What is an Investment Multiplier
An 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. The multiplier attempts to quantify the additional effects of a policy beyond those immediately measurable. The larger an investment's multiplier, the more efficient it is at creating and distributing wealth throughout an economy.
BREAKING DOWN Investment Multiplier
An investment multiplier tries to determine the financial impact of a public or private project. For instance, extra government spending on roads can increase the income of construction workers, as well as the income of materials suppliers. These people may spend the extra income in the retail, consumer goods, or service industries, also boosting the income of workers there. Furthermore, individuals and businesses stand to gain from access to better roads.
Calculating an Investment Multiplier
An investment multiplier's value is a function of several factors, including the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) of the people whose payment for labor constitutes the investment's expenditures, such as the construction workers, engineers and material suppliers in the previous example.
If the marginal propensity to consume of a project's workers is 0.75, then 75% of the workers' income is spent on goods and services that produce income for another individual or business, and 25% of their income is withdrawn from circulation by means of savings, taxation or expenditures on foreign goods and services. This same project has an investment multiplier of 4, which means that for every $1 spent investing in the project, another $4 of income is generated. The investment multiplier is calculated as 1/(1-MPC), or 1/(1-0.75), in the example.
Economic Applications of Investment Multipliers
There are many types of people with a vested interest in quantifying the investment multiplier of a particular project, including government officials, investors, financial analysts, real estate developers and neighborhood groups. Total output and job creation tend to be highest when dealing with commercial and real estate investments because investment costs are overshadowed by a wave of economic activity.
Business cycle analysts, central bankers, and policy planners study investment multipliers on an aggregate level to observe the general flow of wealth in an economy, and to better understand certain variables such as employment, prices and the velocity of the money supply. The concept of a multiplier effect is applied in many other areas, such as unemployment benefits and tax policy.