Question

If the value of the Marginal Propensity to Save (MPS) in an economy is exactly \( 0.2 \), what is the magnitude of the investment multiplier (\( K \))?

• A. \( 5 \)
• B. \( 2 \)
• C. \( 4 \)
• D. \( 0.8 \)

Hint:

The multiplier value has a direct relationship with the Marginal Propensity to Consume (MPC) and an inverse relationship with the Marginal Propensity to Save (MPS). A lower savings rate leaves more income circulating as consumer demand, generating a larger multiplier effect.

Answer 1

The Correct Option is A

Step 1: Understanding the Concept:
The investment multiplier (\(K\)) measures the total increase in national income resulting from a unit increase in autonomous investment.
The multiplier effect occurs because one person's expenditure becomes another person's income, leading to further spending.
However, at every stage, people save a portion of their income. This "leakage" (MPS) determines how long the spending chain continues.
Step 2: Key Formula or Approach:
The relationship between the multiplier and the propensity to save is an inverse one:
\[ K = \frac{1}{MPS} \]
Also, since \(MPC + MPS = 1\), it can be written as:
\[ K = \frac{1}{1 - MPC} \]
Detailed Explanation:
Given in the question:
\(MPS = 0.2\)
Now, plug the value into the formula:
\[ K = \frac{1}{0.2} \]
To simplify the calculation:
\[ K = \frac{1}{\frac{2}{10}} = \frac{10}{2} = 5 \]
This means if the government invests \$100 million, the total income in the economy will increase by \$500 million (calculated as \(100 \times 5\)).
The high multiplier (5) indicates that people are saving only a small fraction (0.2) and consuming a large fraction (0.8) of their additional income, which keeps the money circulating in the economy.
Step 3: Final Answer:
The value of the multiplier is 5.
Therefore, Option (A) is correct.