We have seen in Chapter 9 why
a particular level of real GDP exists in a private, closed economy. Now we examine how and
why that level might change. By adding the foreign sector and government to the model we
gain complexity and realism.
First, the chapter analyzes
changes in investment spending and how they could affect real GDP, income, and employment,
finding that changes in investment are multiplied in their impact on output and incomes.
The simplified "closed" economy is "opened" to show how it would be
affected by exports and imports. Government spending and taxes are brought into the model
to reflect the "mixed" nature of our system. Finally, the model is applied to
two historical periods in order to consider some of the model's deficiencies. The price
level is assumed constant in this chapter unless stated otherwise, so the focus is on real
Few changes have been made to
this chapter. Figure 10-8 (recessionary and inflationary gaps) is now a Key Graph, with
Quick Quiz. This is the culminating figure in our discussion of the aggregate expenditures
model. A summary Table 10-5 has been added to help students calculate the recessionary and
After completing this chapter,
students should be able to:
- Describe and define the
- State the relationships between
the multiplier and the MPS and the MPC.
- Define the net export schedule.
- Explain the impact of positive
(or negative) net exports on aggregate expenditures and the equilibrium level of real GDP.
- Explain the effect of increases
(or decreases) in exports on real GDP.
- Explain the effect of increases
(or decreases) in imports on real GDP.
- Describe how government purchases
affect equilibrium GDP.
- Describe how personal taxes
affect equilibrium GDP.
- Explain what is meant by the
balanced-budget multiplier and why it equals 1.
- Identify a recessionary gap and
explain its effect on real GDP.
- Identify an inflationary gap and
explain its effect.
- Explain the relationship between
the concept of recessionary gap and the Great Depression.
- Explain the relationship between
the Vietnam era inflation and the inflationary gap concept.
- List four deficiencies of the
aggregate expenditures model.
- Define and identify terms and
concepts listed at the end of the chapter.
COMMENTS AND TEACHING
- As stated earlier, some
instructors may choose to skip this chapter as well as Chapter 9 which develop the
aggregate expenditures model. Time limitations may force the macro theory focus to begin
with Chapter 11, on the aggregate demand-aggregate supply model. The text is organized for
this possibility. However, as suggested in Chapter 9, students could still benefit from
the Last Word sections for both Chapters 9 and 10, and the multiplier concept can still be
successfully presented, as suggested in #2 below.
- The multiplier concept can be
demonstrated effectively by a role-playing exercise in which you have students pretend
that one row (group) of students are construction workers who benefit from a $1 million
increase in investment spending. (Some instructors use an oversized paper $1-million
bill.) If their MPC is .9, then they will spend $900,000 of this at stores
"owned" by a second row (group) of students, who will in turn spend $810,000 or
.9 x $900,000. At the end of the exercise, each row can add up its new income and it will
be well in excess of the initial $1 million. In fact, if played out to its conclusion, the
final change in GDP should approximate $10 million, given the MPS is .1 in this example.
If you decide to use an
oversized paper $1-million bill, then students will have to clip off one-tenth of it at
every stage to represent saving. By the end of the process, each row (group) of students
has seen its income increase by nine-tenths of what the previous group received. Adding up
all of these increases illustrates the idea that the original $1 million increase in
spending has resulted in many times that amount in terms of the students' increased
incomes. Obviously, you won't be able to illustrate the final multiplier, but it should
give them a good idea of why the end multiplier would be equal to 10 in this example. In
other words, if the process were carried to its conclusion, the original $1 million of new
investment would result in a $10 million increase in student incomes and $10 million of
If you don't want to use the
prop, students are good at imagining that this could happen if you'll simply ask them to
imagine that a new $1 million injection of investment spending (or government or export
sales) occurs, and then go through the chain of events described above.
- Note that the multiplier effect
can work in reverse as well as the forward direction. The closing of a military base or a
factory shutting down has a multiplied impact on the local community, reducing retail
sales and placing a hardship on other businesses. Ask students to offer examples of the
multiplier effect that they have witnessed.
