Question

Explain the process of working of Investment Multiplier, for a hypothetical economy with Marginal Propensity to Consume (MPC) as 0.8 and Incremental Investment as ₹ 2,500 crore.

Hint:

Round by round, income rises by MPC times the previous round, so the total is 2,500 / (1 - 0.8) = Rs. 12,500 crore and the multiplier is 5.

Answer 1

Step 1: Understand the idea behind the multiplier:
The investment multiplier works because one person spends what another person earns.
When investment rises, someone gets that money as income. A part of it is spent again, and it becomes income for the next person.
This chain goes on round after round, so the final rise in national income is a multiple of the first rise in investment.

Step 2: Note the given data:
Marginal Propensity to Consume (MPC) is 0.8, so 80 percent of every extra rupee of income is spent.
Marginal Propensity to Save (MPS) is 1 - 0.8 = 0.2, so 20 percent is saved.
The first rise in investment is Rs. 2,500 crore.

Step 3: Follow the rounds one by one:
Round 1: Rs. 2,500 crore of new investment becomes income. People spend 0.8 x 2,500 = Rs. 2,000 crore and save Rs. 500 crore.
Round 2: The Rs. 2,000 crore spent becomes income of others. They spend 0.8 x 2,000 = Rs. 1,600 crore and save Rs. 400 crore.
Round 3: The Rs. 1,600 crore spent becomes new income. They spend Rs. 1,280 crore and save Rs. 320 crore.
Each round is smaller than the one before, so the process dies down after many rounds.

Round	Increase in investment (Rs. crore)	Increase in income (Rs. crore)	Increase in consumption (Rs. crore)	Increase in savings (Rs. crore)
1	2,500	2,500	2,000	500
2	-	2,000	1,600	400
3	-	1,600	1,280	320
4 and onwards	-	...	...	...
Total	2,500	12,500	10,000	2,500

Step 4: Read the totals:
Adding all the rounds, the total rise in income is Rs. 12,500 crore.
Total consumption rises by Rs. 10,000 crore and total saving rises by Rs. 2,500 crore.
The total saving equals the first investment of Rs. 2,500 crore, which is the point where the process stops.

Step 5: Find the multiplier:
The multiplier is the ratio of the total rise in income to the first rise in investment.
\[ K = \frac{\Delta Y}{\Delta I} = \frac{12{,}500}{2{,}500} = 5 \]
The same value comes from the formula:
\[ K = \frac{1}{1-MPC} = \frac{1}{1-0.8} = \frac{1}{0.2} = 5 \]

Final Answer:
An investment of Rs. 2,500 crore, with MPC of 0.8, raises national income by Rs. 12,500 crore. The multiplier is 5, so income rises 5 times the rise in investment. \[ \boxed{\Delta Y = Rs.\ 12{,}500\ \text{crore},\ K = 5} \]