begin with the standard assumption in textbook treatments of the model: investment is determinedoutside the model, or in the jargon of economists, it is
.In the table below we have added investment spending to the model. At an expected income of $20,000, consumers will spend $20,000 and expect to save nothing. Business will invest $2,500. Thusactual income will be $22,500 (and actual savings will be $2,500, matching investment). Since actualincome will not equal expected income, expected income should change, causing behavior to changetoo. Not until expected income equals $30,000 will expected income equal actual income and only thenwill behavior stop changing.
Table 2: The Simple Income-Expenditure Model withInvestment
ExpectedIncomeConsumptionExpectedSavingsInvestmentActualIncome$10,000$12,500-$2,500$ 2,500$15,00012,00014,000-2,0002,50016,50020,00020,00002,50022,50030,00027,5002,5002,50030,000Notice that the addition of $2,500 in investment increased the equilibrium from the $20,000 to$30,000. There is a multiplier effect here, and the multiplier is four. The reason for the multiplier effectcan be seen intuitively. As the result of the addition of the $2,500 in investment, actual income rises by$2,500. Expected income will also rise. But at the new expected income of $22,500, people will want tospend more than $20,000 for consumption, so there will be an additional
increase in spending.But the story does not end here. The additional consumption increases actual and thus expectedincome, and changes behavior still further. The chain reaction that the addition of investment sets intoeffect diminishes at each step, and the total will approach $30,000. This more complex model is illustrated graphically below. The only alteration is that the total spendingline now includes investment as well as consumption. As before, the equilibrium exists when expectedincome equals actual income. To complete the standard textbook model, we need to add government. Government affects the flow of spending in two ways: it adds spending in the form of government purchases of goods and services andit takes money from the flow of spending with taxes. Government purchases include payments forfighter planes, salaries of congressmen, and building of new highways. Not included in governmentspending are
such as Social Security payments, food stamps, or grants to needycollege students. Transfers can be treated as negative taxes.Government spending affects the model in exactly the same way as investment spending does, but theaddition of taxes forces some changes in the way we have been presenting the model. Simplyrelabeling the table above shows the effect of adding government spending. The column titled"Investment" could be called "Investment Plus Government Spending." The column titled "ActualIncome" would remain the same, but it would now be computed by adding together consumptionspending, investment spending, and government spending. Because government spending enters themodel in exactly the same way as investment spending, changes in it have the same multiplier effectsas do changes in investment spending.