Investment multiplier:

Aggregate demand  is seen  in  the context of aggregate spending in the economy. Due  to  the circular  flow  of income when one economic  agent spends certain amount  (say one dolor), it causes an  increase in the income  of  another economic  agent by the same amount  (by one dolor). Based on  this simple  logic Kahn developed  the  theory of multiplier,  often  known as  'investment  multiplier.'

In above the term 1/ 1-c is  called  the  'investment multiplier' since mate  demand increases by a multiple of 1/ 1-c for  an  initial spending  by the  government.  In our example above when government expenditure  increased  by Rs.  100  and MPC =  0.65, the increase in aggregate demand would be Rs.  100  x  1/ 1-0.65 = 285.71.

We draw  a few  inferences from the above.

1)  Government spending  has  the beneficial effect ofboosting  up aggregate demand by a  higher amount  than  the  initial  spending.

2)  An increase in MPC will result in an increase  in the value of the multiplier. Conversely, decrease  in MPS would  result in a  higher multiplier value.

3)  We assumed that  government spendmg is  financed  by borrowing hm  the market If it is  tax financed  then the multiplier will  be 1,  not 1/ 1-c since  increase  in  tax will have  the multiplier effect  in  the  opposite direction. Consequently aggregate demand will increase  an amount equal  to  the initial spending  by the government. It is called 'balanced budget multiplier' and  is  equal  to 1.

4)  It is  assumed that households spend according  to their MPC and do not hoard the money.

Keynes projected  the Great Depression  as  a consequence  of demand deficiency.  There was decline  in  income because  of  inaxme  in unemployment. Decline  in  income gave  rise to decrease in consumption  demand. Inadequate demand  reiulted  in excess  supply  in the market and inventories got piled up, which discouraged Wer  production. With curtailment  in production there was  fiather  unemployment and further  decline  in  income. Secondly,  people expected prices  to decline  fiather so  that  they  postponed  their purchases which  reduced aggregate  demand further. There was an  overall gloomy  period of  falling output, income and prices, and rising unemployment. Keynes suggested that the government shbvidincrease  its spending so  that people get employment, which will generate  income and demand.