Government spending has frequently been targeted
geographically to boost a local economy. The special-interest effect can often be seen in
the choices that are made. Powerful congressmen have a vested interest in directing funds
to their districts. The balanced-budget multiplier analysis can be viewed as a
justification for shifting resources from the private sector to the government sector.
Politicians can cheerfully spend more money and demonstrate with the balanced budget
multiplier that we are better off with a higher level of GDP than would be the case if the
money were left in private hands. Government spends all of its money, and consumers have
this habit of saving a bit. It is this bit of saving that creates the balanced budget
- Note that net exports are kept as
independent of the level of GDP to keep the analysis simple. You may want to note in
passing that, in fact, there tends to be a direct relationship between import spending and
the level of GDP.
- The Last Word for this chapter is
a humorous look at the multiplier. demonstration of the concept. Not
only is it funny, but it provides a good
- The "Economics USA"
video series has a good segment on Keynes and the Great Depression. Call 1-800- LEARNER
for information, or ask your McGraw-Hill representative about the availability of these
STUDENT STUMBLING BLOCK
As with equilibrium GDP, the
multiplier is not a difficult concept to grasp with intuitive applications, but
quantitative applications are often difficult for students. If you expect them to be able
to solve problems involving the multiplier, give them practice on assignments such as Key
Questions #2, 5, 8, and 10.
- This chapter examines why and how
a particular level of real GDP might change.
- The revised model adds realism by
including the foreign sector and government in the aggregate expenditures model. C.The new
model is then applied to two historical periods and some of its deficiencies are
considered. The focus remains on real GDP.
||Changes in Equilibrium GDP
and the Multiplier
- Equilibrium GDP changes in
response to changes in the investment schedule or to changes in the saving- consumption
schedules. Because investment spending is less stable than the saving-consumption
schedule, this chapter's focus will be on investment changes.
- Figure 10-1 shows the impact of
changes in investment. Suppose investment spending rises (due to a rise in profit
expectations or to a decline in interest rates).
- Figure 10-1a shows the increase
in aggregate expenditures from (C + Ig)0 to (C + Ig)1.
- Figure 10-1b shows the shift in
investment schedule from Ig0to Ig1.
- In both cases, the $5 billion
increase in investment leads to a $20 billion increase in equilibrium GDP.
- Conversely, a decline in
investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20
- The multiplier effect:
- A $5 billion change in investment
led to a $20 billion change in GDP. This result is known as the multiplier effect.
- Multiplier = change in real GDP /
initial change in spending. In our example M = 4.
- Three points to remember about
- The initial change in spending is
usually associated with investment because it is so volatile.
- The initial change refers to an
upshift or downshift in the aggregate expenditures schedule due to a change in one of its
components, like investment.
- The multiplier works in both
directions (up or down).
- The multiplier is based on two
- The economy has continuous flows
of expenditures and income--a ripple effect--in which income received by Jones comes from
money spent by Smith.
- Any change in income will cause
both consumption and saving to vary in the same direction as the initial change in income,
and by a fraction of that change.
- The fraction of the change in
income that is spent is called the marginal propensity to consume (MPC).
- The fraction of the change in
income that is saved is called the marginal propensity to save (MPS).
- This is illustrated in Table 10-1
and Figure 10-2.
- The size of the MPC and the
multiplier are directly related; the size of the MPS and the multiplier are inversely
related. See Figure 10-3 for an illustration of this point. In equation form M = 1 / MPS
or 1 / (1-MPC).
- The significance of the
multiplier is that a small change in investment plans or consumption-saving plans can
trigger a much larger change in the equilibrium level of GDP.
- The simple multiplier given above
can be generalized to include other "leakages" from the spending flow besides
savings. For example, the realistic multiplier is derived by including taxes and imports
as well as savings in the equation. (Key Question 2)
||International Trade and
- Net exports (exports minus
imports) affect aggregate expenditures in an open economy. Exports expand and imports
contract aggregate spending.
||Exports (X) create domestic
production, income, and employment due to foreign spending on U.S. produced goods and
Imports (M) reduce the sum of consumption and investment expenditures by the amount
expended on imported goods, so this figure must be subtracted so as not to overstate
aggregate expenditures on U.S. produced goods and services.
