The investment multiplier is a concept in economics that explains how an initial increase in investment spending can lead to a larger increase in overall national income or Gross Domestic Product (GDP). Essentially, it quantifies the magnified impact of investment on economic activity.

Here's a breakdown:

• Initial Investment: It starts with an injection of investment into the economy. This could be from businesses investing in new equipment, factories, or research and development.
• Increased Income: This initial investment creates income for those involved in producing the investment goods (e.g., workers, suppliers).
• Spending and Re-spending: The recipients of this new income then spend a portion of it. This spending becomes income for others, who in turn spend a portion of their income, and so on. This cycle of spending and re-spending continues throughout the economy.
• Multiplier Effect: The investment multiplier measures the ratio of the total increase in income to the initial increase in investment. It tells you how many times larger the final increase in income will be compared to the original investment.

Formula:

The simplest formula for the investment multiplier is:

Multiplier = 1 / (1 - MPC)

Where:

• MPC = Marginal Propensity to Consume (the proportion of an additional dollar of income that is spent).

Example:

If the MPC is 0.8 (meaning people spend 80% of any extra income they receive), then the multiplier would be:

Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

This means that an initial investment of $1 million could lead to a $5 million increase in overall national income.

Important Considerations:

• Leakages: The multiplier effect can be reduced by "leakages" from the circular flow of income. These include savings, taxes, and imports. If people save more, pay more taxes, or buy more imported goods, the amount of money re-spent within the domestic economy decreases, reducing the multiplier effect.
• Time Lags: The full impact of the multiplier effect may not be immediate. It takes time for the spending and re-spending to ripple through the economy.
• Economic Conditions: The size of the multiplier can vary depending on the state of the economy. For example, in a recession, the multiplier effect might be larger because there are more idle resources available.

In Summary:

The investment multiplier is a tool used to understand the potential impact of investment on economic growth. It suggests that even a relatively small increase in investment can have a significant impact on overall economic activity due to the circular flow of income and spending.

Source:

Investopedia - Investment Multiplier