What is the Marginal Propensity to Invest (MPI)?
Marginal propensity to invest is the ratio of change in investment to change in income. The marginal propensity to invest shows how much of one additional unit of income will be used for investment purposes. Typically, investment increases when income increases and vice versa. The greater the marginal propensity to invest, the more likely it is that additional income is invested rather than consumed.
Understanding the Marginal Propensity to Invest
Although John Maynard Keynes never explicitly used the term, the marginal propensity to invest originates from Keynesian economics. In Keynesian economics a general principle states that whatever is not consumed is saved. Increases (or decreases) in income levels encourage individuals and businesses to do something with the amount of available money. The marginal propensity to invest is one of several marginals that have been developed through Keynesian economics. These include the marginal propensity to consume, the marginal propensity to save and less well-known ones like the marginal propensity for government purchases.
Marginal propensity to invest is calculated as ΔI=/ΔY, meaning the change in value of the investment function (I) with respect to the change in value of the income function (Y). It is thus the slope of the investment line.
For example, if a $5 increase in income results in a $2 increase in investment, the marginal propensity to invest is 0.4 ($2/$5). In practice, the marginal propensity to invest is much lower, especially in relation to the marginal propensity to consume.
How Marginal Propensity to Invest Impacts the Economy
Although consumption tends to be impacted more by increases in income, the marginal propensity to invest does have an impact on the multiplier effect and it also affects the slope of the aggregate expenditures function. The larger the marginal propensity to invest, the larger the multiplier. For a business, increases in income can be the result of reduced taxes, changes in costs or changes in revenue.
In general, an increase in investment spending will employ people immediately in the investment goods industry and have a multiplied effect by employing some multiple of additional people elsewhere in the economy. This is an obvious extension of the idea that spending on investment will be re-spent. However, there's a limit to the effect. The real output of the economy is limited to output at full employment, and spending multiplied past this point will simply raise prices.
Keynesian theory also suggests that any given investment project (public or private) will raise income and employment with the full force of the multiplier because that decision to invest may take the place of investment that would have happened in its absence. For example, funding a project might raise interest rates, discouraging other investments or competing with other projects for labor.