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Determination of Income and Employment — Economics STD 12 Humanities & Commerce — Question

Rajasthan BoardEnglish MediumSTD 12 Humanities & CommerceEconomicsDetermination of Income and Employment4 Marks
Question
What is investment multiplier? Explain its working using a suitable numerical example.
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Answer

Investment multiplier is the ratio between increase in income $\Delta\text{Y}$ and increase in investment $\Delta\text{I}$.$\text{k}=\frac{\Delta\text{Y}}{\Delta\text{I}}$
Where; k is multiplier$\Delta\text{Y}$ is increase in output,
$\Delta\text{I}$ is increase in investment,
Additional investment $\Delta\text{I}$ generates additional income $\Delta\text{Y}$ but income generated is many times more than the investment. Relationship between multiplier and mpc: There is a direct relationship between multiplier and mpc. Higher the value of mpc, higher the multiplier effect and vice versa. Relationship between multiplier and mps: There is an inverse relationship between multiplier and mps. Higher the value of mps, lower the multiplier effect and vice versa. Assume MPC is 0.5, multiplier mechanism is as follows: As a result of initial increase in investment by ₹ 100 crore, there is change in income by ₹ 100 crore in first round. Hence, mpc is 0.5, consumption will increase by ₹ 50 crore and saving will increase by ₹ 50 crore. In the second round, with the consumption expenditure of ₹ 50 crore, there will be an increase in income by ₹ 50 crore. This change in income ₹ 25 crore is utilised for consumption from ₹ 50 crore and the remaining ₹ 25 crore is saved. Likewise, in different time periods, income will keep on increasing with an increase in consumption expenditure. In an economy, as people become thriftier they end up saving less or same as before in aggregate. This theory produced by Keynes "when people start saving money instead of spending it, in response to growing concerns about recession, they actually make the recession worse". Rise in MPS means a fall in MPC. When MPC falls, aggregate consumption expenditure in the economy falls. It leads to a rise in inventory and the producers and firms would thus plan to reduce the production. The demand for factor services and factor incomes will reduce. As a result, the total volume of saving generated in the economy would fall or remain unchanged. This is known as paradox of thrift.

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