Final answer:
The investment multiplier refers to the impact that an initial investment has on the economy's national income by creating a chain reaction of spending. Using an example with an MPC of 80%, each dollar spent generates further income and expenditures through multiple rounds, potentially increasing the total economic output by a factor that is derived from the formula 1/(1-MPC). However, the real impact may be diluted by savings, taxes, and imports.
Step-by-step explanation:
The investment multiplier is a measure of the economic effect of an initial investment. This concept states that an initial investment can lead to a greater total increase in the national income. For example, if we have a Marginal Propensity to Consume (MPC) of 80%, this means $0.80 of every dollar will be spent. If there is an initial investment of $100, this $100 becomes income for someone else, who in turn spends $80 (80% of $100). This next person would spend 80% of that $80, which is $64, and the process continues. This chain reaction of spending creates successive rounds of income and expenditure.The formula for calculating the multiplier effect is 1/(1-MPC). Assuming no taxes, savings, or imports, the multiplier would be 1/(1-0.8) or 5. This means that an initial investment of $100 would potentially lead to a total increase in spending of $500 within the economy. The multiplier effect can also be applied to fiscal stimulus, as seen with the American Recovery and Reinvestment Act of 2009.Let's consider a scenario with an initial government spending of $100. This money is received as income by individuals or businesses, who spend 80% of it, leading to additional expenditures of $80. Those who receive that $80 spend 80% of it as well, resulting in further spending of $64. With each step, the additional spending becomes smaller, but the total impact on the economy grows.In this explanation, we assume there are no taxes, no savings, and no imports that could reduce the spending at each stage. The economic output increases because each round of spending generates more income and thus more expenditures in the economy. However, in reality, the multiplier effect is less because of taxes and savings reducing the amount of available money to be spent.