Equilibrium Not Necessarily Full Employment

It is important to recognize that an equilib- rium g.n.p. does not necessarily imply that there is full employment. Look back at the aggregate supply curve in Fig. 5-1. If our equilibrium g.n.p. level is less than 0D3 and 0Q3, there will be un- employment and the economy will be operating inside its production possibilities frontier. If equilibrium g.n.p. is above 0D3, the result will be inflation. “Equilibrium” g.n.p. as we have defined it is thus a neutral analytical concept. It does not imply anything, either good or bad, about the level of employment or how well the economic system is performing.

CHANGING INVESTMENT— THE MULTIPLIER

Suppose now that businessmen decide to in- crease their spending on investment, perhaps be- cause of a new invention. This decision will raise the II curve in Fig. 6-2 and the C + I curve in Fig. 6-3. The result, common sense tells you, will be a higher equilibrium level of g.n.p. after the increase in investment. Conversely, a decrease in investment spending will lead to a lower equilib- rium level.

These results are obvious enough, but one additional fact may not be: Each dollar of in- crease in autonomous investment will increase aggregate demand and g.n.p. by a larger, or multi- plied, amount. This is because as each new dollar of investment is spent, it becomes income to a consumer who saves part but respends the rest on consumption. This respending constitutes in- come to someone else, who in turn saves part but respends the rest. And so on. The number of times the final increase in income (g.n.p.) exceeds the new investment is called the “multiplier.” For example, if one additional dollar of invest- ment spending generates four additional dollars of g.n.p., the multiplier is four.

Marginal Propensity To Consume

To explore this process more fully, we now need to be more precise about the consumption function, and to distinguish between the “average propensity to consume” and the “marginal pro- pensity to consume.” Suppose that total income (g.n.p.) is 100 and people are spending 75 on consumption and saving 25 each period. Then the average propensity to consume is .75; people are spending .75 of their incomes on consumption. However, it does not necessarily follow that if they receive additional income they would main- tain this same consumption-income ratio. Suppose their incomes now rise to 110 but they only spend .5 of this additional 10 of income. Then the marginal propensity to consume is .5. The marginal propensity to consume is simply the proportion of additional, or marginal, income which is spent on consumption. It is the marginal propensity on which we need to focus our atten- tion when we are analyzing changes in the level of g.n.p., since it is the marginal propensity to consume that tells us what percentage of addi- tional income people spend on consumption.

The Multiplier

Begin with an equilibrium g.n.p. level of 350 and assume that the marginal propensity to consume is .75. Suppose now that businessmen decide to increase their investment spending by 10. When the 10 is spent on new investment (say, plant construction), it becomes income to the recipients, who then spend 7.5 on consump- tion and save 2.5. The 7.5 of consumption spend- ing becomes income to someone else who in turn respends 75 per cent (5.6) on consumption and saves 25 per cent (1.9). The 5.6 becomes income to someone else, and so the process goes. Remem- ber that savings are withdrawn from the income stream and are not respent in this model; nor do they stimulate more business investment spend- ing. We get a table like the following.

The table shows only the first four rounds, but it gives the general picture. The 10 of new investment generates a chain of respending on consumption—called the “multiplier” effect—that leads to new income of much more than 10. Each round makes a smaller net addition to income than its predecessor because part of the new income is drained off into saving by each recipient, and by assumption these savings are not respent nor do they stimulate additional business investment. If you carry the arithmetic to its conclusion, you will find that the total new g.n.p. generated is 40 (including the 10 of new investment). Of this total, 30 is spent on consumption and 10 is saved, in accordance with our marginal propensity to consume of .75. The new equilibrium g.n.p. is 40 higher, total consumption 30 higher, and total savings and investment each 10 higher than before. The expansion process has continued until the amount people want to save of their higher income just matches the 10 of new investment. Adding these increments to the original equilibrium values, we get a new equilibrium total g.n.p. level of 390. The multiplier is four, since income has risen by 40 in response to 10 of new business investment.

FIG. 6-4 An additional 10 of nvestment rakes the
C + I curve to C’ + I’, and brings the new equilibrium
level of g.n.p. of 390, up 40 from the previous equilib-
rium. The investment multiplier is 4.

This result is shown graphically in Fig. 6-4. The CC and C + I curves before the increase in investment are shown as solid lines, reproduced directly from Fig. 6-3. Now we add 10 more of investment at each level of income. In other words (C + I)’ (the dashed line) now represents consumption plus 110, instead of plus 100, at each level of realized g.n.p. The CC line is unchanged because it was originally drawn to show what households would spend on consumption at each level of g.n.p. But the new equilibrium level of g.n.p. is 390, up 40. This is where the new (C + I)’ curve cuts the 450 line, even though investment has increased only 10.

If this looks like graphical trickery, consider the economic common sense of this multiplier effect of new investment on consumption and g.n.p. Under what conditions is the effect powerful, and when is it weak? Just how does it work? There are four important points:

1. The multiplier effect hinges on the fact that people respend on consumption part of each increment of income they receive. If at any point they save all their new income, the respending spiral stops short.

2. The larger the proportion of its additional income that the public respends each
round, the larger will be the multiplier effect. Conversely, the larger the proportion saved each round, the smaller will be the multiplier effect.

3. The size of the multiplier is given precisely by the formula:

Hence, an increase of $1 in investment would mean an increase of $4 in g.n.p. If the economy’s marginal propensity to consume out of g.n.p. were .90, the multiplier would be 10. (Work out the .90 case in the equation, and check yourself by working out a table like the one in the preceding section. You will find that the formula merely summarizes the arithmetic.) An easy way to look at it is this: The multiplier is the reciprocal of the marginal propensity to save, still using our simple assumptions. Thus, if consumers save one-fourth of their new income, the multiplier is 4. If onetenth, the multiplier is 10. And so on.

4. Last, review again the economic reasoning behind this formula. For example, with a marginal propensity to consume of .75, why is the new equilibrium level of g.n.p. higher by just four times the level of additional investment spending? Because at any assumed g.n.p. level below equilibrium, people would want to save less than the new level of investment, and the respending rounds would continue to raise g.n.p. Equilibrium is achieved only when the public’s income is such that it wants to save just enough to offset the amount being invested. Only if these two just match will the circular flow of income be continuous and stable.

This is the basic multiplier process. But a warning is needed. In the real world, with government taxes and spending and with business as well as consumer saving, the picture becomes more complex. To calculate real-world multipliers, wait for the section, “The Multiplier in the Real World,” afew pages later on.

The Paradox of Thrift

This reasoning suggests a curious paradox. If consumers decide to save a larger percentage of their incomes, this increased propensity to save may in fact lead to a lower multiplier, lower consumption, a lower g.n.p., a decrease in induced investment, and a lower level of aggregate saving in the new (temporary or permanent) equilibrium. Here is an example of the fallacy of composition. More saving may be a very good thing for the individual household, but a simultaneous attempt by many households to save more out of their incomes may throw the economy into a recession which makes us all worse off. This is the paradox of thrift.

But note that an increase in the economy’s propensity to save need not throw us into a recession. If the increased thriftiness comes in a period of inflation, it can have the happy result of pulling aggregate demand down toward maximum potential real g.n.p. and reducing inflationary pressure. And even in noninflationary periods, the drop in consumption may be offset by increased private investment or government spending—which leads us on to the next section. But the paradox of thrift may pose a real problem when the economy is on the verge of unemployment or in a recession.