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The Multiplier Effect

In order to understand how the multiplier effect operates, let's trace the impact of this increase in investment spending as it works its way through the economy. Exhibit 8 illustrates the process. Period one shows the original equilibrium situation from Exh. 7 (note that total output equals total spending at $600 billion). In period two, output and consumption spending remain unchanged, but investment spending increases from $50 billion to $100 billion. That pushes total spending up to $650 billion and disturbs the economy's equilibrium. Since the level of total spending in period two exceeds the economy's output, the demand can be met only by drawing inventories below their desired levels.

In period three, producers increase their output to $650 billion in an attempt to catch up with demand. But when producers expand their output by $50 billion, they create an additional $50 billion of new income—the money that is paid to the owners of economic resources. Recall that our hypothetical economy was constructed with an MPC of 0.75. Therefore, this $50 billion increase in income leads to an additional $37.5 billion of consumption spending (75 percent of $50 billion). As a result, total spending rises by an additional $37.5 billion in period three, and output again fails to keep pace with demand.

EXHIBIT 8. Tracing the Impact of a Spending Increase (hypothetical data in billions)

PERIOD

TOTAL OUTPUT AND INCOME (GDP)

PLANNED

CONSUMPTION

EXPENDITURES

PLANNED

INVESTMENT

EXPENDITURES

TOTAL

PLANNED

EXPENDITURES

One

$600.00

$550.00

$ 50.00

$600.00

Two

600.00

550.00

100.00

650.00

Three

650.00

587.50

100.00

687.50

Four

687.50

615.63

100.00

715.63

Five

715.63

636.73

100.00

736.73

Six

736.73

652.56

100.00

752.56

Ultimately

800.00

700.00

100.00

800.00

In period four, businesses expand their production to $687.5 billion, the level of demand in period three. This $37.5 billion increase in income (output) causes consumption spending to increase by $28.13 billion (75 percent of $37.5 billion). As a consequence, total spending in period four will rise by $28.13 billion, and since total spending continues to exceed total output, inventories again will fall.

As you can see, once equilibrium is disrupted, income and consumption spending continue to feed each other. Any change in income causes consumption spending to expand, which, in turn, causes income and output to expand still further. In theory, the new equilibrium would be reached only after an infinite number of time periods. However, the increases in income and consumption become smaller as equilibrium is approached, so that most of the expansionary effect is felt after the first half-dozen or so periods. In our example, equilibrium is finally attained when output is equal to total spending at $800 billion. (Note that this is the output level at which the total expenditure function crosses the 45-degree line in Exh. 7.)

 
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