Chapter 10Chapter 10

The Multiplier, Net Exports, The Multiplier, Net Exports, & Government& Government

IntroductionIntroduction

We will examine why is GDP We will examine why is GDP unstable and subject to cyclical unstable and subject to cyclical fluctuations.fluctuations.

We will also introduce the We will also introduce the Government & the foreign sector Government & the foreign sector into the aggregate spending model.into the aggregate spending model.

We will then apply the model into We will then apply the model into both the Vietnam War & the Great both the Vietnam War & the Great DepressionDepression

Changes in Equilibrium & Changes in Equilibrium & the Multiplierthe Multiplier

GDP responds to changes in both GDP responds to changes in both consumption & investment. The consumption & investment. The primary focus for this chapter will be primary focus for this chapter will be investmentinvestment

Increase in investment spending Increase in investment spending leads to an exponential increase in leads to an exponential increase in equilibrium GDP.equilibrium GDP.

This is known as the Multiplier This is known as the Multiplier EffectEffect

Continuing the Continuing the MultiplierMultiplier

Initial change in spending is usually Initial change in spending is usually associated w/ investment due to associated w/ investment due to volatilityvolatility

The “initial change” is represented The “initial change” is represented by upward or downward movement by upward or downward movement on the graph (Aggregate on the graph (Aggregate Expenditure Schedule)Expenditure Schedule)

Multiplier works in both directions Multiplier works in both directions (up or down)(up or down)

Basic Facts of the Basic Facts of the MultiplierMultiplier

The Economy has continuous flows of The Economy has continuous flows of expenditures and income – a ripple expenditures and income – a ripple effecteffect

Change in income will cause Change in income will cause consumption and savings to change in consumption and savings to change in the same directionthe same direction

The size of the MPC and the Multiplier The size of the MPC and the Multiplier are directly related, the MPS is are directly related, the MPS is inversely related to the multiplierinversely related to the multiplier

SignificanceSignificance

Small changes in investment plans Small changes in investment plans or consumption can trigger large or consumption can trigger large changes in equilibrium GDP.changes in equilibrium GDP.

Simple Multiplier vs. Complex Simple Multiplier vs. Complex Simple does not include the effect of Simple does not include the effect of

savings, taxes, & importssavings, taxes, & imports

Net ExportsNet Exports

Positive Net Exports increase Positive Net Exports increase aggregate spending and then GDP as aggregate spending and then GDP as wellwell

Negative Net Exports decrease bothNegative Net Exports decrease both What relationship would tariffs have on What relationship would tariffs have on

GDP?GDP? What about depreciation of the dollar?What about depreciation of the dollar? Prosperity abroad typically indicates Prosperity abroad typically indicates

prosperity at home.prosperity at home.

QuestionsQuestions

What is the multiplier effect?What is the multiplier effect? What relationship does the MPC bear to the What relationship does the MPC bear to the

size of the multiplier? The MPS?size of the multiplier? The MPS? Calculate the multiplier if the MPS is 0, .4, .6, Calculate the multiplier if the MPS is 0, .4, .6,

and 1and 1 Calculate the multiplier if MPC is 1, .9, .67, .50, Calculate the multiplier if MPC is 1, .9, .67, .50,

and 0and 0 How much will GDP increase if investment How much will GDP increase if investment

increases 8 billion and the MPC is .8?increases 8 billion and the MPC is .8? What is the difference between the complex & What is the difference between the complex &

simple multiplier? simple multiplier?

The Public SectorThe Public Sector

Government spending boosts aggregate Government spending boosts aggregate expenditures yet reduce disposable expenditures yet reduce disposable incomeincome

Government purchases also subject to the Government purchases also subject to the multipliermultiplier

Taxes will cause disposable income to fall Taxes will cause disposable income to fall short short

How short is determined by multiplying How short is determined by multiplying the MPC and MPS by the total tax the MPC and MPS by the total tax revenue revenue

Injections, Leakage, & Injections, Leakage, & Unplanned InventoryUnplanned Inventory

Savings, Imports, Taxes are all Savings, Imports, Taxes are all considered leakages to the stream of considered leakages to the stream of spendingspending

Investments, Exports, & Government Investments, Exports, & Government Purchases are all considered Purchases are all considered injections injections

At equilibrium GDP, these two will At equilibrium GDP, these two will equal each other (Injections = equal each other (Injections = Leakages @ =GDP)Leakages @ =GDP)

Balanced Budget Balanced Budget MultiplierMultiplier

Equal increases in Government Equal increases in Government spending and taxation increase the spending and taxation increase the equilibrium GDP.equilibrium GDP.

Changes in government spending Changes in government spending affects aggregate spending more affects aggregate spending more powerfully than a tax change of the powerfully than a tax change of the same size.same size.

Balanced Budget Multiplier is always Balanced Budget Multiplier is always oneone

Equilibrium & Full GDPEquilibrium & Full GDP

Recessionary gaps exists when Recessionary gaps exists when equilibrium GDP is below full equilibrium GDP is below full employment GDP. In other words, employment GDP. In other words, we are capable of making morewe are capable of making more

Inflationary Gaps exist when Inflationary Gaps exist when aggregate expenditures cannot aggregate expenditures cannot achieve equilibrium at full achieve equilibrium at full employment. employment.

Limitations of the ModelLimitations of the Model

The Aggregate Spending model does The Aggregate Spending model does not measure inflation – It will show not measure inflation – It will show an inflationary gap, it will not an inflationary gap, it will not however show the exact price level however show the exact price level increaseincrease

Does not allow for GDP to increase Does not allow for GDP to increase once full employment is reachedonce full employment is reached

Does not allow for cost push inflationDoes not allow for cost push inflation