question_answer

Explain the relationship between investment multiplier and marginal propensity to consume.

Answer:

Investment multiplier (k) implies that any change in the investment leads to a corresponding change in the income and output by multiple times. That is, in other words, the change in the income and output is more than (or multiple times of) the change in investment.

Investment Multiplier, k = \[\frac{\Delta Y}{\Delta I}\]

Investment Multiplier shares a direct positive relationship with marginal propensity to consume. That is, higher the value of MPC, higher will be the value of investment multiplier and vice - versa.

Algebraically, the relationship is expressed as follows,

\[k=\frac{1}{1-MPC}\]

Suppose, the value of MPC is 0.5 then,

\[k=\frac{1}{1-0.5}=2\]

Now, if the value of MPC rises to 0.8 then,

\[k=\frac{1}{1-0.8}=5\]

Thus as the value of MPC rises from 0.5 to 0.8 the value of investment multiplier rises from 2 to 5. This confirms the direct positive relation between MPC and investment multiplier.