Discuss briefly the working process of investment multiplier (K), assuming that Change in Investment (ΔI) is ₹

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Q. Discuss briefly the working process of investment multiplier (K), assuming that Change in Investment (ΔI) is ₹ 4,000 crore and Marginal Propensity to Consume (MPC) is 0\cdot5.

Yanam CbseCBSE Class XII Board 2022Subjective· 3mImportance★★★★★

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Concept understanding — Marginal Propensity to Consume

Marginal Propensity to Consume (MPC)

Start with everyday intuition

Think about what happens when you get some extra money — say, a ₹500 bonus from your part-time job, or a cash gift on your birthday. You don't save all of it, and you don't spend all of it either. Most people spend a part and save the rest. That part you spend — the fraction of the extra income that goes into consumption — is exactly what economists call the Marginal Propensity to Consume.

The word "marginal" here means "extra" or "additional." So MPC answers one simple question: Out of every extra rupee you earn, how much do you spend?

The precise meaning

Formally, MPC is the ratio of change in consumption expenditure to the change in income that brought it about.

MPC = \frac{\Delta C}{\Delta Y}

For example, if your income rises by ₹1,000 and your consumption rises by ₹750, your MPC is $750/1000 = 0.75$ (or 75%). This means you spend 75 paise of every extra rupee and save the remaining 25 paise.

The other side of the coin is the Marginal Propensity to Save (MPS) — the fraction of extra income that is saved. Since every extra rupee is either spent or saved:

MPC + MPS = 1

This is not a theory; it's an accounting identity. If MPC = 0.75, then MPS must be 0.25.

Why MPC matters

MPC is not just a number — it is the engine of the multiplier effect, one of the most powerful ideas in macroeconomics.

When someone spends money, that spending becomes someone else's income. That second person, in turn, spends a fraction (their MPC) of that income, which becomes a third person's income, and so on. A single initial injection of spending — say, government investment in a road — ripples through the economy, generating total income many times larger than the original spending.

The size of this ripple depends directly on MPC. The higher the MPC, the larger the multiplier.

Multiplier\ (k) = \frac{1}{1 - MPC} = \frac{1}{MPS}

If MPC = 0.8, the multiplier is $1/(1-0.8) = 5$ . An initial ₹100 crore investment can generate ₹500 crore of total income. If MPC = 0.5, the multiplier is only 2.

A word on the diagram …

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The investment multiplier ( $K$ ) shows how an initial change in investment ( $\Delta I$ ) leads to a larger change in national income ( $\Delta Y$ ) through successive rounds of consumption spending. With $\Delta I = ₹4,000$ crore and MPC $= 0.5$ , the multiplier is $2$ , so the total increase in income is ₹8,000 crore.

The investment multiplier is one of the most elegant ideas in Keynesian economics. It explains why a relatively small injection of investment can cause a much larger increase in total national income. The logic is not about magic — it is about the circular flow of income and the fact that one person’s spending becomes another person’s income.

When a firm invests ₹4,000 crore (say, building a new factory), that money goes directly to workers, suppliers, and contractors as income. These recipients, in turn, spend a part of their new income on consumption goods. That spending becomes income for others, who then spend a part of it, and so on. Each round is smaller than the previous one because people save a fraction of their additional income — the fraction they do not spend is the Marginal Propensity to Save (MPS). The multiplier captures the sum of all these rounds.

K = \frac{1}{1 - MPC} = \frac{1}{MPS}

Here, MPC is 0.5, meaning households spend half of any extra income and save the other half. So MPS $= 1 - 0.5 = 0.5$ .

Watch out

A common mistake is to think the multiplier works instantly or that it applies to all spending equally. The multiplier process takes time to unfold through successive rounds, and it assumes there is spare capacity in the economy — otherwise, extra demand just raises prices, not real output.

Let us now work through the numbers step by step.

Step 1: Calculate the multiplier

$K = \frac{1}{1 - MPC} = \frac{1}{1 - 0.5} = \frac{1}{0.5} = 2$ …

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Same / Similar Concept — real previous-year questions on the same or a closely similar concept, not this exact question.

CA Foundation 2025Set may-20251 markMCQ
$Q. Under the Keynesian theory of determination of national income, the assumption is that the consumption increases with an increase in disposable income but the increase in consumption will be _______ the increase in disposable income. (A) Equal to (B) Opposite to (C) Greater than (D) Less than$
›Reveal solutionSolution

By Keynes's fundamental psychological law, a rise in income raises consumption by less than the rise in income.

Step 1 — Keynes's psychological law of consumption

Keynes held that as disposable income increases, consumption increases too, but not by the full amount of the increase — people save a part of the additional income.

Step 2 — Express with MPC

The marginal propensity to consume measures the share of extra income that is consumed:
$MPC = \frac{\Delta C}{\Delta Y}, \qquad 0 < MPC < 1$
Since $MPC < 1$ , the change in consumption $\Delta C$ is less than the change in disposable income $\Delta Y$ . …
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CA Foundation 2025Set may-20251 markMCQ
$Q. Which of the following is true in respect of relation of Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) as per the Keynesian theory of determination of National Income ? (A) MPC = MPS (B) MPC + MPS = 1 (C) MPC + MPS = 0 (D) No relation exists between MPC and MPS$
›Reveal solutionSolution

Because extra income is either spent or saved, MPC + MPS = 1.

Step 1 — Split additional income

A change in disposable income ( $\Delta Y$ ) is divided between a change in consumption ( $\Delta C$ ) and a change in saving ( $\Delta S$ ):
$\Delta Y = \Delta C + \Delta S$
Step 2 — Divide through by $\Delta Y$
$\frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y} = 1 \;\Rightarrow\; MPC + MPS = 1$
So the two marginal propensities always sum to one, and MPS = 1 − MPC.

Why the other options are wrong: (A) MPC = MPS only in the special case where each equals 0.5; it is not a general rule. (C) MPC + MPS = 0 is impossible, since both are non-negative and their sum is 1. (D) A definite relation clearly exists, so 'no relation' is wrong. …
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Q.Discuss briefly the working process of investment multiplier (K), assuming that Change in Investment (ΔI) is ₹ 4,000 crore and Marginal Propensity to Consume (MPC) is 0·5.

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