Investment Multiplier

What Is Investment Multiplier?

The term investment multiplier refers to the concept that any increase in public or private investment spending has a more than proportionate positive impact on aggregate income and the general economy. It is rooted in the economic theories of John Maynard Keynes.

The multiplier attempted to quantify the additional effects of investment spending beyond those immediately measurable. The larger an investment’s multiplier, the more efficient it is in creating and distributing wealth throughout the economy.

Understanding the Investment Multiplier

The investment multiplier tries to determine the economic impact of public or private investment. For instance, extra government spending on roads can increase the income of construction works, as well as the income of materials suppliers. These people may spend the extra income in the retail, consumer goods, or service industries, boosting the income of the workers in those sectors.

As you can see, this cycle can repeat itself through several iterations; what began as an investment in roads quickly multiplied into an economic stimulus benefiting workers across a wide range of industries.

Mathematically, the investment multiplier is a function of two main factors: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).

Real World Example of the Investment Multiplier

Consider the road construction workers in our previous example. If the average worker has an MPC of 70%, that means they consume $0.70 out of every dollar they earn, on average. In practice, they might spend that $0.70 on items such as rent, gasoline, groceries, and entertainment. If that same worker has an MPS of 30%, that means they would save $0.30 out of every dollar earned, on average.

These concepts also apply to businesses. Like individuals, businesses must “consume” a significant portion of their income by paying for expenditures such as employees’ wages, facilities’ rents, and the leases and repairs of equipment. A typical company might consume 90% of their income on such payments, meaning that its MPS — the profits earned by its shareholders — would be only 10%.

The formula for calculating the investment multiplier of a project is simply:

1 / ( 1 − M P C ) 1 / (1 - MPC) 1/(1−MPC)

Therefore, in our above examples, the investment multipliers would be 3.33 and 10 for the workers and the businesses, respectively. The reason the businesses are associated with a higher investment multiple is that their MPC is higher than that of the workers. In other words, they spend a greater percentage of their income on other parts of the economy, thereby spreading the economic stimulus caused by the initial investment more widely.