Economics Aggregate Expenditures Model Quiz

Aggregate Expenditures Model (Part B): Multiplier Effects

• The multiplier effect highlights how changes in spending ripple through the economy, impacting overall GDP.
• Increased spending leads to higher real GDP, while reduced spending leads to lower real GDP.
• This effect occurs because spending by one person becomes income for another, and that income is then spent, creating further increases in economic activity. This process continues, albeit diminishing in each round, leading to a larger overall impact.
• The effect assumes prices remain unchanged, allowing a direct correlation between spending and real GDP changes. (This situation only holds true when the economy has room to expand without pushing up prices).
• This reciprocal relationship between spending and GDP changes applies in both directions.

The Multiplier Effect

• The multiplier is the ratio of a change in equilibrium GDP to a change in investment or any other component of aggregate expenditures (or aggregate demand).
• The multiplier effect shows any initial change in total spending results in a larger change in GDP.
• A formula for calculation: Multiplier = (change in real GDP) / (initial change in spending)
• A change in GDP equals the multiplier * the initial change in spending.

The Multiplier Process (MPC = 0.75)

• An illustration demonstrates how an initial investment change of $5 billion (for example) can ultimately lead to a total change in GDP greater than the initial investment. Assume the MPC (marginal propensity to consume) is 0.75.
• Each round of spending has a smaller effect on overall GDP. This is due to some portions of the income being saved.
• The total effect of the initial change is the sum of all the rounds of spending and income changes.

The Rationale of the Multiplier

• The multiplier effect operates in both directions.
• A continuous flow of income and expenditures exists in the economy. Expenditure creates income, and vice versa.
• Changes in income affect consumption and saving in the same direction as, and by a constant proportion of, the change in income. This emphasizes the feedback loop between spending and income.
• The multiplier process depends on the MPC (marginal propensity to consume) and MPS (marginal propensity to save).

Multiplier and Marginal Propensities

• The multiplier is directly related to the MPC, a larger MPC results in larger increases in spending.
• The multiplier is inversely related to the MPS, a larger MPS results in smaller increases in spending.
• The formula for calculating the multiplier given the MPS or the MPC is:
  • Multiplier = 1 / MPS
  • Multiplier = 1 / (1 − MPC)

The Actual Multiplier Effect

• Actual multipliers in the real world are usually lower than the model predicts.
• Factors like:
  • Consumers buying imported products
  • Households paying income taxes
  • Inflation
  • Possibility of multiplier being zero

Changes in Equilibrium GDP and the Multiplier

• Changes in initial spending have a magnified impact on equilibrium GDP, determined by the multiplier.
• Multiplier = (change in equilibrium GDP) / (initial change in spending)
• Therefore Δ(spending)initial = Δ(spending)initial * Multiplier

Changes in Equilibrium GDP and the Multiplier in an Open Economy

• Similar to the previous multiplier formulas, considering exports, imports and other open economy components also results in a change in equilibrium GDP.
• Multiplier = (change in equilibrium GDP) / (initial change in spending)
• The initial spending change in the previous equation could be in exports, imports, or government purchases (among others).

Changes in Equilibrium GDP and the Multiplier in the Public Sector

• Changes in government spending affect GDP, this is similar to the previous formulas and calculation methods for the multiplier effect.
• A formula is presented similar to the others for the multiplier, showing the initial spending and resultant GDP change.

The impact of Government Purchases on Equilibrium GDP

• An illustration of how an increase in government purchases (e.g., $20 billion) results in a larger increase in equilibrium GDP, due to the multiplier effect.
• The amount of the increase in GDP will depend on the multiplier.

Taxation and Equilibrium GDP

• An increase in taxes will cause equilibrium GDP to decrease.
• The formula for the multiplier will depend on various factors including the MPC and the amount of the tax.

Changes in Equilibrium GDP and the Lump-Sum Tax Multiplier

• The multiplier is the ratio of the change in equilibrium GDP to the change in the tax.
• The formula for calculating the multiplier is shown, relating change in the tax and the resultant change in equilibrium GDP.

Injections and Leakages

• At equilibrium GDP in an open economy, the sum of leakages (saving, taxes, imports) equals the sum of injections (investment, exports, government purchases).
• This equation is essential for understanding equilibrium GDP determination in open economies.

The Balanced-Budget Multiplier

• The balanced budget multiplier occurs when government spending and taxes increase by the same amount.
• The multiplier in this scenario is 1.
• An increase in both spending and taxes by an equal amount results in no net change in the budget deficit.

Equilibrium versus Full-Employment GDP (Recessionary Expenditure Gap)

• Equilibrium GDP need not equal full-employment GDP.
• The difference, the "recessionary expenditure gap," describes the amount which aggregate expenditure falls short of full employment.
• The expenditure gap shows the additional spending needed to reach full employment and stable prices.

Equilibrium versus Full-Employment GDP (Inflationary Expenditure Gap)

• Equilibrium GDP can exceed full-employment GDP.
• This is called the "inflationary expenditure gap" and represents the excess demand at full employment levels that can result in inflation.
• This excess demands require spending to be decreased to achieve equilibrium.

Application: The Recession of 2007-09

• The 2007-2009 recession saw decreasing aggregate expenditures impacting real GDP.
• Government policies like tax rebate checks and a stimulus package were implemented in an attempt to decrease the recessionary expenditure gap and boost the economy.

Test your understanding of the Aggregate Expenditures Model and the multiplier effect. This quiz covers how spending changes influence GDP, the reciprocal relationship between spending and economic activity, and the assumptions underlying the multiplier effect. Dive in to explore the dynamics of the economy's response to spending variations.