Aggregate Expenditures Model (Part B) - Multiplier Effects PDF

Principles of Macroecono mics (EC 1101) Aggregate expenditures model (part B): Multiplier Dr. Panagiotis Palaios effects Assistant Professor in Economics PPal...

Principles of Macroecono mics (EC 1101) Aggregate expenditures model (part B): Multiplier Dr. Panagiotis Palaios effects Assistant Professor in Economics [email protected]  The Multiplier Effect  Assuming that the economy has room to expand – so that increases in spending do not lead to increases in prices – there is a direct (positive) relationship between changes in spending and changes in real GDP  More spending results in a higher real GDP…but…as stated above… assuming that the economy has room to expand  The multiplier effect works in both directions. Therefore, less spending results in a lower real GDP  The Multiplier Effect  Multiplier: The ratio of a change in equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand  The number by which a change in any component of aggregate demand must be multiplied to find the resulting change in equilibrium GDP change in real GDP Multiplier  initial change in spending Change in GDP multiplier initial change in spending  The Multiplier Effect  As an example, note that an initial change in investment spending can change output and income by a larger amount  That surprising result is called the multiplier effect:  Any initial change in a component of total spending can lead to a larger change in GDP  The Multiplier Process (MPC = 0.75) (3) (1) (2) Change in Change Change in Saving in Consumption (MP S = Income (MP C = 0.75) 0.25) Increase in investment $5.00 $3.75 $1.25 of $5.00 Second round 3.75 2.81 0.94 Third round 2.81 2.11 0.70 Fourth round 2.11 1.58 0.53 Fifth round 1.58 1.19 0.39 All other rounds 4.75 3.56 1.19 Total $20.00 $15.00 $5.00  The Multiplier Effect  In the previous example an initial change in investment of $ 5 billion creates an equal $ 5 billion of new income in round 1  Under the assumption that households have a MPC equal to 0.75 households will spend 0.75 x $ 5 = $ 3.75 billion of this new income and save $ 1.25 billion, creating $ 3.75 billion of added income.  The $ 3.75 billions of spending will create $ 3.75 of new income  The Rationale of the Multiplier  It holds: Spending New (depends on the MPC) Income Spending New Income (Initial) Saving (depends on the MPS)  The Rationale of the Multiplier  The multiplier effect works in both directions  The economy has continuous flows of income and expenditure. Expenditure creates income and vice versa  Any change in income changes both consumption and saving in the same direction as, and by a constant fraction of, the change in income  Multiplier and Marginal Propensities  Multiplier and MPC directly related: Large MPC results in larger increases in spending  Multiplier and MPS inversely related: Large MPS results in smaller increases in spending 1 1 Multiplier  Multiplier  1  MPC MPS  Therefore: Multiplier = The MPC and the Multiplier  The Actual Multiplier Effect?  Actual multiplier is lower than the model assumes  Consumers buy imported products  Households pay income taxes  Inflation  Multiplier may be 0  Changes in Equilibrium GDP and the Multiplier  It also holds that: Multiplier =  Therefore: = Δ(spending)initial = Δ(spending)initial  We conclude that the extent of changes in the equilibrium GDP will depend on the size of the multiplier Changes in Equilibrium GDP and the Multiplier  Changes in Equilibrium GDP and the Multiplier  It also holds that: Multiplier =  Therefore: = Δ(I)initial = Δ(I)initial  We conclude that the extent of changes in the equilibrium GDP will depend on the size of the multiplier  Changes in Equilibrium GDP and the Multiplier in an open economy  It also holds that: Multiplier =  Therefore: = Δ(NX) = Δ(NX)  We conclude that the extent of changes in the equilibrium GDP will depend on the size of the multiplier Changes in Equilibrium GDP and the Multiplier  Changes in Equilibrium GDP and the Multiplier in the public sector  It also holds that: Multiplier =  Therefore: = Δ(G)initial = Δ(G)initial  We conclude that the extent of changes in the equilibrium GDP will depend on the size of the multiplier Changes in Equilibrium GDP and the Multiplier  The impact of Government Purchases on Equilibrium GDP  The new (7) equilibrium is $ (1) Real (5) Net (5) Net (6) Aggregate Expenditu 550 billion Domestic Output Exports (Xn), Exports (Xn), Governme nt res (C+Ig+Xn+ and (2) (4) Billions Billions Purchase G), Investme  A $ 20 billion Income (GDP=DI), Consumpt ion (C), (3) Saving (S), nt (Ig), for