Marginal Propensity to Invest (MPI): Definition and Calculation (2024)

What Is the Marginal Propensity to Invest (MPI)?

The marginal propensity to invest (MPI) is theratio of change in investment to change in income. It shows how much of one additional unit of income will be used for investment purposes. Typically, people will only invest a portion of their income, and investment increases when income increases and vice versa, meaning that the MPI is a positive ratio between 0 and 1. The greater the MPI, the larger the proportion of additional income is invested rather than consumed.

Understanding the Marginal Propensity to Invest (MPI)

Although John Maynard Keynes never explicitly used the term, the MPI originates from Keynesian economics. In Keynesian economics, a general principle states that whatever is not consumed is saved. Increases (or decreases) in income levels encourage individuals and businesses to do something with the amount of available money.

The MPI is one of several marginal rates that have been developed through Keynesian economics. Others include the marginal propensity to consume (MPC), the marginal propensity to save (MPS), and less well-known ones such as the marginal propensity for government purchases (MPG).

The MPI is calculated asMPI = ΔI/ΔY, meaning the change in value of the investment function (I) with respect to the change in value of the income function (Y). It is thus the slope of the investment line. For example, if a $5 increase in income results in a $2 increase in investment, the MPI is 0.4 ($2/$5). In practice, the MPI is much lower, especially in relation to the MPC.

How the Marginal Propensity to Invest (MPI) Impacts the Economy

Consumption tends to be impacted more by increases in income, although the MPI does have an impact on the multiplier effect and also affects the slope of the aggregate expenditures function. The larger the MPI, the larger the multiplier. For a business, increases in income can be the result of reduced taxes, changes in costs, or changes in revenue.

According to Keynesian theory,an increase in investment spendingwill employ people immediately in the investment goods industry and have a multiplied effect by employing some multiple of additional people elsewhere in the economy. This isan obvious extension of the idea that spending on investment will be re-spent. However, there's a limit to the effect. The real output of the economy is limited to output at full employment, and spending multiplied past this point will simply raise prices—especially in the case of capital goods or financial assets.

Keynesian theory, and its critics, also suggest thatany given investment project (public or private) may not always raise income and employment with the full force of the multiplierbecause that decision to invest may take the place of investment that would have happened in its absence.

For example, funding a project might raise interest rates,discouraging other investmentsor competing with other projects for labor. This is related to the phenomenon that economists refer to as crowding out, where public investment spending or other policies meant to encourage investment have diminished or even have a negative effect on economic growth to the extent that they replace investment that would otherwise have occurred, rather than encouraging additional investment.

Factors That Impact MPI

The MPI for individual firms or investors can be influenced by a variety of factors. Here are some of the key implications that change how firms and and investors save:

• Prevailing Expected Rate of Return. The expected rate of return on investment is a critical factor in MPI as it dictates the psychology of whether or not it is worth investing. Firms and investors are more likely to invest when they anticipate higher returns on their capital investments. This can be influenced by factors such as market conditions, demand for their
  products or services, and competition in any given investment space.
• Interest Rates. The prevailing interest rates in the financial markets can significantly impact MPI. Lower interest rates can make borrowing more attractive for financing investments, potentially increasing the MPI. Conversely, higher interest rates can discourage borrowing for investments. Alternatively, monetary policy that is striving to slow or boost the economy may influence growth and market expansion.
• Access to Financing. The availability of financing options and capital resources is a key determinant. Firms with easy access to financing, whether through bank loans, equity markets, or internal funds, may have a higher MPI. This relates to the bullet above about interest rates, as a lower cost of capital or greater ease of liquidity make make investing more desirable.
• Tax Incentives and Policy. Government policies and tax incentives can influence MPI. For example, tax credits for research and development or accelerated depreciation schedules can encourage firms to invest
  in these areas, effectively raising the MPI. Government policies (like monetary policy mentioned above) also influence investment decisions.
• Technological Advancements. Technological innovations can drive MPI as firms seek to invest in new technologies and equipment to improve productivity, reduce costs, or enter new markets. Industries with rapid technological change often have higher MPI as there stands greater cost efficiency opportunities and greater revenue growth opportunities.
• Risk Appetite. A firm's or investor's willingness to take on risk can influence MPI. Those with a higher risk appetite may be more inclined to invest in higher-yield but riskier projects. This may also be the case when talking about general market conditions; though expected rate of returns may be lower, more risk-seeking investors may still be okay pursuing lower yield opportunities.
  

Users of MPI

Economists and policymakers frequently use MPI to assess and fine-tune fiscal and monetary policies. For instance, central banks use it to gauge the impact of interest rate changes on investment decisions. When MPI is high, lower interest rates can stimulate investment as borrowing becomes cheaper. In contrast, when MPI is low, interest rate adjustments may have a weaker effect on encouraging investment.

Investment decisions at both the micro and macro levels are influenced by the MPI. Businesses use MPI to make capital allocation decisions and to anticipate the impact of changes in economic conditions on their investments. Households consider MPI when deciding how much of their disposable income to invest rather than consume. Policymakers use MPI to craft effective economic policies, particularly during periods of economic uncertainty or recession, where stimulating investment can be crucial to economic recovery.

MPI also plays a significant role in economic forecasting. Economists use it as a parameter in macroeconomic models to predict how changes in investment spending will affect overall economic activity, employment, and growth. Therefore, MPI is a tool that helps in understanding the drivers of economic fluctuations and ultimately understanding its overall economic health and stability.

MPI vs. MPC

The MPC represents the proportion of additional income that households or individuals will spend on consumption. In many ways, an individual can either spend money or save it for future consumption, so MPI and MPC somewhat contrasting in what they measure, at least regarding the time horizon in which capital is spend.

The MPC is primarily used to understand and predict the overall level of consumer spending in an economy. It is crucial for analyzing the impact of changes in income or government policies like tax cuts or stimulus packages on consumption patterns. For example, governments may analyze how implementing a reduction in taxes helped boost the economy by giving individuals more capital to spend. Meanwhile, the MPI is used to analyze and predict the level of investment in an economy meant for expanded production and contribution to longer-term economic growth.

The MPC focuses on the behavior of households and individuals, while the MPI focuses on the behavior of firms and investors. Therefore, each have different economic implications. A high MPC suggests that a significant portion of income is spent on consumption which can stimulate current economic activity but may not contribute as much to long-term growth. A high MPI suggests that a substantial part of income is channeled into productive investments, which can lead to diminished shorter-term objectives but increased productivity and innovation over a longer horizon.

The Bottom Line

The marginal propensity to invest is an economic concept that measures the change in investment resulting from changes in income. It represents the fraction of any additional income that individuals or entities choose to invest, as opposed to spending on consumption or saving in other forms. MPI is a vital component of macroeconomic analysis, helping economists and policymakers understand how shifts in income affect investment behavior.