1. © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model Chapter 10

2. 10 - 2 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model u The multiplier model tells us how much output may change as the AD shifts due to an initial change in expenditures.

3. 10 - 3 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model u The multiplier model assumes that the price level remains constant - and then explores specific questions about expenditures.

4. 10 - 4 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model u The multiplier model gives numerical answers about the effect of changes in aggregate expenditures on aggregate output.

5. 10 - 5 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model When Prices Are Fixed, Fig. 10-1, p 236 ? Cumulative shift 20 P0P0 Aggregate supply AD 0 Real output Price level AD 1 Initial shift Induced shift (Multiplier effects)

6. 10 - 6 © 2003 McGraw-Hill Ryerson Limited. Aggregate Production u Aggregate production (AP) is the total amount of goods and services produced in every industry in an economy.

7. 10 - 7 © 2003 McGraw-Hill Ryerson Limited. Aggregate Production u Production creates an equal amount of income. u Thus, actual production and actual income are always equal.

8. 10 - 8 © 2003 McGraw-Hill Ryerson Limited. Aggregate Production u Graphically, aggregate production in the multiplier model is represented by a 45° line through the origin.

9. 10 - 9 © 2003 McGraw-Hill Ryerson Limited. Aggregate Production u Real production (in dollars) is on the vertical axis, and real income (in dollars) is on the horizontal axis. u At all points on this curve, income equals production.

10. 10 - 10 © 2003 McGraw-Hill Ryerson Limited. The Aggregate Production Curve, Fig. 10-2, p 237 Aggregate production (production = income) A 45º $4,000 0 Real production Real income $4,000 B Potential income C

11. 10 - 11 © 2003 McGraw-Hill Ryerson Limited. Aggregate Expenditures u Aggregate expenditures (AE) in the multiplier model consist of: l Consumption – spending by consumers. l Investment – spending by business. l Spending by government. l Net foreign spending on Canadian goods – the difference between Canadian exports and Canadian imports.

12. 10 - 12 © 2003 McGraw-Hill Ryerson Limited. Aggregate Expenditures u The four expenditure components of national income accounting were developed around the multiplier model. AE = C + I + G + (X - IM)

13. 10 - 13 © 2003 McGraw-Hill Ryerson Limited. Autonomous and Induced Expenditures u As income changes, expenditures change, but not as much as income.

14. 10 - 14 © 2003 McGraw-Hill Ryerson Limited. Autonomous and Induced Expenditures u Even if income is zero, spending is still taking place. u The money comes from borrowing, or from previous savings.

15. 10 - 15 © 2003 McGraw-Hill Ryerson Limited. Autonomous and Induced Expenditures u Autonomous expenditures are those that would exist at a zero level of income. u Autonomous expenditures are independent of income.

16. 10 - 16 © 2003 McGraw-Hill Ryerson Limited. Autonomous and Induced Expenditures u Autonomous expenditures change because something other than income changes.

17. 10 - 17 © 2003 McGraw-Hill Ryerson Limited. Autonomous and Induced Expenditures u Induced expenditures are those that change as income changes. u Induced expenditures change by less than the change in income.

18. 10 - 18 © 2003 McGraw-Hill Ryerson Limited. Aggregate Expenditures Related to Income, Table 10-1, p 238

19. 10 - 19 © 2003 McGraw-Hill Ryerson Limited. Expenditures Function u The relationship between expenditures and income can be expressed more concisely as an expenditures function. u An expenditures function is a representation of the relationship between aggregate expenditures and income.

20. 10 - 20 © 2003 McGraw-Hill Ryerson Limited. Expenditures Function AE = aggregate expenditures AE o = autonomous expenditures mpc = marginal propensity to consume Y = income l The expenditures function is expressed as a mathematical function: AE = AE o + mpcY

21. 10 - 21 © 2003 McGraw-Hill Ryerson Limited. The Marginal Propensity to Consume  The marginal propensity to consume (mpc) is the ratio of a change in consumption (  C) to a change in income (  Y).

22. 10 - 22 © 2003 McGraw-Hill Ryerson Limited. The Marginal Propensity to Consume u The mpc is the fraction spent from an additional dollar of income.

23. 10 - 23 © 2003 McGraw-Hill Ryerson Limited. The Marginal Propensity to Consume u The mpc captures the rule of thumb that individuals in aggregate tend to follow: u Their consumption varies with their income, but not by as much as their income varies.

24. 10 - 24 © 2003 McGraw-Hill Ryerson Limited. The Marginal Propensity to Consume u Since only consumption expenditures depend on income, in our simple model:

25. 10 - 25 © 2003 McGraw-Hill Ryerson Limited. Graphing the Expenditures Function u The graphical representation of the expenditures function is called the aggregate expenditures curve. u The expenditures function's slope tells us how much expenditures change with a particular change in income.

