ASSIGNMENT ON INVESTMENT MULTIPLIER

SUBMITTED TO AMRINDER SINGH

SUBMITTED BY GAURAV KATARIA (5706) MBA-1, SEC -E

SCHOOL OF MANAGEMENT STUDIES, PUNJABI UNIVERSITY PATIALA

INTRODUCTION TO INVESTMENT MULTIPLIER Investment Multiplier tells us about the changes in income for changes in the investment. The concept o Multiplier was developed by Kahn. With change in the investment here will be a change in the income, because the investment expenditure turns into income. There after the income induce the consumption to increase depending on the level of marginal propensity of consumption. This way an increase in the consumption expenditure creates incomes in the second round. The induced income again increases the consumption. This cycle repeats and an increase in the investment generates income several times more. This is called as the multiplier effect. WHAT IS THE INVESTMENT MULTIPLIER? Investment multiplier is simply the multiplier effect of an injection of investment into an economy. In general, a multiplier shows how a sum injected into an economy travels and generates more output. For example if you buy $100 worth of chips. Say the stallowner saves $10 and spends $90 on burgers. Then the burger stall owner saves 10% that is $9 and consumes the rest ($81) on cheese, and so on... Each $ receivedm 10% is saved (marginal propensity to save- MPS) and 90% consumed (marginal propensity to consume - MPC). This eventually results in 100/(1-.9)=$1000 worth of expenditure in the economy. The multiplier=1/(1-MPC). The investment multiplier is simply the same idea applied to an increase in investment as opposed to consumption above. Using consumption just makes it easier to understand; investment multiplier is just the same. Now, autonomous investment increases for many reasons. People might start believing that better times are ahead, hence prepare for the future. Another could be that more people decide to become entrepreneurs. Another could be government policies that make small loans available for SMEs. Another could be peace rather than war. Another could be change in trade reginme towards an open economy so people try to invest to export... hope that helped.

MULTIPLIER EFFECT The multiplier has a time lag. The multiplier works into the long run. Each year some income is added and consumption is generated. This may taper with time but it shall continue for ever, theoretically. This is called multiplier effect

DERIVATION OF MULTIPLIER

Illustration For a given change in the Investment of Rs. 10,000 cr and a MPC of 0.5: Multiplier is the inverse of Marginal Propensity of Consumption.

Then the multiplier value shall be 2. For the given illustration the Y will

increase to Rs, 20,000 cr Working of Multiplier

ASSUMPTIONS OR LIMITATIONS OR LEAKAGES IN MULTIPLIER 1. Multiplier effect lasts over a larger time period. There is time lag in the realization of multiplier effect. So in the short run only a part of the multiplier effect can be got. The remaining is considered as a leakage n the multiplier. 2. If the increased incomes are used in the repayment of old debts, the multiplier effect stops. 3. The increased incomes shall be spent on domestic consumption only. Money pent on imports will shift the multiplier effect outside the country. 4. With increased incomes the Government increases tax, the multiplier effect reduces. This is because the disposable income decreases each time. 5. There shall not be liquidity preference. If people hold cash balances with out spending the multiplier effect stops. 6. Investment in second hand securities and gold reduces multiplier effect. 7. There should be excess capacity in the industry to produce goods with increasing demand for consumer goods.

WHAT IS CONSUMPTION FUNCTION? HOW IS IT DETERMINED? Consumption function is also called propersity to consume. Consumption means amount spent on consumption at a given level of income. Consumption function or propersity to consume means the whole of schedule showing consumption expenditure at various level of income. FACTORS INFLUENCE CONSUMPTION These factors are 1. The real income of the individual. 2. His Past savings. 3. Rate of interest. Income plays a major role in order to influence consumption function. Past saving are very small and for specific purpose like contributions to social security (Pension etc). Rate of interest encourage some people save more to earn a higher rate of interest. AVERAGE AND MARGINAL PROPERSITY TO CONSUMER The r/s between income and consumption is measured by the average and marginal propersity to consume. APC = C / Y [Where C --> Consumption and Y --> Income] APC is the ratio of consumption and income where MPC = /\ C / /\Y MPC is the rate of change in consumption to the change in income. The normal r/s between income and consumption is such that income rises, consumption also rises, but by less than the rise in come.