- The net export schedule (Table
- Shows the amount of net exports
(X - M) that will occur at each level of GDP.
- Assumes that net exports are
autonomous or independent of GDP level.
- Figure 10-4b shows Table 10-2
- Xn1 shows a positive
$5 billion in net exports.
- Xn2 shows a negative
$5 billion in net exports.
- The impact of net exports on
equilibrium GDP is illustrated in Figure 10-4.
- Positive net exports increase
aggregate expenditures beyond what they would be in a closed economy and thus have an
expansionary effect. The multiplier effect also is at work. In Figure 10-4a we see that
positive net exports of $5 billion lead to a positive change in equilibrium GDP of $20
billion (to $490 from $470 billion).
- Negative net exports decrease
aggregate expenditures beyond what they would be in a closed economy and thus have a
contractionary effect. The multiplier effect also is at work here. In Figure 10-4a we see
that negative net exports of $5 billion lead to a negative change in equilibrium GDP of
$20 billion (to $450 from $470 billion).
- International economic linkages:
- Prosperity abroad generally
raises our exports and transfers some of their prosperity to us. (Conversely, recession
abroad has the reverse effect.)
- Tariffs on U.S. products may
reduce our exports and depress our economy, causing us to retaliate and worsen the
situation. Trade barriers in the 1930s contributed to the Great Depression.
- Depreciation of the dollar
(Chapter 6) lowers the cost of American goods to foreigners and encourages exports from
the U.S. while discouraging the purchase of imports in the U.S. This could lead to higher
real GDP or to inflation, depending on the domestic employment situation.
||Adding the Public Sector
- Simplifying assumptions are
helpful for clarity when we include the government sector in our analysis. (Many of these
simplifications are dropped in Chapter 12, where there is further analysis on the
- Simplified investment and net
export schedules are used where we assume they are independent of the level of GDP.
- We assume government purchases do
not impact private spending schedules.
- We assume that net tax revenues
are derived entirely from personal taxes so that GDP, NI, and PI remain equal. DI is PI
minus net personal taxes.
- We assume tax collections are
independent of GDP level.
- The price level is assumed to be
- Table 10-3 gives a tabular
example and Figure 10-5 gives the graphical illustration.
- Increases in public spending
boost aggregate expenditures.
- Public spending is subject to the
- In the leakages-injections
approach, government spending is an injection and taxes are a leakage.
- Table 10-4 and Figure 10-6 show
the impact of taxes. (Key Question 8)
- Taxes reduce both DI and
therefore consumption and saving at each level of GDP.
- An increase in taxes will lower
the aggregate expenditures schedule relative to the 45-degree line and reduce the
- Using leakages-injections
approach, taxes reduce DI and cause saving to fall by a fraction of this amount.
Graphically, the intersection of the Sa+ M + T and the Ig+ X + G
schedules determine equilibrium GDP (Figure 10-6b).
- Balanced-budget multiplier is a
curious result of this effect.
- Equal increases in government
spending and taxation increase the equilibrium GDP. (See Figure 10-7)
- If G and T are each increased by
a particular amount, the equilibrium level of real output will rise by that same amount.
- In text's example, an increase of
$20 billion in G and an offsetting increase of $20 billion in T will increase equilibrium
GDP by $20 billion (from $470 billion to $490 billion).
- The example reveals the
- An increase in G is direct and
adds $20 billion to aggregate expenditures.
- An increase in T has an indirect
effect on aggregate expenditures because T reduces disposable incomes first, and then C
falls by the amount of the tax times MPC.
- The overall result is a rise in
initial spending of $20 billion minus a fall in initial spending of $15 billion (.75
[!]$20 billion), which is a net upward shift in aggregate expenditures of $5 billion. When
this is subject to the multiplier effect, which is 4 in this example, the increase in GDP
will be equal to 4 [!]$5 billion or $20 billion, which is the size of the change in G.
