How is the investment multiplier related to MPC, and how do I solve multiplier numericals in Class 12 Macroeconomics?
GradeHunt_TeamGradeHunt Team · · Delhi Board 12th
Delhi school, CBSE 12th Economics. In the chapter Determination of Income and Employment, I memorised k = 1/(1 - MPC) but I don't get why an increase in investment raises income by more than the investment. And when MPS is given, or change in income is given and I have to find change in investment, I get confused.
The multiplier tells you how many times national income rises when autonomous investment rises.
k = change in income / change in investment = 1 / (1 - MPC) = 1 / MPS
(because MPC + MPS = 1)
Why does income rise by more than the investment? One person's spending is another person's income. Say MPC is 0.8 and investment rises by Rs 100 crore.
Round 1: Rs 100 crore becomes income for workers and suppliers.
Round 2: they spend 80% of it, so Rs 80 crore becomes someone else's income.
Round 3: 80% of 80 = Rs 64 crore.
Round 4: Rs 51.2 crore, and so on.
Add all rounds: 100 + 80 + 64 + 51.2 + ... = 100 / (1 - 0.8) = Rs 500 crore.
So k = 5. Each round is smaller than the one before because a part (MPS) leaks out as saving, so the total settles at a fixed figure.
Three types of numericals:
1. MPC given, find k: MPC = 0.75, k = 1 / 0.25 = 4.
2. Find change in income: k = 4, investment rises by Rs 200 crore, so income rises by 4 x 200 = Rs 800 crore.
3. Find change in investment: income must rise by Rs 1,000 crore and MPS = 0.2. k = 1 / 0.2 = 5, so investment needed = 1,000 / 5 = Rs 200 crore.
Range of k:
MPC lies between 0 and 1. If MPC = 0, k = 1 (minimum). As MPC moves closer to 1, k becomes very large. Higher MPC means a bigger multiplier, because more of each round is spent.
Common slips:
1. Using k = 1/MPC. It is 1/(1 - MPC).
2. Mixing up APC and MPC. The multiplier uses MPC, the marginal one.
3. Forgetting that the multiplier works in reverse too: a fall in investment lowers income by k times the fall.
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