The investment multiplier: Comparing benefits and drawbacks of different approaches

The objective of this paper is to review the standard methods introductory macroeconomic textbooks use to talk about the investment multiplier and to explain why the traditional approaches for its explanation may not be the best ones to illustrate the concept for beginning students.

The investment multiplier is a staple of modern macroeconomics.  The idea of this theorem is as follows: If we begin at equilibrium income, and then change investment, equilibrium income will change as a multiple of the change in investment.  There are several ways to show this simple yet powerful result.  It can be shown on a production possibility curve, on a circular flow diagram, on a leakages-injections diagram, on an aggregate demand curve, on an IS diagram and most elegantly in equation form.  This paper looks at each of these methods and comments upon each one’s pedagogical benefits and drawbacks.  It concludes that the most insightful approach is the one that uses the production possibility curve diagram.  The interesting thing here is that the standard textbooks traditionally do not use the production possibility curve approach when introducing the investment multiplier.  As a result, the students are not learning as much as they can from this essential macroeconomic concept. 

The main benefits of the production possibility curve approach will be shown to be two-fold.  First, it highlights the essential fact that the multiplier operates only in an unemployment environment.  The second benefit of the production possibility curve presentation is the clarity of the path followed by income as it moves towards equilibrium, and this path, of course, depends upon the marginal propensity to consume.