Multiplier Effect of Investment Spending - Online Tutor, Practice Problems & Exam Prep

An increase in investment spending can trigger a multiplier effect, enhancing consumer spending and overall economic activity. For instance, if firms invest $5 billion and the marginal propensity to consume (MPC) is 0.75, households will spend $3.75 billion, leading to further rounds of spending. The total increase in GDP can be calculated using the formula $(1/(1-\mathrm{MPC}\left)\right)$, illustrating how initial spending multiplies through the economy.

Multiplier Effect of Investment Spending

So let's discuss how an increase in investment spending can have a multiplier effect and set off a chain reaction in consumer spending and extra spending in the economy. Let's check it out. So an increase in investment spending, let's say firms invest in new equipment, in growing their businesses here, it's going to cause a chain reaction in the economy. So let's see how this works out. When firms increase their investment spending, this isn't going to in turn increase the income of households, right? Because that extra spending, let's say they're growing their business, they're going to hire new workers, right? This is going to increase the income of the households and what happens when the household income increases? Well, as we discussed with marginal propensity to consume and marginal propensity to save, right? When you have extra income, well, you're going to consume more and you're going to save more. So there was an increase in spending from the investment and now there's an increase in household consumption because they have more money, they're going to increase their consumption, right? And this has to do with our marginal propensity to consume. So go back to that video if you need a little more information earlier in this topic. So this extra consumption, well guess what? That's going to lead to more income which leads to more consumption leading to more consumption and this chain reaction is going to continue. So let's go to an example here and let's kind of see how this follows. So we talk about investment land has increased investment spending by $5,000,000,000. So they have this extra $5,000,000,000 that gets spent, which in turn is earned by the households and they're going to spend based on this increased income, right? Let's assume that MPC equals let's say 0.75 in this example.

So, that extra $5,000,000,000, well, that's going to lead to extra spending. So if we have $5,000,000,000 of extra income and let's just ignore taxes for now. $5,000,000,000 of extra income, well, they're going to spend 75% of that, right? $5,000,000,000 times 75%, well, they are going to spend $3,750,000,000, right? So there's an extra $3,750,000,000 of spending at this 0.75 Marginal Propensity to Consume and guess what? That's going to lead to another round of increased spending because of this chain reaction where now this spending has led to higher income which that income is going to be spent again.

Now, let's look at how this affects our consumer spending when it occurs repeatedly: MPC × 5,000,000,000 = 3,750,000,000 , then MPC ² × 5,000,000,000 , and continuing , MPC ³ × 5,000,000,000

So this is called the multiplier effect, just like we see here. The multiplier effect describes how the total increase in spending is more than just the initial boost, right? Because there's this chain reaction of extra spending. So the actual multiple, it depends on the MPC, right? On the marginal propensity to consume. So the total increase in GDP is more than just the initial spending boost. Now, the infinite series can be summed up in this equation right here: 1 1 - MPC This tells us that the initial spending boost depends on the MPC, but the total increase in GDP is a multiple of the result of this equation. In our case, with an MPC of 0.75, it equals 4, showing that the initial spending boost is multiplied by 4 in terms of the total increase in GDP. This is a remarkable illustration of the multiplier effect.

Multiplier

So right here at the bottom, investment land has increased investment spending by $5,000,000,000. If MPC is 0.75, what is the multiplier and the total increase in GDP? Okay. So remember, this initial $5,000,000,000 spending is going to set off a chain reaction. So our multiplier is going to be equal to 1 divided by 1 minus MPC. Okay? You guys want to be familiar with that equation. You're going to want to have that one down to memory or on your equation sheets, whatever it is, you definitely want to have that one at the ready. So one over 1 minus MPC, that's one over 1 minus 0.75, 1 minus 0.25 which comes out to 4. Our multiplier here is 4. That means that our initial spending of $5,000,000,000, we multiply it by the multiplier to get the total increase. So the total increase in GDP is going to equal our multiplier of 4 times the initial spending boost of $5,000,000,000 and we're going to get a $20,000,000,000 increase in GDP. So not only did we have that $5,000,000,000 originally, that chain reaction of consumer spending led to a total $20,000,000,000 increase. So notice if the MPC had been different, we would have gotten different numbers because our multiplier would have been different leading to a different total increase. Cool? So that's about it. Get familiar with the multiplier and then let's move on to the next video.

Here’s what students ask on this topic:

What is the multiplier effect in economics?

The multiplier effect in economics refers to the phenomenon where an initial increase in spending (such as investment spending) leads to a larger overall increase in economic activity and GDP. This occurs because the initial spending generates income for households, who then spend a portion of this income, leading to further rounds of spending. The total increase in GDP can be calculated using the formula $\frac{1}{1-\mathrm{MPC}}$, where MPC is the marginal propensity to consume. This formula shows how the initial spending multiplies through the economy.

How does the marginal propensity to consume (MPC) affect the multiplier effect?

The marginal propensity to consume (MPC) significantly affects the multiplier effect. MPC represents the fraction of additional income that households spend on consumption. A higher MPC means that households spend a larger portion of their additional income, leading to a larger multiplier effect. The multiplier can be calculated using the formula $\frac{1}{1-\mathrm{MPC}}$. For example, if MPC is 0.75, the multiplier is 4, meaning the initial spending will be multiplied four times in the economy. Conversely, a lower MPC results in a smaller multiplier effect.

How do you calculate the total increase in GDP from an initial investment?

To calculate the total increase in GDP from an initial investment, you use the multiplier formula $\frac{1}{1-\mathrm{MPC}}$. First, determine the marginal propensity to consume (MPC). Then, apply the formula to find the multiplier. Multiply the initial investment by this multiplier to get the total increase in GDP. For example, if the initial investment is $5 billion and MPC is 0.75, the multiplier is 4. Therefore, the total increase in GDP is $5 billion × 4 = $20 billion.

What role does the marginal propensity to save (MPS) play in the multiplier effect?

The marginal propensity to save (MPS) is the fraction of additional income that households save rather than spend. It is related to the marginal propensity to consume (MPC) by the equation $1-\mathrm{MPC}=\mathrm{MPS}$. MPS plays a crucial role in determining the multiplier effect because the multiplier can also be expressed as $\frac{1}{\mathrm{MPS}}$. A lower MPS (higher MPC) results in a larger multiplier, meaning the initial spending will have a more significant impact on the overall economy.

Can you provide an example of the multiplier effect with specific numbers?

Sure! Let's say firms invest $5 billion in new equipment, and the marginal propensity to consume (MPC) is 0.75. The initial $5 billion investment increases household income, leading to $3.75 billion in additional consumer spending (0.75 × $5 billion). This $3.75 billion further increases income and spending. The total increase in GDP can be calculated using the multiplier formula $\frac{1}{1-\mathrm{MPC}}$. With an MPC of 0.75, the multiplier is 4. Therefore, the total increase in GDP is $5 billion × 4 = $20 billion.