentioned below:
Multiplier = 1 / (1 – MPC)
Here, MPC stands for the marginal propensity to consume, which is the fraction of additional income spent on consumption.
The Investment Multiplier formula calculates the total impact of such an effect by taking into account the marginal propensity to consume. It indicates that this process considers how much the additional income generated by the initial investment will be spent on other products and services rather than saved.
Investment Multiplier Numerical Example
Let’s assume that a business decides to invest Rs. 500 crores in new capital goods.
We can calculate the impact of this investment on the economy using the Investment Multiplier formula:
Multiplier = 1 / (1 – MPC)
Suppose the MPC in this economy is 0.75.
So, the Investment Multiplier can be calculated as,
Multiplier = 1 / (1 – 0.75) = 4
It means that for every Rs. 500 crore increase in investment spending, there will be a Rs. 2000 crore increase in overall economic output or GDP.
Now let’s see how this works in practice.
When the business invests Rs. 500 crores in new capital goods, this creates income for workers and suppliers in the form of wages, salaries, and profits.
Let’s assume that the workers and suppliers who receive this income spend 75% of it on other goods and services in the economy.
So, out of the initial Rs. 500 crores invested, Rs. 375 crores is spent on other goods and services, creating income for other workers and suppliers. These workers and suppliers, in turn, spend 75% of this income on other goods and services, creating more income for others. This process continues, with each increase in spending creating more income and leading to more spending.
Based on the investment multiplier formula, we can calculate the total impact of the initial Rs. 500 crores investment as follows:
Total Impact = Initial Investment x Multiplier
Total Impact = Rs. 500 crores x 4
Total Impact = Rs. 2000 crores
Therefore, the initial investment of Rs. 500 crore leads to a total impact of Rs. 2000 crore on the economy, highlighting the significant influence of the investment multiplier.
The investment multiplier shows us that even small investments can have a significant effect on the economy, and that’s why it’s essential to understand the workings. Using the investment multiplier formula and investing smartly in a business can help build a better future for both individuals and communities.
It is a magical spark that ignites a chain reaction of economic growth and benefits everyone. So, the next time you think about investing in your business, remember the investment multiplier and its powerful effects.
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