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Multiplication, Net Exports, and Government

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I. Multiplier Multiplier effect: a change in a component of agg expenditures leads to a larger change in equilibrium GDP Multiplier = change rGDP/initial change in spending 1) initial change usually investment (more volatile), but can be C,G, I, X 2) initial change: up or downshift in agg expend schedule due to up or downshift in component 3) multiplier can be negative

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Source of Multiplication 1) repetitive, continuous flow of money 2) change income fractional, same direction change in S and C diminishing spending chain ∆I ∆wage, rent, interest, profit (spending and receiving income sides same coin) Multiplication ends when ∆I matched by exactly offsetting S: corrects disequilibrium

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MPC and MPS Amount of multiplication necessary to recreate equilibrium determined by MPC and MPS Multiplier = 1/MPS MPS + MPC = 1 Multipliers = 1/(1-MPC)

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Significance and Generalization Multiplier creates larger fluctuations in economy from biz decisions: greater booms, greater busts Simple multiplier: leakage only into savings (MPS of.05 = 20x) Complex: leakage into taxes, imports (“fraction of the change in income which leaks, or is diverted, from the income- expenditure stream”); estimated at 2x

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II. Trade and Equilibrium Output C + I = private closed economy agg expend C + I + (X-M)= private open economy Net exports increase agg expenditure beyond what closed is capable of, so GDP up; net imports reduce agg ex below closed level, so GDP down HOWEVER…

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AS determined by input prices Int’l trade generally increases efficiency lower costs of production (of all resources, including investment capital (“money” is the single largest traded “good”)) greater output Therefore, GDP higher in open economy Also, int’l trade increases international incomes, therefore higher levels of exports (partly offsets lower GDP from imports) Empirical evidence: “beggar-thy-neighbor” tariff wars of 1920s-30s

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Exchange rates Depreciation: dollar losing value (inflation) –Effect on net exports? Appreciation: dollar gaining value (dis- or deflation) –Effect on net exports? Effect on GDP? –Where are we on the curve?

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III. Government C + I + G + (X-M) 1) Continue simplified investment and net export schedules 2) G no effect on private spending 3) Assume tax revenue entirely personal taxes; DI

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Spend and Tax G spending increases agg expenditures and equilibrium GDP by a multiplier G is an injection offsetting S and M –No, that’s not what I mean G taxing reduces ae and eGDP by a multiplier, but indirectly by reducing DI C; tax multiplier = tax x MPC G taxes are a leakage Tax cuts increase ae and eGDP, but less than an increase in spending

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Balanced Budget Multiplier $20 B in spending + $20 B in higher taxes Increase spending: AE increases by full $20 B Increase taxes: AE decreases by 20 x MPC= 20(.95)= 19 Net ∆ AE = 1 1 x (1/1-.95) = $20 B ∆ GDP Balanced budget multiplier is always 1

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25 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment.

25 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment.

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