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CHANGES IN SPENDING AND THE MULTIPLIER EFFECT

Changes in the spending plans of either consumers or investors will alter the equilibrium level of income and output in our hypothetical economy. At any given level of income (GDP), consumers may decide to spend more if they believe that prices are going to rise in the near future or if they expect wage and salary increases. Such a change in consumer expectations would be represented graphically by an upward shift of the consumption function. Similarly, investors may increase their rate of investment spending if they become more optimistic about the future or if interest rates decline. This change in the level of planned investment would be depicted by an upward shift of the investment function.

Because the economy's total expenditure function is nothing more than the sum of the consumption and investment functions, an upward shift of

EXHIBIT 7. The Multiplier Effect

The Multiplier Effect

either one would cause an upward shift of the total expenditure function, which, in turn, would increase the equilibrium level of output. Any change resulting in a downward shift of the consumption or investment functions would reduce the equilibrium output.

To illustrate the impact of a change in the level of planned expenditures, let's assume that the rate of autonomous investment increases by $50 billion per year. This change is represented in Exh. 7 by a shift of the total expenditure function from C + I1 to C + I2. The most important thing to notice about this example is the relationship between the initial change in investment spending and the resulting change in total output. When investment spending increases by $50 billion, total output increases by much more than that— by $200 billion, to be exact. This phenomenon—that small changes in spending are magnified into larger changes in income and output—is called the multiplier effect.

 
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