1. MACROECONOMIC MODELS PART 2 GECO6400

2. THE AGGREGATE EXPENDITURE MODEL THE EXPENDITURE MULTIPLIER Changes in autonomous expenditure lead to greater changes in the level of output. This concept is encapsulated in the Multiplier (k). The multiplier concept derives from the relationships that exist within the macroeconomy.

3. THE EXPENDITURE MULTIPLIER One person’s expenditure becomes another’s income The Circular Flow of income depicts interdependence between each sector of the economy – what happens in one sector influences what happens in another. The initial change in expenditure comes from outside the system – it is not due to a change in income but is autonomous. THE AGGREGATE EXPENDITURE MODEL

4. THE EXPENDITURE MULTIPLIER Such changes can be due to factors that influence household Autonomous Consumption such as prices and wealth. Such changes can also be due to factors that influence businesses’ Autonomous Investment expenditure such as expectations or interest rates. THE AGGREGATE EXPENDITURE MODEL

5. The Multiplier Process The initial expenditure in spent and re-spent multiple times. The eventual increase in income is greater in magnitude than the initial increase in expenditure that caused it. This is the expenditure multiplier effect. THE AGGREGATE EXPENDITURE MODEL

6. The Multiplier Process  Round 1: the initial increase in expenditure causes an increase in income.  Round 2: part of the increase in income of round 1 is saved (MPS), the rest is spent (MPC), causing another increase in income.  Round 3: part of the increase in income of round 2 is saved (MPS), the rest is spent MPC), causing another increase in income.  Round n: The total effect of the initial increase in expenditure is exhausted. There is no more expenditure occurring. THE AGGREGATE EXPENDITURE MODEL

7. The Multiplier Process Not all of the initial expenditure is re-spent. Some leaks out of the system through savings. The multiplier also works in reverse. The leakage from savings at each level or round of expenditure means that the Multiplier process eventually comes to an end. The change in expenditure gradually becomes smaller and smaller as it works its way through the economy (circular flow) until it eventually is completely spent. THE AGGREGATE EXPENDITURE MODEL

8. The Multiplier Process An initial change in autonomous expenditure can be due to a change in an exogenous variable (external influence) such as interest rates, wealth, expectations or prices. THE AGGREGATE EXPENDITURE MODEL The investment schedule would shift up on the 45 degree- line diagram, causing the AE schedule to also shift up, producing a multiplied increase in income (GDP). r AE I Y A drop in interest rates for instance would cause the following to occur:

9. EXAMPLEC=60+0.8YS=-60+0.2YI1=10 Increase in autonomous Investment due to improved business expectations I2=20 THE AGGREGATE EXPENDITURE MODEL

10. Working out Equilibrium Income Equilibrium occurs where: Y=AE AE=C+I AE=60+0.8Y+10 AE=70+0.8Y

11. Working out Equilibrium Income Y=AEY=70+0.8YY-0.8Y=700.2Y=70Y=70/0.2Y=350 THE AGGREGATE EXPENDITURE MODEL

12. Working out Equilibrium Income Leakages-Injections Approach Equilibrium occurs also where: Leakages = Injections S=I S=1-C S=1-(60+0.8Y) S=-60+0.2Y I=10

13. Equilibrium Income: S=I-60+0.2Y=100.2Y=70Y=70/0.2Y=350 THE AGGREGATE EXPENDITURE MODEL

14. YCIAE 0601070 5010010110 10012010130 15018010190 20022010230 25026010270 300 10310 35034010350 40038010390 45042010430 50046010470 THE AGGREGATE EXPENDITURE MODEL

15. A Change in Autonomous Expenditure Autonomous investment increases by $20B Working out Equilibrium Income Y=AEAE=C+IAE=60+0.8Y+30AE=90+0.8Y THE AGGREGATE EXPENDITURE MODEL

16. Finding Equilibrium Income Equilibrium occurs where: Y=AEY=90+0.8YY-0.8Y=900.2Y=90Y=90/0.2Y=450 THE AGGREGATE EXPENDITURE MODEL

17. Finding Equilibrium Income Equilibrium occurs also where: Leakages = Injections S=IS=1-CS=1-(60+0.8Y)S=-60+0.2YI=30 THE AGGREGATE EXPENDITURE MODEL

18. Equilibrium Income: S=I-60+0.2Y=300.2Y=90Y=90/0.2Y=450 THE AGGREGATE EXPENDITURE MODEL

19. YCIAE 0603090 5010030130 10012030150 18030210 20022030250 26030290 300 30330 35034030370 40038030410 45042030450 50046030490 THE AGGREGATE EXPENDITURE MODEL

