The investment multiplier: Comparing three alternative approaches

The investment multiplier (Keynes, J.M., The General Theory… Harcourt, Brace and Company; New York, 1936) is a staple of macroeconomics. The idea is this…beginning from equilibrium income, an increase in investment stimulates income. At the next equilibrium state, the change in income will be seen to be a multiple of the initial change in investment. This paper looks at three ways to explain the theorem.

One treatment to explain the investment multiplier is to employ introductory calculus. This method begins with the simple equilibrium income equation where income is equal to consumption plus investment. Once the consumption function is specified, one merely takes the derivative of income with respect to investment and the multiplier falls out. While this treatment is elegant mathematically, it actually moves the reader instantly from one equilibrium state to the next while hiding the process that is assumed to be happening.

A second treatment is to use the circular flow. Once we begin from equilibrium income, and an exogenous increase in investment is introduced, one follows the circular flow of income through several successive flows noting that it is the operation of the marginal propensity to consume that causes secondary additional spending and then causes additional income. Given a positive change in consumption, the change in equilibrium income must be larger than the initial change in investment. This procedure can be depicted using a stone and a pool of water. If one drops in a stone (the change in investment), secondary ripples in the water will inevitably result (the resultant changes in consumption). While this treatment clarifies the nature of the change in consumption necessary, it leaves out the resource allocation issue.

The third treatment is to introduce the investment multiplier in the framework of a production possibility curve; consumption on one axis, investment on the other. Now, picking a point of equilibrium inside the curve (unemployment must exist), a change in investment causes a change in consumption and the new point inside the production possibility curve can be traced. This procedure provides insight into how resources are allocated between consumption and investment. It further provides evidence that a larger marginal propensity to consume, while generating a larger value for the multiplier, pulls the system’s resources towards the consumption axis.

The three procedures provide different insights into the investment multiplier.