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Theory of Investment

The document discusses several economic theories: 1) The investment multiplier theory developed by Kahn and Keynes which holds that an initial increase in investment will lead to a multiplied increase in income, where the multiplier is determined by the marginal propensity to consume. 2) The accelerator theory which explains that an increase in consumption leads to an increase in investment in capital goods, where the accelerator coefficient is the ratio of induced investment to changes in consumption or output. 3) The super-multiplier or multiplier-accelerator interaction combines the multiplier and accelerator to show how autonomous investment leads to a multiplied increase in income determined by the super-multiplier, which is a function of marginal propensities to consume and invest.

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41 views14 pages

Theory of Investment

The document discusses several economic theories: 1) The investment multiplier theory developed by Kahn and Keynes which holds that an initial increase in investment will lead to a multiplied increase in income, where the multiplier is determined by the marginal propensity to consume. 2) The accelerator theory which explains that an increase in consumption leads to an increase in investment in capital goods, where the accelerator coefficient is the ratio of induced investment to changes in consumption or output. 3) The super-multiplier or multiplier-accelerator interaction combines the multiplier and accelerator to show how autonomous investment leads to a multiplied increase in income determined by the super-multiplier, which is a function of marginal propensities to consume and invest.

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aman dwivedi
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The Theory of Investment

Multiplier
First developed by R.F. Kahn in his article “The
Relation of Home Investment to
Unemployment” in the Economic journal of
June 1931
Kahn’s multiplier was the Employment
Multiplier
Keynes took the idea from the Kahn and
formulated Investment Multiplier
The Investment Multiplier
 The multiplier, according to Keynes, “establishes a
precise relationship, given the propensity to
consume, between aggregate employment and
income and the rate of investment. It tells us
that, when there is an increment of investment,
income will increase by an amount which is K
times the increment of investment”
 i.e., dY = KdI
 Or K= dY/dI
 Where Y is income, I is investment, d is change
and K is the multiplier(coefficient)
The Multiplier Theory
K refers to the power by which any initial
investment expenditure is multiplied to obtain
a final increase in income
The value of the multiplier is determined by
the marginal propensity to consume
Higher the MPC, higher the value of multiplier
and vice versa
Relationship between the Multiplier
and the MPC
Y = C + I
dy = dC + dI
dY = cdY + dI (dC = cdY)
dY – cdY = dI
dY(1-c) = dI
dY = dI / 1-c
dY /dI = 1 / 1-c
K = 1 / 1-c (K = dY / dI)
Contd...
Where c is the MPC, K the Multiplier
Because, 1- MPC = MPS
 Therefore, K = 1 / MPS
Where MPS is marginal propensity to Save
As, 0 < MPC < 1
Therefore, 1 < K < oc (infinity)
The Principle of Acceleration
According to Kurihara, “ The accelerator
coefficient is the ratio between induced
investment and an initial change in
consumption expenditure”
It explains the process by which an increase
(or decrease) in the demand for consumption
goods leads to an increase (or decrease) in
investment on capital goods
Contd...
 Symbolically, v = dI / dC
Where v is the accelerator coefficient, dI is net
change in investment and dC is the net change
in consumption expenditure
Interpreted by Hicks as, the ratio of induced
investment to changes in output, i.e.,
dI / dY
Thus v = dI / dY
Contd...
 The acceleration principle can be expressed as:-
 I(gt) = v (Y(t) – Y(t-1)) + R
= vdY(t) + R
 Where I(gt) is gross investment in period t, v is the
accelerator, Y(t) is the national output in period t, Y(t-1)
is the national output in the previous period (t-1), and
R is the replacement investment
 Equation tells that gross investment during period “t”
depends on the change in output Y from period (t-1)
to period t multiplied by the accelerator (v) plus
replacement investment R
Contd...
 Net Investment I(n) :
 R must be deducted from both sides of equation
of gross investment so that net investment in
period t is,
 I(nt) = v(Y(t) – Y(t-1))
 = vdY(t)
 If Y(t) > Y(t-1), net investment is positive during
period t
 If Y(t) < Y(t-1), net investment is negative or there
is disinvestment in period t
The Super-Multiplier or
The Multiplier-Accelerator Interaction
Hicks has combined the multiplier and the
accelerator mathematically and given the
name “super-multiplier”
The combined effect of the multiplier and the
accelerator is also called the leverage effect
which may lead the economy to very high or
low level of income propagation
Contd...
 Super-multiplier is worked out by combining both
induced consumption(cY or dC/dY or MPC) and
induced investment (vY or dI/dY or MPI)
 Hicks divides the investment component into
autonomous investment and induced investment
 So that in vestment I = I(a) + vY
 Where I(a) is autonomous investment and vY is
induced investment
Contd...
 Since Y = C + I
 Therefore, dY = cdY + dI
 = cdY + dI(a) + vdY
 dY – cdY – vdY = dI(a)
 dY(1-c-v) = dI(a)
 dY/dI(a) = 1/(1-c-v)
 = 1/(s-v)
 K(s) = 1/(1-c-v)
 = 1/(s-v)
Contd...
 Where K(s) is the super-multiplier, c is the
marginal propensity to consume, v is the
marginal propensity to invest, and s is the
marginal propensity to save (s = 1-c)
 The super-multiplier tells us that if there is an
initial increase in autonomous investment,
income will increase by K(s) times the
autonomous investment
 The super-multiplier in the general form will be
 dY = 1/(1-c-v) x dI(a)
 = K(s) x dI(a)

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