Exports for Imports s (G), Billions (2)+(4)+(5) Billions Billions Billions Billions (X) (M) Billions +(6) increase in (1) $370 $375 $−5 $20 $10 $10 $20 $415 Government (2) 390 390 0 20 10 10 20 430 Purchases (G) (3) 410 405 5 20 10 10 20 445 (4) 430 420 10 20 10 10 20 460 has increased (5) 450 435 15 20 10 10 20 475 equilibrium (6) 470 450 20 20 10 10 20 490 GDP by $ 80 (7) 490 465 25 20 10 10 20 505 billion (from $ (8) 510 480 30 20 10 10 20 520 (9) 530 495 35 20 10 10 20 535 470 to $ 550 (10) 550 510 40 20 10 10 20 550 billion), because the multiplier is 4  Taxation and Equilibrium GDP  The government not only spends but also collects taxes  Suppose it imposes a lump – sum tax, which is a constant amount or, more precisely, a tax yielding the same amount of tax revenue at each level of GDP  Taxation causes the Disposable Income (DI) to fall short of GDP by the amount of the taxes  Therefore, the fall of Disposable Income (DI), because of the taxes, lowers both consumption and saving, depending on the MPC and MPS  Equilibrium GDP decreases according to The Lump – Sum Tax Multiplier  Changes in Equilibrium GDP and the Lump- Sum Tax Multiplier  It also holds that: Multiplier =  Therefore: = - ΔT = - ΔT  We conclude that the extent of changes in the equilibrium GDP will depend on the size of the multiplier Changes in Equilibrium GDP and the Lump-Sum Tax Multiplier  The impact of Taxation on Equilibrium GDP  Let’s assume the tax imposed is $ 20 (1) Real Domestic (2) Taxes (3) Dispos (4) Consu (5) Saving (6) Invest (7) Net (7) Net Export (8) Gover (9) Aggregate  Disposable Income Output and (T ), Billion able Income mptio n (Ca), s (Sa), Billions ment (Ig), Export s (Xn), s (Xn), Billions nment Purch Expenditu res (Ca + Ig is $ 20 billion lower Income (GDP = N s (D I), Billions Billion s (3) − (4) Billion s Billion s for for Import ases (G), + Xn + G ), Billions (4) than before I), (1) − Export s (M) Billion + (6) + (7) Billions (2) s (X) s + (8)  As a result C and S (1) $370 $20 $350 $360 $−10 $20 $10 $10 $20 $400 will decline, (2) 390 20 370 375 −5 20 10 10 20 415 according to MPC (3) 410 20 390 390 0 20 10 10 20 430 and MPS (4) 430 20 410 405 5 20 10 10 20 445  Equilibrium GDP (5) 450 20 430 420 10 20 10 10 20 460 decreases (6) 470 20 450 435 15 20 10 10 20 475 according to The (7) 490 20 470 450 20 20 10 10 20 490 Lump – Sum Tax (8) 510 20 490 465 25 20 10 10 20 505 Multiplier (9) 530 20 510 480 30 20 10 10 20 520 (10) 550 20 530 495 35 20 10 10 20 535  Injections and Leakages  At the equilibrium GDP, the sum of the leakages equals the sum of injections, as follows:  S+M+T=I+X+G Where: S: after tax saving M: Imports T: Taxes I: Investment X: Exports G: Government purchases  The Balanced-Budget Multiplier  Budget Balance: G – T  An increase in G will increase equilibrium GDP  = ΔG  = - ΔT  An increase in T will decrease equilibrium GDP  The Balanced-Budget Multiplier  Suppose the government wants the budget intact  ΔG = ΔT  What happened to GDP if G and T increase by the same amount?  = = ΔG – ΔT = ΔG = ΔT  Therefore, GDP increase by ΔG = ΔT  Multiplier: + = = = 1  Equilibrium versus Full-Employment GDP (Recessionary Expenditure Gap)  In the aggregate expenditures model equilibrium GDP need not equal the economy’s full employment GDP  Recessionary expenditure gap: The amount by which aggregate expenditures fall short of the amount required to achieve the full employment level of GDP  In other words, the amount by which the aggregate expenditures schedule must shift upward to increase real GDP to its full employment, noninflationary level Equilibrium versus Full-Employment GDP (Recessionary Expenditure Gap)  Equilibrium versus Full-Employment GDP (Recessionary Expenditure Gap)  Keynes’s pointed to two different policies that a government might pursue to close a recessionary expenditure gap and achieve full employment:  The first is to increase government spending  The second is to lower taxes  Both work to by increasing the aggregate demand but, in the short run, they cause budget deficits  Equilibrium versus Full-Employment GDP : (Inflationary Expenditure Gap)  The amount by which the aggregate expenditures schedule must shift downward to decrease the nominal GDP to its full employment noninflationary level Equilibrium versus Full-Employment GDP : (Inflationary Expenditure Gap)  Application: The Recession of 2007-09  December 2007 recession began  Aggregate expenditures declined  Consumption spending declined  Investment spending declined  Recessionary gap  Federal government undertook Keynesian POLICIES  Tax rebate checks  $ 787 billion stimulus package