The simple investment multiplier

The simple investment multiplier shows the effects of an injection of new spending on the final size of a country's national income. 

Understanding the multiplier concept is important in terms of describing how national income changes, and how policy makers can assess the likelihood that their policies are successful.

The general expression is:

The investment multiplier

The cross diagram can be used to illustrate the impact of a change in investment on ‘final’ national income.

For example, if investment increases by $100bn, income (Y) will increase by $200 bn, which gives the multiplier a value of ‘2’.

The investment multiplier

What is key here is to see that the value of the multiplier depends on the marginal propensity to save, or 'mps' for short, which determines the gradient of the savings line.

The greater the mps, the smaller the value of the multiplier, as more leaks out of the economy following an injection of investment. With savings line S2, the multiplier falls from 2 to 1.2.

The multiplier principle can be applied to other injections, including exports and government spending.


Video on the investment multiplier

The multiplier (k) can be calculated by the following:

The investment multiplier
The mpc formula

Example

The mpc for 2019 to 2020 is:

The investment multiplier
The mpc formula

0.6 (+50)/(+30). This gives a multiplier of:

The investment multiplier

The fiscal multiplier

The multiplier is an important concept in helping governments decide how much new public spending is required to achieve a given increase in GDP. The multiplier effect resulting from government purchases is called the fiscal multiplier.

Understanding the fiscal multiplier - that is, how much new GPD result from a given injection of public spending - is a key element in the case for the use of fiscal policy when an economy is going into recession - or simply growing at a level below the long term trend rate of growth.

The size of fiscal multipliers can be estimated in a variety of ways, including through econometric models, time series analysis and what are called 'dynamic, stochastic general equilibrium (DSGE) models'. ['Stochastic' models are those which include a random variable in their estimations, and hence can arrive a different outcomes each time they are run.]

The IMF has estimated that the multiplier effects of fiscal policy can last for up to seven years, with around 80% of the effect occurring in the first year, then tailing off towards zero.