- It can be seen, therefore, that
the balanced-budget multiplier is equal to 1.
- This can be verified by using
different MPCs .
- When equilibrium GDP is below
full-employment GDP, a recessionary gap exists.
- Recessionary gap is the amount by
which aggregate expenditures fall short of those required to achieve the full- employment
level of GDP.
- In Table 10-4, assuming the
full-employment GDP is $510 billion, the corresponding level of total expenditures there
is only $505 billion. The gap would be $5 billion, the amount by which the schedule would
have to shift upward to realize the full-employment GDP.
- Graphically, the recessionary gap
is the vertical distance by which the aggregate expenditures schedule (Ca+ Ig
+ Xn+ G)1lies below the full-employment point on the 45-degree
- Because the multiplier is 4, we
observe a $20-billion differential (the recessionary gap of $5 billion times the
multiplier of 4) between the equilibrium GDP and the full-employment GDP. This is the GDP
gap we encountered in Chapter 8's Figure 8-5.
- When aggregate expenditures
exceed full-employment GDP, an inflationary gap exists.
- Figure 10-8b shows that a
demand-pull inflationary gap exists when aggregate spending exceeds what is necessary to
achieve full employment.
- The inflationary gap is the
amount by which the aggregate expenditures schedule must shift downward to realize the
full-employment noninflationary GDP.
- The effect of the inflationary
gap is to pull up the prices of the economy's output.
- In this model, if output can't
expand, pure demand-pull inflation will occur (Key Question 10).
- The Great Depression of the 1930s
provides a significant case study. A major factor was the decline in investment spending,
which fell by 82 percent between 1929 and 1933.
- Overcapacity and business
indebtedness had resulted from excessive expansion by businesses in the 1920s, during a
period of prosperity. Expansion of auto industry ended as the market became saturated, and
this affected related industries of petroleum, rubber, steels, glass, and textiles.
- A decline in residential
construction followed the boom of the 1920s, which had resulted from population growth and
a need for housing following World War I.
- In October 1929, a dramatic crash
in stock market values occurred, causing pessimism and highly unfavorable conditions for
acquiring additional investment funds.
- The nation's money supply fell as
a result of Federal Reserve monetary policies and other forces.
- The Vietnam War era inflation
provides a historical example of an inflationary gap period.
- The policies of the Kennedy and
Johnson administrations had called for fiscal incentives to increase aggregate demand.
- Unemployment levels had fallen
from 5.2 percent in 1964 to 4.5 percent in 1965.
- The Vietnam War resulted in a 40
percent rise ingovernment defense expenditures and a draft that removed young people from
potential unemployment. The unemployment rate fell below 4 percent from 1966 to 1969.
- In terms of Figure 10-8, the boom
in investment and government spending boosted the aggregate expenditures schedule upward
and created a sizable inflationary gap.
||Critique and Preview
- The aggregate expenditures model
has four limitations.
- The model can account for
demand-pull inflation, but it does not indicate the extent of inflation when there is an
- It doesn't explain how inflation
can occur before the economy reaches full employment. It doesn't indicate how the economy
could produce beyond full-employment output for a time.
- The model does not address the
possibility of cost-push type of inflation.
- In Chapter 11, these deficiencies
are remedied with a related aggregate demand-aggregate supply model.
||LAST WORD: Squaring the
- Humorist Art Buchwald illustrates
the concept of the multiplier with this funny essay.
- Hofberger, a Chevy salesman in
Tomcat, Va., called up Littleton of Littleton Menswear & Haberdashery, and told him
that a new Nova had been set aside for Littleton and his wife.
- Littleton said he was sorry, but
he couldn't buy a car because he and Mrs. Littleton were getting a divorce.
- Soon afterward, Bedcheck the
painter called Hofberger to ask when to begin painting the Hofbergers' home.