20. OUTPUT AGGREGATE EXPENDITURE AE=70+0.8Y AE=90+0.8Y $20B $350B$450B $20B $100B I 2 =30 I 1 =10 S=-60+0.2Y 45 O OUTPUT SAVINGS AND INVESTMENT $70B $90B $10B $30B 0$350B$450B $350B $450B THE AGGREGATE EXPENDITURE MODEL

21. Calculating the Size of the Multiplier Change in autonomous expenditure (Investment) of $20B has induced a change in Income of $100B. This can be represented: k=ΔY/ ΔAE k=$100B/$20Bk=5 That is, the change in Autonomous Expenditure has caused Income to increase by five times. This is the value of the multiplier. THE AGGREGATE EXPENDITURE MODEL

22. EXPENDITURE ROUND CHANGE IN INCOME CHANGE IN CONSUMPTION CHANGE IN SAVINGS First Round 20164 Second Round 1612.83.2 Third Round 12.810.242.56 Fourth Round 10.248.192.05 Fifth Round 8.196.551.64 Sixth Round 6.555.241.31 Other Rounds 26.2220.985.24 TOTAL100.0080.0020.00 The Multiplier process can be represented in the following way: THE AGGREGATE EXPENDITURE MODEL

23. Using algebra to determine the multiplier  ΔY= ΔC + ΔI  ΔC=MPC x ΔY  ΔY=(MPC x ΔY) + ΔI  (1-MPC) ΔY= ΔI  ΔY=1/(1-MPC) x ΔI  ΔY/ΔI=1/(1-MPC)  k=1/(1-MPC)  k=1/MPS So, changes in the MPS affect the size of the multiplier THE AGGREGATE EXPENDITURE MODEL

24. Calculating the Multiplier Using Algebra  k=1/MPS  k=1/0.2  k=5 THE AGGREGATE EXPENDITURE MODEL

25. THE PUBLIC SECTOR Government Expenditure Government expenditure is considered autonomous of income in the simple Aggregate Expenditure model. G=A The impact of a change in G is identical to a change in I – it shifts the AE curve up and has a multiplier effect on income. THE AGGREGATE EXPENDITURE MODEL

26. C+I+G C+I THE AGGREGATE EXPENDITURE MODEL OUTPUT AGGREGATE EXPENDITURE 45 O 0 C

27. Taxation Taxation has 2 components: 1.Autonomous Taxation (a): independent of income. This is like sales Tax; and 2.Induced Taxation (t): taxation that changes as income changes. This is like income tax The equation for Taxation is: T=a+tY THE AGGREGATE EXPENDITURE MODEL

28. Government Expenditure and Taxation can be represented on the leakages-injections diagram (similar to Investment and Savings) T=a+tY G=A THE AGGREGATE EXPENDITURE MODEL OUTPUT G and T

29. DISPOSABLE INCOME The introduction of taxation causes a difference between Gross Income and Disposable Income. Disposable Income is calculated by subtracting taxes from Gross Income: Yd=(1-NT)Y Disposable Income is then used as the basis for calculating equilibrium income. THE AGGREGATE EXPENDITURE MODEL

30. THE EXTERNAL SECTOR Exports Export expenditure is considered autonomous of income in the simple Aggregate Expenditure model. Export expenditure depends on other economies’ income. X=A The impact of a change in X is identical to a change in I and G– it shifts the AE curve up and has a multiplier effect on income. THE AGGREGATE EXPENDITURE MODEL

31. C+I+G C+I AE=C+I+G+NX THE AGGREGATE EXPENDITURE MODEL OUTPUT AGGREGATE EXPENDITURE 0 45 O

32. Imports Imports are considered to have 2 aspects – autonomous and induced. 1.Autonomous Imports (a): independent of income; and 2.Induced Imports (m): imports expenditure that depends on the level of national income. The equation for Imports is: M=a+mY THE AGGREGATE EXPENDITURE MODEL

33. Net Exports Net exports are the balance of international trade in the model – the amount of exports sold overseas minus the value of imports consumed. NX=X-(a+mY) THE AGGREGATE EXPENDITURE MODEL

34. Export Expenditure and Imports can be represented on the leakages-injections diagram M=a+mY X=A NX THE AGGREGATE EXPENDITURE MODEL OUTPUT X and M 0

35. OUTPUT AGGREGATE EXPENDITURE AE=C+I AE=C+I+G I+G 45 O OUTPUT LEAKAGES AND INJECTIONS 0 AE=C I AE=C+I+G+NX I+G+X S+T+M S S+T THE AGGREGATE EXPENDITURE MODEL

36. The Multiplier in the Full Aggregate Expenditure Model The more leakages there are from the macroeconomy, the lower the impact of the expenditure multiplier. So, when the full open macroeconomy multiplier is calculated, the following formula is used: k=1/1-[b(1-t)-m] THE AGGREGATE EXPENDITURE MODEL