question_answer

Assuming that increase in investment is Rs 800 crore and marginal propensity to consume is 0.8, explain the working of multiplier.

Answer:

The working of multiplier can be explained as follows:
We are given that the value of MPC = 0.8 and also that initial increase in investment is Rs. 800 crore. This implies that with every increase of Rs 1 in the income, people consume 0.8 part of the increased income. That is, people consume Rs 0.80 and save Rs. 0.20.
Round	Increase investment \[\Delta I\]	Change in Income \[\Delta Y\]	Induced Change in Consumption\[\Delta C\]	Savings \[\Delta S\]
1	800	800	640	160
2	?	640	512	128
3	?	512	409.6	102.4
4	?	409.6	327.68	81.92
5	?	327.68	264.14	63.54
The table shows that initial increase in investment of Rs. 800 will lead to change in income by Rs. 800 in the first round. As MPC is 0.8, so people will consume 0.8 of the increased income (i.e. Rs. 640), there by, saves Rs. 160. This will be termed as leakage (as it is not ploughed back into the economy).
In the next round, due to the increase in the consumption expenditure by Rs. 640, there will be an increase in income Rs. 640. The people will again spend the increased income i.e. Rs. 512 and save the rest part of the income Rs. 128. In the third round, similarly the increased consumption expenditure of Rs. 512 will cause a change in the income by Rs. 512. They will spend a part of this income on consumption i.e., Rs. 409.6 and will save the rest of the increased income Rs. 102.4.
This process will continue and the income will go on increasing as a result of increase in consumption. The total change (\[\Delta Y\]) = Rs. 4000 (approx) and the change in. the investment (\[\Delta I\]) will be 800.
\[k=\frac{1}{1-MPC}=\frac{\Delta Y}{\Delta I}\]
\[k=\frac{1}{1-0.8}=\frac{\Delta Y}{800}\]
or,        \[\frac{1}{0.2}=\frac{\Delta Y}{800}\]
So,       \[\Delta Y\,\,=\,\,4,000\]
Thus, we can observe that an initial increase in the investment by Rs 800 crore results in increase of income and output by Rs 4000 crore.