26. 10 - 26 © 2003 McGraw-Hill Ryerson Limited. Graphing the Expenditures Function u It is assumed that only consumption changes with income; the other expenditure components – I, G, (X - IM) – are all independent of income.

27. 10 - 27 © 2003 McGraw-Hill Ryerson Limited. Graphing the Expenditures Function, Fig. 10-3, p 240 0 45º AE = 1,000 + 0.8Y Real expenditures ( AE ) $12,200 10,000 8,000 6,000 4,000 2,000 5,000 1,000 $5,000 $11,250 $14,000 $8,750 Real income  AE = 2,000  Y = 2,500 Aggregate production

28. 10 - 28 © 2003 McGraw-Hill Ryerson Limited. Shifts in the Expenditures Function u The expenditure function shifts up and down when autonomous C, I, G, or X - IM change. u The reason that these shifts are so important is that the multiplier model is an historical model in time.

29. 10 - 29 © 2003 McGraw-Hill Ryerson Limited. Shifts in the Expenditures Function u The multiplier model can be used to analyze shifts in aggregate expenditures from an historically given level. u It cannot be used to determine income independent of the economy's historical position.

30. 10 - 30 © 2003 McGraw-Hill Ryerson Limited. Determining the Level of Aggregate Income u In bringing AP and AE together in one framework, the following is assumed : l The price level is constant. l The AP curve is a 45 o line until the economy reaches its potential income. l Expenditures shown on the AE line do not necessarily equal AP or income.

31. 10 - 31 © 2003 McGraw-Hill Ryerson Limited. Determining the Level of Aggregate Income u To determine income graphically, you find the income level at which AE equals AP.

32. 10 - 32 © 2003 McGraw-Hill Ryerson Limited. Solving for Equilibrium Graphically, Fig. 10-4, p 241 45° Aggregate expenditures AE = 1,000 + 0.8 Y Aggregate production 12,200 0 Real expenditures (AE) 5,000 1,000 $5,000$14,000 10,000 8,000 Real income$2,000 $10,000 2,600 AE 0 = $1,000 E

33. 10 - 33 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Equation u The multiplier equation tells us that income equals the multiplier times autonomous expenditures. Y = (multiplier)(autonomous expenditures)

34. 10 - 34 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Equation u The multiplier equation is a useful way to determine the level of income in the multiplier model.

35. 10 - 35 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Equation u The multiplier is a number that reveals how much income will change in response to a change in autonomous expenditures. Multiplier = 1/(1 – mpc)

36. 10 - 36 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Equation u As the mpc increases, the multiplier increases:

37. 10 - 37 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Process u The multiplier process amplifies changes in autonomous expenditures. u What forces are operating to ensure that the income level we determined is actually the equilibrium income level?

38. 10 - 38 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Process u When expenditures do not equal current output, business people change planned production: l Which changes income, which changes expenditures, l Which changes production, which changes income, l Which changes... etc.

39. 10 - 39 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Process, Fig. 10-5, p 244 C, I, G, (X – IM) A2A2 A1A1 C B1B1 B2B2 0 Real expenditures (AE) 6,000 2,000 $5,000$14,000 10,000 Real income$2,000 $10,000 Aggregate expenditures 45° Aggregate production $13,200 AE = 1,000 + 0.8 Y

40. 10 - 40 © 2003 McGraw-Hill Ryerson Limited. The Circular Flow Model and the Multiplier Process u The circular flow model provides the intuition behind the multiplier process.

41. 10 - 41 © 2003 McGraw-Hill Ryerson Limited. The Circular Flow Model and the Multiplier Process u Expenditures are injections into the circular flow. u The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow. u But there are withdrawals.

42. 10 - 42 © 2003 McGraw-Hill Ryerson Limited. The Circular Flow Model and the Multiplier Process u Economists use the term the marginal propensity of save (mps) to represent the percentage of income flow that is withdrawn from the economy for each round of the circular flow.

43. 10 - 43 © 2003 McGraw-Hill Ryerson Limited. The Circular Flow Model and the Multiplier Process u By definition: mpc + mps = 1 u Alternatively expressed: mps = 1 - mpc multiplier = 1/mps

44. 10 - 44 © 2003 McGraw-Hill Ryerson Limited. The Circular Flow Model and the Multiplier Process Aggregate income Aggregate expenditures Households Firms

45. 10 - 45 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model in Action u The first step in understanding the AP/AE analysis is determining the level of income using the multiplier. u This was already explained.