- Hofberger said he couldn't,
because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger
could not afford to paint his house.
- When Bedcheck went home that
evening, he told his wife to return their new television set to Gladstone's TV store.When
she returned it the next day, Gladstone immediately called his travel agent and canceled
his trip. He said he couldn't go because Bedcheck returned the TV set because Hofberger
didn't sell a car to Littleton because Littletons are divorcing.
- Sandstorm, the travel agent, tore
up Gladstone's plane tickets, and immediately called his banker, Gripsholm, to tell him
that he couldn't pay back his loan that month.
- When Rudemaker came to the bank
to borrow money for a new kitchen for his restaurant, the banker told him that he had no
money to lend because Sandstorm had not repaid his loan yet.
- Rudemaker called his contractor,
Eagleton, who had to lay off eight men.
- Meanwhile, General Motors
announced it would give a rebate on its new models. Hofberger called Littleton to tell him
that he could probably afford a car even with the divorce. Littleton said that he and his
wife had made up and were not divorcing. However, his business was so lousy that he
couldn't afford a car now. His regular customers, Bedcheck, Gladstone, Sandstorm,
Gripsholm, Rudemaker, and Eagleton had not been in for over a month!
ANSWERS TO END-OF-CHAPTER
- 10-1 What effect will each of the
changes designated in question 4 at the end of Chapter 9 have on the equilibrium level of
GDP? Explain your answers.
- If this means people have become
less wealthy, then their consumption schedule will shift down and GDP will decrease by a
multiple of the decrease in consumption. However, if the decline in government bond
holding means households have been cashing them in to increase their consumption, then the
effect will be the opposite.
- The increased consumption--and
the possible increased investment in addition--will increase GDP.
- This will increase
interest-sensitive consumer purchases and investment, causing GDP to increase.
- By reducing consumption (because
households will feel--or be--less wealthy, or because they fear a recession) and by
decreasing investment, the AE schedule will shift downward, causing the GDP to decline.
- This will increase AE, causing
GDP to increase.
- Investment will increase both
because of increased profitability and because of increased innovations, causing GDP to
- The announcement will lead to an
upward shift of the saving schedule (downward shift of the consumption schedule), causing
GDP to decline.
- To the extent that this leads to
increased buying for, say, a year, the AE schedule will shift upward for a year, leading
to a temporary increase in GDP.
- An increase in the personal
income tax will decrease the level of disposable income, decrease consumer spending, which
could mean a decline in aggregate expenditures. But if the government increases its
purchases to the extent of the tax increase, then aggregate expenditures will actually
increase, since consumer expenditures fall only by a fraction of the decline in income and
government spending is more than offsetting this decline. If this happens, the equilibrium
level of GDP should rise. On the other hand, if government spending does not rise, then
the equilibrium level of GDP may fall as private spending falls.
- 10-2 (Key Question) What
is the multiplier effect? What relationship does the MPC bear to the size of the
multiplier? The MPS? What will the multiplier be when the MPS is 0, .4, .6, and 1? When
the MPC is 1, .90, .67, .50, and 0? How much of a change in GDP will result if businesses
increase their level of investment by $8 billion and the MPC in the economy is .80? If the
MPC is .67? Explain the difference between the simple and the complex multiplier.
The multiplier effect is the
magnified increase in equilibrium GDP that occurs when any component of aggregate
expenditures changes. The greater the MPC (the smaller the MPS), the greater the
MPS = 0, multiplier = infinity; MPS = .4, multiplier = 2.5; MPS = .6, multiplier = 1.67;
MPS = 1, multiplier = 1.
MPC = 1; multiplier = infinity; MPC = .9, multiplier = 10; MPC = .67; multiplier = 3; MPC
= .5, multiplier = 2; MPC = 0, multiplier = 1.
MPC = .8: Change in GDP = $40 billion (= $8 billion [!]multiplier of 5); MPC = .67: Change
in GDP = $24 billion ($8 billion [!]multiplier of 3). The simple multiplier takes account
of only the leakage of saving. The complex multiplier also takes account of leakages of
taxes and imports, making the complex multiplier less than the simple multiplier.
