Q.In an economy, if initial investments are increased by ₹ 100 crores, discuss the working of investment multiplier presuming marginal propensity to consume is 0·8.

The investment multiplier describes how an initial change in investment leads to a much larger change in the final income of an economy. This occurs because one person's spending becomes another person's income, which is then partially spent again, creating a chain reaction of expenditure.

Given an initial increase in investment ($\Delta I$) of ₹ 100 crores and a marginal propensity to consume (MPC) of 0.8, the working of the investment multiplier can be understood as follows:

1. Initial Injection: The economy receives an initial investment of ₹ 100 crores. This directly increases income by ₹ 100 crores for those who receive it.
2. First Round of Spending: With an MPC of 0.8, recipients of this income will spend 80% of it, which is $0.8 \times ₹ 100 \text{ crores} = ₹ 80 \text{ crores}$. This ₹ 80 crores becomes income for others.
3. Second Round of Spending: The new recipients of ₹ 80 crores will, in turn, spend 80% of it, i.e., $0.8 \times ₹ 80 \text{ crores} = ₹ 64 \text{ crores}$. This ₹ 64 crores becomes income for yet another group.
4. Continuing Rounds: This process continues, with each subsequent round of spending being 80% of the previous round, until the additional income generated becomes negligible. The savings component (1 - MPC) leaks out of the spending stream in each round. …

The investment multiplier is a core concept in Keynesian economics that explains how an initial change in investment can lead to a much larger change in the overall national income. The economic intuition behind it lies in the circular flow of income: one person's expenditure becomes another person's income. When an investment is made, it generates income for those involved in producing the investment goods. A portion of this newly generated income is then spent on consumption, which in turn becomes income for others, and this process continues in a chain reaction.

The magnitude of this multiplier effect depends crucially on the marginal propensity to consume (MPC), which is the proportion of additional income that households spend on consumption. The higher the MPC, the larger the multiplier, because a greater portion of each round's income is re-spent, perpetuating the income-generating process. Conversely, the marginal propensity to save (MPS), which is the proportion of additional income saved, acts as a leakage from this circular flow.

Let's discuss the working of the investment multiplier with the given values:

1. Calculate the Investment Multiplier ($k$)

   The investment multiplier ($k$) is defined as the ratio of the total change in national income ($\Delta Y$) to the initial change in investment ($\Delta I$). It can be calculated using the marginal propensity to consume (MPC) or the marginal propensity to save (MPS).

   $k = \frac{1}{1 - MPC}$

   or

   $k = \frac{1}{MPS}$

   Given that the marginal propensity to consume (MPC) is $0.8$:

   $k = \frac{1}{1 - 0.8}$

   $k = \frac{1}{0.2}$

   $k = 5$

   This means that for every ₹1 increase in investment, the national income will increase by ₹5.

2. Working of the Multiplier (Round by Round)

   An initial increase in investment of ₹100 crores sets off a chain reaction of spending and income generation throughout the economy.

   • Round 1: The initial investment of ₹100 crores directly increases the income of those who receive it (e.g., workers, suppliers of capital goods). So, $\Delta Y_1 = ₹100 \text{ crores}$.
   • Round 2: Out of this ₹100 crores, people will spend a portion according to their MPC. Since MPC is $0.8$, they will spend $0.8 \times ₹100 \text{ crores} = ₹80 \text{ crores}$. This ₹80 crores becomes income for others (e.g., retailers, service providers). So, $\Delta Y_2 = ₹80 \text{ crores}$.
   • Round 3: Out of the ₹80 crores received in Round 2, people will again spend $0.8$ of it. This amounts to $0.8 \times ₹80 \text{ crores} = ₹64 \text{ crores}$. This ₹64 crores becomes income for yet another group of people. So, $\Delta Y_3 = ₹64 \text{ crores}$. …