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The investment multiplier: a different pedagogical approach.

JEL A20 E00

This paper presents an alternative method of presenting the investment multiplier by employing the concept of the production possibility curve. A standard presentation to explain the investment multiplier to beginning economics students is to use the C + I diagram, or what is sometimes called the "forty-five degree line" diagram. Given a positively sloped consumption function and a fixed investment value, one identifies equilibrium income, then the C + I line shifts up (due to an exogenous change in investment), and the new equilibrium income is located. If one divides the change in equilibrium income by the change in investment, the result is the multiplier. As long as the slope of the consumption function, or the marginal propensity to consume, is positive and less than one the value of the multiplier is greater than one. This is simply because the change in income is made up of the change in investment plus the change in consumption.

An alternative and rather unique way to explain the investment multiplier is to employ the production possibility curve. Place quantity of consumption (in dollars) on one axis, and quantity of investment (in dollars) on the other. Start within the curve at one point and call that point an equilibrium one. This point has, as its coordinates, the starting consumption and the starting investment values, and by their addition, the initial equilibrium income level. Now suppose we increase investment by some amount (the exogenous change). This causes an increase in income (which is hidden) and a forced movement up of consumption (due to the marginal propensity to consume), and then a second movement of consumption (due to the impact of the higher consumption on income), and then a third movement up, and so on. Since the marginal propensity to consume is less than one, these changes in consumption become smaller and smaller until they stop. The new final consumption and investment values combine to give the new equilibrium income. Finally, dividing the change in equilibrium income by the initial change in investment gives the investment multiplier. Since the change in consumption is positive, the change in equilibrium income exceeds the change in investment.

This approach highlights a number of interesting points: (1) the multiplier works as long as unemployment exists. This is because we must begin inside the production possibility curve if both consumption and investment rise, (2) the size of the resulting change in consumption (the role of the mpc) is made evident: the larger it is, the larger the multiplier, (3) the economy is seen as moving, albeit in logical rather than historical time, from one equilibrium to the next, not jumping from one to the other, (4) allocation of resources is shown to be important since this is the critical rationale of the production possibility frontier, and (5) the curve itself does not shift since investment in the Keynesian world is demand creating only.

DOI 10.1007/s11294-016-9588-6

Alan Hochstein [1]

Published online: 30 May 2016

[mail] Alan Hochstein

[1] Department of Finance, Concordia University, Montreal, Canada

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Title Annotation:RESEARCH NOTE
Author:Hochstein, Alan
Publication:International Advances in Economic Research
Article Type:Report
Geographic Code:1USA
Date:Aug 1, 2016
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