'Investment multiplier and Marginal Propensity to Consume are directly related to each other.' Explain with the help of numerical example.

Question

Accepted Answer

The investment multiplier and Marginal Propensity to Consume (MPC) are directly related. The multiplier formula is k = 1/(1-MPC), which shows that as MPC increases, the value of the multiplier increases.

Numerical Example:
Consider two economies with different MPC values:

Economy A: MPC = 0.5
Multiplier (k) = 1/(1-0.5) = 1/0.5 = 2
If investment increases by ₹100 crores:
ΔY = k × ΔI = 2 × ₹100 = ₹200 crores

Economy B: MPC = 0.8
Multiplier (k) = 1/(1-0.8) = 1/0.2 = 5
If investment increases by ₹100 crores:
ΔY = k × ΔI = 5 × ₹100 = ₹500 crores

Explanation:
- Higher MPC means people spend a larger proportion of additional income on consumption.
- This creates larger successive rounds of spending and income generation.
- Each round of spending becomes income for others, who then spend a portion based on MPC.
- With higher MPC, the chain reaction is stronger, leading to a larger cumulative increase in income.
- Thus, the multiplier is higher when MPC is higher, confirming the direct relationship.