46. 10 - 46 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model in Action u The second step is to modify that analysis to answer a question that is of much more interest to policy makers. u How much would a change in autonomous expenditures change the equilibrium level of income?

47. 10 - 47 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model in Action u Autonomous expenditures are determined outside the model not as a result of changes in income. u Autonomous expenditures can, and do, shift for a number of reasons. u When they do, the multiplier process is called into play.

48. 10 - 48 © 2003 McGraw-Hill Ryerson Limited. The Steps of the Multiplier Process u The income adjustment process is directly related to the multiplier. u Any initial shock (a change in autonomous AE) is multiplied in the adjustment process.

49. 10 - 49 © 2003 McGraw-Hill Ryerson Limited. The Steps of the Multiplier Process u The multiplier process repeats and repeats until a new equilibrium level is finally reached.

50. 10 - 50 © 2003 McGraw-Hill Ryerson Limited. Shifts in the Aggregate Expenditure Curve, Fig. 10-6, p 246 C, I $4,200 4,100 832 4,160 4,060 812 0 Real income$4,060$4,160 $100 20 E1E1 E0E0 Aggregate production AE 0 = 832 +.8 Y AE 1 = 812 +.8 Y E1E1 100 E0E0 D AE A = $20 $20 $16 12.8 D AE A = $16 D AE A = $12.8

51. 10 - 51 © 2003 McGraw-Hill Ryerson Limited. The First Five Steps of Four Multipliers, Fig. 10-7, p 247

52. 10 - 52 © 2003 McGraw-Hill Ryerson Limited. The First Five Steps of Four Multipliers, Fig. 10-7, p 247

53. 10 - 53 © 2003 McGraw-Hill Ryerson Limited. The Effect of Shifts in Aggregate Expenditures u Autonomous expenditures can, and do, shift for a number of reasons: l Natural disasters. l Sudden climatic changes. l Changes in consumption caused by changes in consumer choice.

54. 10 - 54 © 2003 McGraw-Hill Ryerson Limited. The Effect of Shifts in Aggregate Expenditures u Autonomous expenditures can, and do, shift for a number of reasons: l Changes in investment caused by technological developments. l Shifts in government expenditures. l Shifts in imports and exports.

55. 10 - 55 © 2003 McGraw-Hill Ryerson Limited. The Effect of Shifts in Aggregate Expenditures u An understanding of these shifts can be enhanced by tying them to the formula: AE = C + I + G + (X - IM)

56. 10 - 56 © 2003 McGraw-Hill Ryerson Limited. The Effect of Shifts in Aggregate Expenditures u Changes in consumer sentiment affect C. u Major technological breakthroughs affect I. u Changes in government spending affect G. u Changes in exchange rates affect (X - IM).

57. 10 - 57 © 2003 McGraw-Hill Ryerson Limited. An Upward Shift of AE, Fig. 10-8a, p 248 Aggregate production 1,052.5 AE 1 30 4,090 $4,090 $4,210 $120 Real expenditures 0Real income 1,022.5 AE 0

58. 10 - 58 © 2003 McGraw-Hill Ryerson Limited. $90 $4,152 $4,062 4,062 AE 0 1,412 AE 1 1,382 An Downward Shift of AE, Fig. 10-8b, p 248 Real expenditures 30 0Real income Aggregate production

59. 10 - 59 © 2003 McGraw-Hill Ryerson Limited. Real World Examples u Canada in 2000. u Japan in the 1990s. u The 1930s depression.

60. 10 - 60 © 2003 McGraw-Hill Ryerson Limited. Canada in 2000 u Consumer confidence rose substantially causing autonomous consumption expenditures to increase more than economists had predicted. u While economists had expected the economy to grow slowly, it boomed.

61. 10 - 61 © 2003 McGraw-Hill Ryerson Limited. Japan in the 1990s u A dramatic rise in the value of the yen cut Japanese exports. u Suppliers could not sell all they had produced. u Suppliers laid off workers and decreased output. u Aggregate income (aggregate expenditures) fell causing the multiplier to work in reverse.

62. 10 - 62 © 2003 McGraw-Hill Ryerson Limited. The 1930s Depression u The 1929 stock market crash, which continued into 1930, threw the financial markets into chaos. u This resulted in a downward shift of the AE curve.

63. 10 - 63 © 2003 McGraw-Hill Ryerson Limited. The 1930s Depression u Frightened business people decreased investment and laid off workers. u Frightened consumers decreased autonomous consumption and increased savings, thereby increasing withdrawals from the system. u Governments cut spending to balance their budgets, as tax revenue declined.

