The Impact of Investment Increase on Real GDP

Investment plays a crucial role in the growth and development of an economy. When firms decide to increase their investment, it means they are expanding their production capacity, creating more job opportunities, and contributing to higher levels of economic output.

The relationship between firms increasing investment and the change in real GDP can be understood through the concept of the spending multiplier. The spending multiplier shows how an initial increase in spending by firms can lead to a larger overall increase in economic output.

Understanding the Spending Multiplier

The spending multiplier is a key concept in economics that measures the impact of an initial change in spending on the overall economy. It is influenced by the marginal propensity to consume, which is the proportion of additional income that individuals choose to spend rather than save.

For example, if firms increase investment by $5 million and the marginal propensity to consume is 0.8, the spending multiplier can be calculated as follows:

Given that the marginal propensity to consume is 0.8:

This means that for every dollar increase in investment, the overall GDP will increase by $5 due to the multiplier effect.

Impact on Real GDP

When firms increase investment by $5 million, the total increase in real GDP can be calculated by multiplying the spending multiplier by the increase in investment:

Substituting the values:

Therefore, the maximum possible change in real GDP as a result of firms increasing investment by $5 million with a marginal propensity to consume of 0.8 is $25 million.