1. 9 9 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES

2. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●GDP cannot be at its equilibrium if total spending differs from the value of output. ●If spending exceeds output, inventories fall and firms increase production. ●If output exceeds spending, inventories rise and firms reduce production. ●GDP cannot be at its equilibrium if total spending differs from the value of output. ●If spending exceeds output, inventories fall and firms increase production. ●If output exceeds spending, inventories rise and firms reduce production. The Meaning of Equilibrium GDP

3. TABLE 2: The Determination of Equilibrium Output Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

4. FIGURE 2: Construction of the Expenditure Schedule Copyright © 2006 South-Western/Thomson Learning. All rights reserved. G = $1,300 I = $900 C +I+G C +I +G + (X– IM) C +I C 7,2006,8006,4006,0005,600 6,000 6,100 4,800 Real Expenditure Real GDP 5,200 3,900 X–IM = –$100

5. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP. ●All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium. ●Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP. ●All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium. The Mechanics of Income Determination

6. FIGURE 3: Income-Expenditure Diagram Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Spending exceeds output Output exceeds spending Equilibrium 6,000 Real Expenditure 45° 5,2005,6006,0006,4006,8007,2000 4,800 5,600 6,400 6,800 7,200 Real GDP 4,800 5,200 C + I + G + (X –IM) E

7. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  price level   consumption ♦  price level   purchasing power of wealth (not real income) ♦A change in real income would be illustrated as a movement along the consumption function, not a shift. ●  price level   consumption ♦  price level   purchasing power of wealth (not real income) ♦A change in real income would be illustrated as a movement along the consumption function, not a shift. The Aggregate Demand Curve

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  price level   consumption ♦Therefore,  price level   total expenditures and  equilibrium GDP ♦Therefore,  price level   equilibrium level of real aggregate quantity demanded ●  price level   consumption ♦Therefore,  price level   total expenditures and  equilibrium GDP ♦Therefore,  price level   equilibrium level of real aggregate quantity demanded The Aggregate Demand Curve

9. FIGURE 5: The Effect of the Price Level on Equilibrium AD Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (b) Fall in Price Level Real Expenditure Real GDP C 0 +I +G + (X–IM) Y 0 Y 2 (a) Rise in Price Level Real Expenditure Real GDP C 0 +I +G + (X–IM) Y 0 Y 1 45 C 2 +I +G + (X–IM) E 0 E 0 C 1 +I +G X–IM) E 1 E 2

10. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #2 ●Identify and graph full employment, recessionary, and inflationary gaps.

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Aggregate Demand Curve ●The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP. ●Remember that any income-expenditure diagram is drawn for a specific price level. ●The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP. ●Remember that any income-expenditure diagram is drawn for a specific price level.

12. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Equilibrium GDP may not = full- employment GDP. ●Recessionary gap: amount by which equilibrium GDP < potential GDP ●Inflationary gap: amount by which equilibrium GDP > potential GDP ●Equilibrium GDP may not = full- employment GDP. ●Recessionary gap: amount by which equilibrium GDP < potential GDP ●Inflationary gap: amount by which equilibrium GDP > potential GDP Demand-Side Equilibrium and Full Employment

13. FIGURE 7: A Recessionary Gap Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Recessionary gap C + I + G + (X –IM) 45° Potential GDP 7,000 Real Expenditure Real GDP 6,000 E F B

14. FIGURE 8: An Inflationary Gap Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Inflationary gap 45° Potential GDP 8,000 Real Expenditure Real GDP 7,000 C + I + G + (X –IM) F B E

15. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Coordination of Saving and Investment ●Equilibrium GDP = full employment only if saving out of full-employment incomes = investment ●Savers are not the same people as investors, so it is unlikely that this condition will hold. ●Equilibrium GDP = full employment only if saving out of full-employment incomes = investment ●Savers are not the same people as investors, so it is unlikely that this condition will hold.

16. FIGURE 9: A Simplified Circular Flow Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 1 3 Investors Consumers Financial System Saving (S) Consumption (C) Investment (I) C + I Y Firms (produce the domestic product) 2

17. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #3 ●Explain the function of the multiplier and use it properly.

18. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Multiplier = ratio of the change in equilibrium GDP (Y) divided by the original change in spending that caused the change in GDP

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Demystifying the Multiplier: How It Works ♦The multiplier is greater than 1 because one person’s spending is another person’s income. ♦  spending   income ♦A portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on. ●Demystifying the Multiplier: How It Works ♦The multiplier is greater than 1 because one person’s spending is another person’s income. ♦  spending   income ♦A portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on.

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS Let’s say you find a dollar in the street. You now have one dollar you did not have before. You now have an “income” of one dollar. What can you do with that dollar?? You can spend all of it, save all of it, or spend some of it and save some of it. You have options!

21. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Let’s assume you decide to spend the WHOLE dollar. Your spending of that dollar is an EXPENDITURE for you and INCOME for the person (entrepreneur) you traded with.

22. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 (you bought “stuff”) How much did GDP increase with this transaction? $1.00 (you bought “stuff”)

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had: Spend it or Save it. ●Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had: Spend it or Save it.

24. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS Let’s assume the entrepreneur spends the WHOLE dollar at another business. This expenditure for the entrepreneur is now INCOME for another entrepreneur. Let’s assume the entrepreneur spends the WHOLE dollar at another business. This expenditure for the entrepreneur is now INCOME for another entrepreneur.

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 Does this sound familiar?? How much did GDP increase with this transaction? $1.00 Does this sound familiar??

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS This “found” dollar has now purchased $2.00 worth of goods and/or services. The original dollar appears to be cloning itself!! This “found” dollar has now purchased $2.00 worth of goods and/or services. The original dollar appears to be cloning itself!!

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? Unlikely…Why?

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS People have a TENDENCY TO SAVE some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive. People have a TENDENCY TO SAVE some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive. The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Example: If I get an additional dollar I may consume.90 and save.10. ●My Marginal Propensity to Consume (MPC) that dollar is then: 90%. ●My Marginal Propensity to Save (MPS) that dollar is then: 10%. ●Example: If I get an additional dollar I may consume.90 and save.10. ●My Marginal Propensity to Consume (MPC) that dollar is then: 90%. ●My Marginal Propensity to Save (MPS) that dollar is then: 10%.

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Example: If I get an additional dollar I may consume.80 and save.20. ●My Marginal Propensity to Consume (MPC) is then: 80%. ●My Marginal Propensity to Save (MPS) is then: 20%. ●Example: If I get an additional dollar I may consume.80 and save.20. ●My Marginal Propensity to Consume (MPC) is then: 80%. ●My Marginal Propensity to Save (MPS) is then: 20%.

32. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS Do you notice a pattern? MPC + MPS = 1.00 (or 100%) Do you notice a pattern? MPC + MPS = 1.00 (or 100%)

33. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Let’s see how this works in practice. ●Assume the Government wants to increase their spending by $10 billion dollars. Assume that the MPC in the economy is 90% and the MPS is 10% (remember these must equal 100%). What is going to be the effect on the GDP when we consider the Multiplier effect of EACH of those dollars? ●Let’s see how this works in practice. ●Assume the Government wants to increase their spending by $10 billion dollars. Assume that the MPC in the economy is 90% and the MPS is 10% (remember these must equal 100%). What is going to be the effect on the GDP when we consider the Multiplier effect of EACH of those dollars?

34. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●The Government initially spends $10 billion in the economy to purchase goods and services. Does the Government SAVE any of this money? NO. They spend the whole shebang! What is the immediate effect of this transaction on GDP? It INCREASES by $10 billion.

35. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●What is now going to happen to that $10 billion now in the hands of people in the economy? Keynes says that people in general will spend 90% of it and save 10%. ●So when people spend 90% of $10 billion, how much is GDP going to increase by? $9 billion. ●What is now going to happen to that $10 billion now in the hands of people in the economy? Keynes says that people in general will spend 90% of it and save 10%. ●So when people spend 90% of $10 billion, how much is GDP going to increase by? $9 billion.

36. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●With these initial two transactions, how much has GDP increase by? $10B + 9B = 19B ●Once again the original $10B has “magically” turned into $19B in GDP. ●With these initial two transactions, how much has GDP increase by? $10B + 9B = 19B ●Once again the original $10B has “magically” turned into $19B in GDP.

37. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Now when people who receive the $9B, they are going to spend 90%, or $8.1B and save 10%, or $900 Million. ●GDP is now growing again! $10B + $9B + $8.1B = $27.1 Billion It does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number. ●Now when people who receive the $9B, they are going to spend 90%, or $8.1B and save 10%, or $900 Million. ●GDP is now growing again! $10B + $9B + $8.1B = $27.1 Billion It does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

38. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Do you want to do all that math to arrive at how much GDP is going to increase in the end. I did not think so. ●Keynes came up with a simple formula to do the math for you. Remember in the beginning it was GOVERNMENT that started this buying frenzy. This is very IMPORTANT to remember. ●Do you want to do all that math to arrive at how much GDP is going to increase in the end. I did not think so. ●Keynes came up with a simple formula to do the math for you. Remember in the beginning it was GOVERNMENT that started this buying frenzy. This is very IMPORTANT to remember.

39. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●The Keynesian Government Spending Multiplier is 1/MPS. WOW that will be hard to remember! ●Let’s use the information we have already been given: The MPC is 90% and the MPS is 10%. ●We can plug the appropriate number into the Government Spending Multiplier and come up with a useful number. ●Govt. Spending Multiplier = 1/MPS = 1/10% = 1/.10 = 10 ●The Keynesian Government Spending Multiplier is 1/MPS. WOW that will be hard to remember! ●Let’s use the information we have already been given: The MPC is 90% and the MPS is 10%. ●We can plug the appropriate number into the Government Spending Multiplier and come up with a useful number. ●Govt. Spending Multiplier = 1/MPS = 1/10% = 1/.10 = 10

40. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Now this is AMAZING! According to KEYNES when government spends a dollar in the economy it is going to purchase a multiple of 10 times itself in GDP. ●If Government increases spending by 10 Billion, then the eventual impact on GDP is going to be an increase of: $10 Billion X 10 = $100 Billion NOTE: This works in REVERSE as well. If Government DECREASES spending by $10 Billion, it will serve to DECREASE GDP by a multiple of 10! ●Now this is AMAZING! According to KEYNES when government spends a dollar in the economy it is going to purchase a multiple of 10 times itself in GDP. ●If Government increases spending by 10 Billion, then the eventual impact on GDP is going to be an increase of: $10 Billion X 10 = $100 Billion NOTE: This works in REVERSE as well. If Government DECREASES spending by $10 Billion, it will serve to DECREASE GDP by a multiple of 10!

41. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS SUBTLETY ALERT!! Notice in the VERY FIRST round of spending by the Government that NOTHING is SAVED. The economy has the benefit of the FULL impact of the $10Billion in new spending. In subsequent rounds of spending people are saving a portion of the money they receive, therefore REDUCING the impact on the economy. When we do the TAX CUT MULTIPLIER next, this distinction will be important. It forms the foundation of why Keynes suggested that in times of severe economic crisis it should be the role of Government to be “active” in the economy. SUBTLETY ALERT!! Notice in the VERY FIRST round of spending by the Government that NOTHING is SAVED. The economy has the benefit of the FULL impact of the $10Billion in new spending. In subsequent rounds of spending people are saving a portion of the money they receive, therefore REDUCING the impact on the economy. When we do the TAX CUT MULTIPLIER next, this distinction will be important. It forms the foundation of why Keynes suggested that in times of severe economic crisis it should be the role of Government to be “active” in the economy.

42. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS TAX CUT MULTIPLIER ●Instead of Government changing its spending, they could change TAXES instead. TAX CUT MULTIPLIER ●Instead of Government changing its spending, they could change TAXES instead.

43. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Assume in the economy the MPC and the MPS are still 90% and 10% respectively. ●Assume the Government decides to REDUCE taxes by $10 Billion. This means that $10B is now in the hands of people and NOT in the hands of the Government. According to Keynes, what is the first thing that people in the economy are going to do with that new $10Billion?? They are going to Spend 90% and Save 10%!! ●Assume in the economy the MPC and the MPS are still 90% and 10% respectively. ●Assume the Government decides to REDUCE taxes by $10 Billion. This means that $10B is now in the hands of people and NOT in the hands of the Government. According to Keynes, what is the first thing that people in the economy are going to do with that new $10Billion?? They are going to Spend 90% and Save 10%!!

44. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●When they spend 90% it is going to INCREASE GDP by $9Billion in the FIRST ROUND of Spending (how does that compare when in the previous example Government spent FIRST). ●This transaction INCREASED GDP by $9B. ●When they spend 90% it is going to INCREASE GDP by $9Billion in the FIRST ROUND of Spending (how does that compare when in the previous example Government spent FIRST). ●This transaction INCREASED GDP by $9B.

45. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●The people who receive the $9B are going to SPEND 90%, or $8.1Billion and SAVE $900 Million. ●This transaction will INCREASE GDP by $8.1Billion. GDP is now $9B + $8.1B = $17.1Billion. ●The people who receive the $9B are going to SPEND 90%, or $8.1Billion and SAVE $900 Million. ●This transaction will INCREASE GDP by $8.1Billion. GDP is now $9B + $8.1B = $17.1Billion.

46. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●The people who receive the $8.1Billion are going to SPEND 90%, or $7.290 Billion and SAVE 10%, or $810 Million ●This transaction will INCREASE GDP by $7.290 Billion. GDP is now $9B + $8.1B + 7.29B = 24.390Billion. ●Once again, it does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number. ●The people who receive the $8.1Billion are going to SPEND 90%, or $7.290 Billion and SAVE 10%, or $810 Million ●This transaction will INCREASE GDP by $7.290 Billion. GDP is now $9B + $8.1B + 7.29B = 24.390Billion. ●Once again, it does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

47. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Keynes came up with a simple formula to do the math for you. Remember in the beginning it was PEOPLE in the Economy that start this buying frenzy. This is very IMPORTANT to remember. The KEYNESIAN TAX CUT MULTIPLIER = -MPC/MPS. ●WOW that will be hard to remember! ●Keynes came up with a simple formula to do the math for you. Remember in the beginning it was PEOPLE in the Economy that start this buying frenzy. This is very IMPORTANT to remember. The KEYNESIAN TAX CUT MULTIPLIER = -MPC/MPS. ●WOW that will be hard to remember!

48. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Example: ●We know the MPC is 90% and the MPS is 10%. ●We can plug the appropriate number into the Tax Cut Multiplier and come up with a useful number. ●Tax Cut Multiplier -MPC/MPS = 90%/10% =.-,90/.10 = -9 ●Example: ●We know the MPC is 90% and the MPS is 10%. ●We can plug the appropriate number into the Tax Cut Multiplier and come up with a useful number. ●Tax Cut Multiplier -MPC/MPS = 90%/10% =.-,90/.10 = -9

49. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●According to Keynes if the Government REDUCED TAXES (-) and you multiply by the TAX CUT MULTIPLIER, that is how much GDP will INCREASE. ●In our example, the Government DECREASED taxes by 10Billion (-) and you multiply this by the tax cut multiplier of -9, then GDP will eventually INCREASE (two negatives make a positive) by $90Billion. ●NOTE: This works in REVERSE. If Government INCREASE TAXES by $10Billion then this will serve to DECREASE GDP by a multiple of –9. (+10billion X -9 = -90Billion). ●According to Keynes if the Government REDUCED TAXES (-) and you multiply by the TAX CUT MULTIPLIER, that is how much GDP will INCREASE. ●In our example, the Government DECREASED taxes by 10Billion (-) and you multiply this by the tax cut multiplier of -9, then GDP will eventually INCREASE (two negatives make a positive) by $90Billion. ●NOTE: This works in REVERSE. If Government INCREASE TAXES by $10Billion then this will serve to DECREASE GDP by a multiple of –9. (+10billion X -9 = -90Billion).

50. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS NOT SO “SUBTLE” ALERT!!! Do you notice the different effects of the Government Spending Multiplier and the Tax Cut Multiplier? The Government Spending Multiplier appears to ALWAYS come out ahead of the Tax Cut Multiplier in terms of how much GDP is eventually impacted. THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!! According to Keynes, INCREASED Government spending “outperforms” DECREASES in Taxes to stimulate (“prime the pump”) the economy. NOT SO “SUBTLE” ALERT!!! Do you notice the different effects of the Government Spending Multiplier and the Tax Cut Multiplier? The Government Spending Multiplier appears to ALWAYS come out ahead of the Tax Cut Multiplier in terms of how much GDP is eventually impacted. THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!! According to Keynes, INCREASED Government spending “outperforms” DECREASES in Taxes to stimulate (“prime the pump”) the economy.

51. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Let’s put these Keynesian Multipliers together and see how it all washes out ●Assume the Government wants to do the right thing when they INCREASE Government spending they ALSO INCREASE Taxes to pay for it, so they won’t have to borrow to pay for the spending. Novel idea, I know, but it could happen…NOT! ●Let’s put these Keynesian Multipliers together and see how it all washes out ●Assume the Government wants to do the right thing when they INCREASE Government spending they ALSO INCREASE Taxes to pay for it, so they won’t have to borrow to pay for the spending. Novel idea, I know, but it could happen…NOT!

52. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Assume Government want to INCREASE spending by $20 Billion and the MPC is 80% and the MPS is 20%. If they don’t want to create a budget deficit they must INCREASE Taxes by $20 Billion to pay for the new spending. ●What is going to be the NET EFFECT of this action on the Economy? ●Assume Government want to INCREASE spending by $20 Billion and the MPC is 80% and the MPS is 20%. If they don’t want to create a budget deficit they must INCREASE Taxes by $20 Billion to pay for the new spending. ●What is going to be the NET EFFECT of this action on the Economy?

53. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Calculate the Government Spending Multiplier (1/MPS = 1/20% = 1/.20 = 5) ●If government spending INCREASES by $20B and the multiplier is 5 then, GDP is going to INCREASE by $100B ($100B X 5 = $100B). ●Calculate the Government Spending Multiplier (1/MPS = 1/20% = 1/.20 = 5) ●If government spending INCREASES by $20B and the multiplier is 5 then, GDP is going to INCREASE by $100B ($100B X 5 = $100B).

54. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●This is only half the story…Now we have to take $20B OUT of the Economy in TAXES to pay for the new spending. ●Calculate the TAX CUT MULTIPLIER (-MPC/MPS = -80%/20%=-.80/.20 = -4) ●If TAXES are INCREASED by $20B and the tax cut multiplier is -4 then GDP is going to DECREASE by $80B ( +20B X -4 = - 80B) ●The multiplier effect is working in REVERSE to DECREASE GDP by a multiple of 4! ●This is only half the story…Now we have to take $20B OUT of the Economy in TAXES to pay for the new spending. ●Calculate the TAX CUT MULTIPLIER (-MPC/MPS = -80%/20%=-.80/.20 = -4) ●If TAXES are INCREASED by $20B and the tax cut multiplier is -4 then GDP is going to DECREASE by $80B ( +20B X -4 = - 80B) ●The multiplier effect is working in REVERSE to DECREASE GDP by a multiple of 4!

55. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●What is the NET EFFECT after the TWO MULTIPLIERS do their work? ●The INCREASED Government Spending has INCREASED the GDP by $100B ●The Tax INCREASE has DECREASED the GDP by -80B. ●BOTTON LINE: GDP (AGGREGATE DEMAND) has INCREASED by $20B!! The Miracle of the Keynesian Multiplier… ●NOTE: This works in REVERSE as well. If Government Spending DECREASED by $20B and DECREASED Taxes by $20B, then the NET EFFECT on the Economy will be a Net DECREASE in GDP of -$20B. THE HORRORS!! ●What is the NET EFFECT after the TWO MULTIPLIERS do their work? ●The INCREASED Government Spending has INCREASED the GDP by $100B ●The Tax INCREASE has DECREASED the GDP by -80B. ●BOTTON LINE: GDP (AGGREGATE DEMAND) has INCREASED by $20B!! The Miracle of the Keynesian Multiplier… ●NOTE: This works in REVERSE as well. If Government Spending DECREASED by $20B and DECREASED Taxes by $20B, then the NET EFFECT on the Economy will be a Net DECREASE in GDP of -$20B. THE HORRORS!!

56. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS Think about this: Government INCRESED spending by $20B and INCREASED Taxes by $20B to pay for the spending and the economy came out AHEAD by $20B in INCREASED GDP. Notice a pattern??

57. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS NOT SO SUBTLE ALERT: Pick any dollar amount that Government could increase it spending by and increase taxes by the SAME amount to maintain a BALANCED BUDGET. The result will be an INCREASE in GDP by the SAME amount that you increased spending and increased taxes. Cool, huh!! NOT SO SUBTLE ALERT: Pick any dollar amount that Government could increase it spending by and increase taxes by the SAME amount to maintain a BALANCED BUDGET. The result will be an INCREASE in GDP by the SAME amount that you increased spending and increased taxes. Cool, huh!!

58. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Keynes called this the BALANCED BUDGET MULTIPLIER The BALANCED BUDGET MULTIPLIER is 1 ●Take whatever you INCREASE Government Spending and INCREASE Taxes by and Multiply by 1 you will get what the NET INCREASE is in GDP. Note: THIS WORKS IN REVERSE AS WELL ●Keynes called this the BALANCED BUDGET MULTIPLIER The BALANCED BUDGET MULTIPLIER is 1 ●Take whatever you INCREASE Government Spending and INCREASE Taxes by and Multiply by 1 you will get what the NET INCREASE is in GDP. Note: THIS WORKS IN REVERSE AS WELL

59. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Let’s Do Some Examples… ●Assume we can determine there is a recessionary gap in the Economy of $100 Billion. ●Assume the MPC is 75% and the MPS is 25% ●If the Govt. decides to change spending, would they INCREASE or DECREASE spending? By How Much? ●Let’s Do Some Examples… ●Assume we can determine there is a recessionary gap in the Economy of $100 Billion. ●Assume the MPC is 75% and the MPS is 25% ●If the Govt. decides to change spending, would they INCREASE or DECREASE spending? By How Much?

60. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Determine the Govt. Multiplier. 1/MPS = 1/25% = 1/.25 = 4 This means that ANY dollar the Govt spends in the economy is going to multiply on itself 4 TIMES The Recessionary Gap is $100B $100/4 = $25 Billion This is the amount Govt. would INCREASE spending to close this $100B gap (move closer to Full-Employment) ●Determine the Govt. Multiplier. 1/MPS = 1/25% = 1/.25 = 4 This means that ANY dollar the Govt spends in the economy is going to multiply on itself 4 TIMES The Recessionary Gap is $100B $100/4 = $25 Billion This is the amount Govt. would INCREASE spending to close this $100B gap (move closer to Full-Employment)

61. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Assume we can determine there is a recessionary gap in the Economy of $100 Billion. ●Assume the MPC is 75% and the MPS is 25% ●If the Govt. decides to change TAXES would they INCREASE or DECREASE Taxes? By How Much? ●Assume we can determine there is a recessionary gap in the Economy of $100 Billion. ●Assume the MPC is 75% and the MPS is 25% ●If the Govt. decides to change TAXES would they INCREASE or DECREASE Taxes? By How Much?

62. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. KEYNESIAN MULTIPLIER EFFECTS ●Determine the TAX CUT MULTIPLIER. -MPC/MPS = -75%/25% = -.75/.25 = -3 This means that ANY dollar received in Tax Cuts in the economy is going to multiply on itself 3 TIMES The Recessionary Gap is $100B $100/-3 = -$33.33 Billion (-$33B X -3 = $100B) This is the amount Govt. would DECREASE TAXES by to close this$100B gap (move closer to Full-Employment) ●Determine the TAX CUT MULTIPLIER. -MPC/MPS = -75%/25% = -.75/.25 = -3 This means that ANY dollar received in Tax Cuts in the economy is going to multiply on itself 3 TIMES The Recessionary Gap is $100B $100/-3 = -$33.33 Billion (-$33B X -3 = $100B) This is the amount Govt. would DECREASE TAXES by to close this$100B gap (move closer to Full-Employment)

63. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Algebraic Statement of the Multiplier ♦The MPC has been estimated to be about 0.9, implying that the multiplier is 10. ♦In fact, the multiplier is < 2. ●Algebraic Statement of the Multiplier ♦The MPC has been estimated to be about 0.9, implying that the multiplier is 10. ♦In fact, the multiplier is < 2.

64. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■International trade ■Inflation ■Income taxation ■Financial system ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■International trade ■Inflation ■Income taxation ■Financial system Changes on the Demand Side: Multiplier Analysis

65. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Multiplier Is a General Concept ●Multiplier is just as effective with a change in spending for any component of GDP.

66. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  GDP in a foreign country   its imports, a portion of which are exports from the U.S. ●The growth in U.S. exports has a multiplier effect, raising GDP in the U.S. ●Booms and recessions tend to be transmitted across national borders. ●  GDP in a foreign country   its imports, a portion of which are exports from the U.S. ●The growth in U.S. exports has a multiplier effect, raising GDP in the U.S. ●Booms and recessions tend to be transmitted across national borders. The Multiplier Is a General Concept