WHAT IS MARGINAL PROPERSITY TO CONSUME? SHOW HOW MULTIPLIER DEPENDS ON THE MAGNITUDE OF THE MPC. MPC shows r/s between a given rise in investing and the resulting change in income. Suppose we invest 100Rs, so we expect more than that as additional income. We spend some amount from additional income and save the rest income. Additional spending depends on their MPC. Now we suppose MPC is 3/4. Then they will spend 75 Rs and save 25 Rs. If the MPC is stable the series of consecutive expenditure becomes. /\(income) Y = 100 + 100 x (3/4) + 100 x (3/4)2 + 100 x (3/4)3 => /\Y = 100 [1 + (3/4) + (3/4)2 + (3/4)3 + ......] We see that an initial primary investment of 100 Rs gives rise to an icrease of 40 Rs in the National Income. The investment Multiplier measures the r/s between an increase in income caused by a primary increase in investment Investment Multiplier = /\Y / /\I In our case, Multiplier = 400/100 = 4 Multiplier is given by the following formula Multiplier = I / I MPC If MPC = 4/5 than Multiplier is 5 If MPC = 9/10 than Multiplier is 10 But If MPC = 1 than Multiplier is infinite this shows a little increase of investment will load automatically a full employment. If MPC = 0 than Multiplier = 1 shows increase in investment is equal to increase in total income.

Limitation of the Multiplier Concept The factors which tends to reduce multiplying effect are called Leakage. The various limitation of multiplier are 1. MPC Not Constant MPC is assumed constant in keyness concept of multiplier so that mps will necassarily be constant. Keyness ignor the possibility of leakager. In dynamic economy MPC or MPS never be constant. 2. Debit Concellation If people use a part of new increment in income to repay their add debts instead of spending on further consumption. 3. Purchase of Old Stock and Securities If new income is spent on buying on buying old stock, shares and securities, consumption will be less and multiplies in respect will be low. 4. Net Imports If import is greater than export than if means outflow of funds to foreign coutries. 5. Price Inflation If the price of goods increase mpc will automatically increase. Instead of all above problem, Multiplier have very importance in economics and for economics policy. Its play a vital role as an instrument of income.

DISTINGUISH BETWEEN AUTONOMOUS AND INTRODUCED INVESTMENT ON WHAT FACTORS INVESTMENT DEPEND? In the keynessian system employment depends upon effective demand. Effective demand should be constitute of investment and consumption. Investment mean addition to stock of capital to the nations like building of new factories, new machines etc. Autonomous and Induced Investment is done by Govt. for promoting peoples welfares as under plan developed. Induced investment is made by the people as a result of change in income level or consumption. CONCEPT OF MARGINAL EFFICIENCY OF CAPITAL (MEC) It has very importance in macro economics. When ever an enterprise makes a certain investment in his business, he first looks into the marginal efficiency of capital. What return he is going to certain from the given investment. MEC is the expected rate of profit of a new capital asset. Lets suppose, we invest 10,000 Rs on purchase of new machine. The net return of this machine is expected to Rs. 1000 per annum, The MEC will be 1000/10000 x 100 = 10% Show the ratio of expected annual return.

FACTORS ON WHICH INVESTMENT DEPENDS. Investment depends on 1. MEC 2. Rate of Interest 1. MEC The MEC is the expected annual rate of return on an additional unit of a capital good. According to Keynels The MEC is the rate of discount which makes the present value of the prospective field from the Capital asset equal to its supply price. MEC is -vely shoped. 2. Rate of Interest As the investment increases the rate of interest also increase so MEC decline. Factors Effecting MEC MEC is influenced by shortrun as well as long run factors. These are A. Short Run Factors i. Demand for the Product. ii. Liquid Assets. iii. Sudden changes in income. iv. Current rate of investment. B. Long Run Factors i. Rate of Growth of Population ii. Technological Development iii. Rate of Taxes.