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Macroeconomics, Maclachlan 11/1/04 1 Principles and Policies I: Macroeconomics Chapter 10: The Multiplier Model

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Macroeconomics, Maclachlan 11/1/04 2 Chapter 10 Learning Objectives You should be able to … Explain the difference between induced and autonomous expenditures. Show how the level of income is graphically determined in the multiplier model. Use the multiplier equation to determine equilibrium income. Explain how the multiplier process amplifies shifts in autonomous expenditures. Demonstrate how fiscal policy can eliminate recessionary and inflationary gaps. List six reasons why the multiplier model might be misleading.

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Macroeconomics, Maclachlan 11/1/04 3 The AS/AD Model When Prices Are Fixed ? Cumulative shift 20 P0P0 Aggregate supply AD Real output Price level AD Initial shift Induced shift (Multiplier effects)

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Macroeconomics, Maclachlan 11/1/04 4 The Circular Flow

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Macroeconomics, Maclachlan 11/1/04 5 The Aggregate Production Curve Aggregate production (production = income) A 45º $4,000 0 Real production Real income $4,000 B Potential income C

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Macroeconomics, Maclachlan 11/1/04 6 Multipler Model Aggregate Production curve meets … Aggregate Expenditure = C + I + G + (X-M)

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Macroeconomics, Maclachlan 11/1/04 7 Building Aggregate Expenditure Function: Autonomous and Induced Expenditures Autonomous expenditures – expenditures that do not systematically vary with income. Induced expenditures – expenditures that change as income changes.

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Macroeconomics, Maclachlan 11/1/04 8 Building Aggregate Expenditure Function: The Marginal Propensity to Expend Marginal propensity to expend (mpe) – the ratio of the change in aggregate expenditures to a change in income. It is composed of the various relationships between the component of aggregate expenditures. Its value is greater than 0 and less than 1. It is the slope of the aggregate expenditure curve.

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Macroeconomics, Maclachlan 11/1/04 9 Expenditures Function Autonomous expenditures is the sum of the autonomous components of expenditures: AE 0 = C 0 + I 0 + G 0 + (X 0 – M 0 ) Induced expenditures is the sum of the induced components of expenditures.

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Macroeconomics, Maclachlan 11/1/04 10 Real income (in dollars) Real expenditures ( AE ) (in dollars) Solving for Equilibrium Graphically 14,000 12,000 10,000 7,000 5,000 4,00010,00014,000 Aggregate production Aggregate expenditures AE 0 = 5,000 AE = 5, Y Equilibrium

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Macroeconomics, Maclachlan 11/1/04 11 The Multiplier Equation Expenditures multiplier – a number that reveals how much income will change in response to a change in autonomous expenditures.

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Macroeconomics, Maclachlan 11/1/04 12 The Circular Flow Model and the Multiplier Process Not all of the flow of income is spent on domestic goods (the mpe < 1). –This represents a leakage from the circular flow. Autonomous expenditures are injections into the circular flow. –They offset the leakages.

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Macroeconomics, Maclachlan 11/1/04 13 The First Five Steps Multiplier = 1/(1-0.4) = Multiplier = 1/(1-0.5) = mpe =.4mpe =.5

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Macroeconomics, Maclachlan 11/1/04 14 An Upward Shift of AE Aggregate production 1,052.5 AE ,090 $4,090 $4,210 $120 Real expenditures 0Real income 1,022.5 AE 0

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Macroeconomics, Maclachlan 11/1/04 15 $90 $4,152 $4,062 4,062 AE 0 1,412 AE 1 1,382 An Downward Shift of AE Real expenditures 30 0Real income Aggregate production

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Fighting Recession: Expansionary Fiscal Policy Potential output Aggregate production AE 0 AE 1 E1E1 mpe = 0.67 Recessionary gap ∆G = $60 $1,000$1,180 Real income AE 1 = Y $1,000$1,180 Real income SAS LAS AD 1 AD 0 E2E2 AD 1 ΄ $180 $60$120 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial expenditures increase Multiplier effect

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Fighting Inflation: Contractionary Fiscal Policy McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Potential output Aggregate production AE 0 AE 1 E2E2 mpe = 0.8 E1E1 Inflationary gap ∆G = $200 $4,000$5,000 Real income AE 1 = Y B A $4,000$5,000 Real income SAS LAS AD 0 AD 1 P1P1 P0P0 $1,000

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Macroeconomics, Maclachlan 11/1/04 18 Limitations of Multiplier Model 1.It’s incomplete: needs info on where economy starts and potential output. 2.It over emphasizes shifts in AE. 3.It assumes a fixed price level. 4.It doesn’t consider expectations. 5.It ignores possibility of desired shifts in AE. 6.It ignores permanent income hypothesis.

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Macroeconomics, Maclachlan 11/1/04 19 Problem 10-1 The mpe is 0.8. Autonomous expenditures are $4,200. What is the equilibrium income in the economy? $21,000

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Macroeconomics, Maclachlan 11/1/04 20 Problem 10-4 mpe =.6 Multiplier = 2.5 A = 1, , , ,000 = 20,000 Y = 50,000 Increase in A of 2,000 Y increases by 5,000 (or 10%) Unemployment decreases by 5 percentage points. mpe =.5 Multiplier = 2 Y= 40,000 Y increases by 4,000 (or 10%) Unemployment decreases by 5 percentage points.

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