64. 10 - 64 © 2003 McGraw-Hill Ryerson Limited. The 1930s Depression u Business people responded by decreasing output, which decreased income, starting a downward cycle, thereby confirming the fears of the businesspeople.

65. 10 - 65 © 2003 McGraw-Hill Ryerson Limited. The 1930s Depression u The process continued until the economy settled at a low-level equilibrium, far below the potential level of income.

66. 10 - 66 © 2003 McGraw-Hill Ryerson Limited. The 1930s Depression u The process caused the paradox of thrift, whereby individuals attempting to save more, spent less, and caused income to decrease. u They ended up saving not more, but less.

67. 10 - 67 © 2003 McGraw-Hill Ryerson Limited. Limitations of the Multiplier Model u On the surface, the multiplier model makes a lot of intuitive sense. u Surface sense can often be misleading.

68. 10 - 68 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model Is Not a Complete Model of the Economy u The multiplier model does not determine income from scratch. u At best, it can estimate the directions and rough sizes of autonomous demand or supply shifts.

69. 10 - 69 © 2003 McGraw-Hill Ryerson Limited. Shifts Are Not as Great as Intuition Suggests u The multiplier model leads people to overemphasize the aggregate expenditure shifts that would occur in response to a shift in autonomous expenditures.

70. 10 - 70 © 2003 McGraw-Hill Ryerson Limited. The Price Level Will Often Change in Response to Shifts in Demand u The multiplier model assumes that the price level is fixed. u The price level can change in response to changes in aggregate demand. u Price level changes will occur when the SAS is upward sloping.

71. 10 - 71 © 2003 McGraw-Hill Ryerson Limited. The Multiplier With a Flexible Price Level, Fig. 10-9, p 251 AE 0 AE 1 AE 2 AP Real income Real expenditures Price level LRAS A C B SAS AD 0 AD 1 Y0Y0 Y0Y0 Y2Y2 Y1Y1 Y1Y1 Y2Y2 Price level increases

72. 10 - 72 © 2003 McGraw-Hill Ryerson Limited. The Multiplier With Output Fixed, Fig. 10-10, p 252 AE 0 AE 1 AP Real income Real expenditures Real income Price level Y0Y0 Y0Y0 LRAS A B SAS 1 AD 0 AD 1 SAS 0

73. 10 - 73 © 2003 McGraw-Hill Ryerson Limited. Forward-Looking Expectations Complicate the Adjustment Process u People's forward-looking expectations make the adjustment process much more complicated. u Most people, however, act upon their expectations of the future.

74. 10 - 74 © 2003 McGraw-Hill Ryerson Limited. Forward-Looking Expectations Complicate the Adjustment Process u Business people may not automatically cut back production and lay-off workers if they think a fall in sales is temporary.

75. 10 - 75 © 2003 McGraw-Hill Ryerson Limited. Forward-Looking Expectations Complicate the Adjustment Process u Some modern economists have put forward a rational expectations model of the economy. u Rational expectations model – all decisions are based upon the expected equilibrium in the economy.

76. 10 - 76 © 2003 McGraw-Hill Ryerson Limited. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand u Shifts in demand can occur for many reasons. u Many shifts can reflect desired shifts in aggregate production which are accompanied by shifts in aggregate demand.

77. 10 - 77 © 2003 McGraw-Hill Ryerson Limited. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand u Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers' responses to changes in demand.

78. 10 - 78 © 2003 McGraw-Hill Ryerson Limited. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand u Expansion of this line of thought has led to the real business cycle theory of the economy.

79. 10 - 79 © 2003 McGraw-Hill Ryerson Limited. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand u Real business cycle theory of the economy – fluctuations in the economy reflect real phenomena such as simultaneous shifts in supply and demand, not simply supply responses to demand shifts.

80. 10 - 80 © 2003 McGraw-Hill Ryerson Limited. Expenditures Depend on Much More Than Current Income u If people base their spending on lifetime income, not yearly income, the mpc out of changes in current income could be very low, even approaching zero.

81. 10 - 81 © 2003 McGraw-Hill Ryerson Limited. Expenditures Depend on Much More Than Current Income u In that case, the expenditures function would essentially by a flat line, and the multiplier would be one, and there would be no secondary effects of an initial shift.

82. 10 - 82 © 2003 McGraw-Hill Ryerson Limited. Expenditures Depend on Much More Than Current Income u This set of arguments is called the permanent income hypothesis. u Permanent income hypothesis -- the hypothesis that expenditures are determined by permanent or lifetime income.

83. © 2003 McGraw-Hill Ryerson Limited. The Multiplier Model End of Chapter 10