investment multiplier

Investment Multiplier: Definition, Assumptions, Uses, and Leakages

Investment Multiplier

The concept of the multiplier is a component of the Keynesian theory of employment. It is a business, cycle analysis. The concept of the multiplier as a form of ’employment multiplier’ was first developed by F.A. Kahn in his article “The Relation of Home Investment to Unemployment” in the Economic Journal of June 1931 But Keynes later further refined it and propounded the concept of ‘investment multiplier’ concerning the increase in employment and output.

According to Keynes, “Investment multiplier tells us that when there is at the increment of aggregate investment, income will increase by an amount which is times the increment of investment.”

In the words of D. Dillard, “Investment multiplier is the ratio of an increased income to a given increase in investment.”

In short, the multiplier refers to the effects of changes to investment outlay on aggregate income through induced consumption expenditures. Thus, the multiplier establishes a quantitative relationship between an initial increment of investment and the resulting increase in aggregate income. In other words, it tells us how many times the income increases as a result of investment important tool of income propagation and the multiplier is the ratio of the change in income with the change in autonomous investment.

Mathematically, it is expressed as:

K =Y/l

where, K = multiplier, Y = change in income, l = change in investment

The basic idea behind the theory of multiplier is that of the induced consumption as a result of increased investment. Whenever an investment is made, the effect is to increase income not only by the amount of original investment but by a multiple of it. The initial effect of an increase in investment expenditure is the increase in income by the same amount.

But as income increases, consumption also increases. Consumption expenditure, in turn, becomes the additional income of those employed in the consumer goods industries. Thus, there is a further increase in income due to induced consumption and so on. To sum up, the investment does not increase income in the industries where investment is originally made, but also in other industries whose products are demanded by the men employed in the investment industries.

Assumptions of Multiplier

The assumptions which are implicit in the Keynesian Theory of Multiplier may be stated as under:

  • The original propensity to consume remains constant during the process of income propagation.
  • There is a change in autonomous investment and that induced investment is absent.
  • There is a closed economy unaffected by foreign influence.
  • There are no changes in prices.
  • The accelerator effect of consumption on investment is ignored.
  • There is less than a full-employment level in the economy.
  • Consumption is a function of current income.
  • There are no time lags in the multiplier process.
  • An increase (decrease) in investment instantaneously leads to multiple increases (decrease) in income.
  • The new level of investment is maintained steadily for the completion of the multiplier process.
  • There is a net increase in investment.
  • Consumer goods are available in response to effective demand for them.
  • There is surplus capacity in consumer goods industries to meet the increased demand for consumer goods in response to a rise in income following increased investment.
  • Other resources of production are also easily available within the economy.
  • There is an industrial economy in which the multiplier process operates.

Importance (Uses) of Multiplier

The main uses of a multiplier are described below:

To evaluate the extent of business cycles: is of great importance for evaluating the extent of different phases of the trade cycle and for its accurate forecasting and control.

To highlight the role of public spending: The concept of multiplier highlights the special significance of public investment or government development expenditure in achieving a high level of employment and growth rate.

To highlight the role of deficit financing: It also highlights the significance of deficit financing to accelerate the process of economic expansion.

To understand the process of equilibrium: The multiplier process helps to understand how equality between saving and investment is brought about. An increasing investment leads to an increase in income. As a result of increasing income, saving also increases and becomes equal to investment.

To formulate economic policies: The concept of the multiplier is a very useful tool for formulating suitable economic policies.

To examine the role of investment in income propagation: The concept of multiplier highlights the importance of investment as the major dynamic element in the process of income generation in the economy.

Leakages

Leakages of a multiplier are the potential diversions from the income stream which tend to weaken the multiplier effect of new investment. The process of income propagation peters out because of these leakages which are discussed below:

Saving: Saving is the most important leakage of the multiplier process. Since the marginal propensity to consume is less than one, the whole increment in income is not spent on consumption. A part of it is saved which peters out of the income stream and the increase in income in the next round declines. Thus, the higher the marginal propensity to save, the smaller the size of the income stream, and vice versa.

Undistributed Profits: If profits accruing to joint-stock companies are not distributed to the shareholders in the form of dividends but are kept in the reserve fund, it is a leakage from the income stream. Undistributed profits with the companies tend to reduce the income and hence further expenditure on consumer goods thereby weakening the multiplier process.

Taxation: Taxation policy is also an important factor in weakening the multiplier process. Progressive taxes have the effect of lowering the disposable income of the taxpayers and reducing their consumption expenditure. Similarly, commodity taxation tends to increase the prices of goods, and a part of improved income may be dissipated on higher prices. Thus, increased taxation decreases the income stream and lowers the size of the multiplier.

Debt Cancellation: If people use a part of the increment of income to repay old bank debts, then instead of spending it for further consumption, that part of the income disappears from the income stream.

Purchase of Old Shares and Securities: If a part of the newly earned income is spent on buying old stocks, shares, and securities or on financial investments, consumption will be less, and correspondingly the multiplier will be lower.

Hoarding of Cash Balance: If people prefer to hoard cash balances in the form of inactive bank deposits, with a strong liquidity preference to satisfy transaction, precautionary or speculative motives, there will be a leakage from the income stream. This type of leakage will be greater if business prospects are bad and smaller when business prospects are good. Whenever new-created money income is hoarded, it cannot reappear as income in the next round, and the multiplier effect will be arrested.

Inflation: When there is a rise in the price of consumption goods, a good part of the increased money expenditure out of the increased income will be dissipated on higher prices instead of promoting consumption, income, and employment.

Net Imports: A leakage in the domestic stream also occurs when there is an excess of imports over exports, causing a new outflow of funds to foreign countries.

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