- 10-3 Graphically depict the
aggregate expenditures model for a private closed economy. Next, show a decrease in the
aggregate expenditures schedule and explain why the decrease in real GDP in your diagram
is greater than the initial decline in aggregate expenditures. What would be the ratio of
a decline in real GDP to the initial drop in aggregate expenditures if the slope of your
aggregate expenditures schedule were .8?
If the slope of the aggregate
expenditures schedule were .8, then the MPC = .8 and the MPS = .2. Therefore, the
multiplier would be 1/(.2) = 5. The ratio of decline in real GDP to the initial drop of
expenditures would be a ratio of 5:1. That is, if expenditures declined by $100 million,
GDP should decline by $500 million. On the graph it can be seen that a one-unit decline in
(C + I) leads to a five-unit decline in real GDP.
- 10-4 Speculate on why a planned
increase in saving by households, unaccompanied by an increase in investment spending by
businesses, might result in a decline in real GDP and no increase in actual saving.
Demonstrate this point graphically, using the leakage-injection approach to equilibrium
real GDP. Now assume in your diagram that investment instead increases to match the
initial increase in desired saving. Using your knowledge from Chapter 2, explain why these
joint increases in saving and investment might be desirable for a society.
A planned increase in saving
means a decline in consumer spending. This decrease in aggregate expenditures means a
downward shift in the schedule, and the multiplier effect will cause the new real GDP to
be lower than the initial level by a factor equal to the multiplier. If, as in #3, the
multiplier were 5, then the real GDP would drop by 5 times the initial decline in
consumption. It is possible that this new low level of income will not support higher
saving, because there is a direct relationship between income and saving. While households
intended to save more by increasing the fraction of their income saved, they now have less
income and a smaller income "pie" to divide. The larger fraction of a smaller
pie may not be any more than the previous smaller fraction of the bigger income pie. (This
is known as the paradox of thrift.)
If investment rose to offset the increase in saving, real GDP would not be affected in
terms of its level. However, the composition would change from consumer goods toward more
capital goods production. This is desirable for a society's future growth in output and
- 10-5 (Key Question) The
data in columns 1 and 2 of the table below are for a private closed economy.
- Use columns 1 and 2 to determine
the equilibrium GDP for this hypothetical economy.
- Now open this economy for
international trade by including the export and import figures of columns 3 and 4.
Calculate net exports and determine the equilibrium GDP for the open economy. Explain why
equilibrium GDP differs from the closed economy.
- Given the original $20 billion
level of exports, what would be the equilibrium GDP if imports were $10 billion larger at
each level of GDP? Or $10 billion smaller at each level of GDP? What generalization
concerning the level of imports and the equilibrium GDP is illustrated by these examples?
- What is the size of the
multiplier in these examples?
- Equilibrium GDP for closed
economy = $400 billion.
- Net export data for column 5 (top
to bottom); $-10 billion in each space. Aggregate expenditure data for column 6 (top to
bottom): $230; $270; $310; $350; $390; $430; $470; $510. Equilibrium GDP for the open
economy is $350 billion, $50 billion below the $400 billion equilibrium GDP for the closed
economy. The $- 10 billion of net exports is a leakage which reduces equilibrium GDP by
- Imports = $40 billion: Aggregate
expenditures in the private open economy would fall by $10 billion at each GDP level and
the new equilibrium GDP would be $300 billion. Imports = $20 billion: Aggregate
expenditures would increase by $10 billion; new equilibrium GDP would be $400 billion.
Exports constant, increases in imports reduce GDP; decreases in imports increase GDP.
- Since every rise of $50 billion
in GDP increases aggregate expenditures by $40 billion, the MPC is .8 and so the
multiplier is 5.
- 10-6 Assume that, without taxes,
the consumption schedule of an economy is as shown below:
- Graph this consumption schedule
and note the size of the MPC.
- Assume now a lump-sum tax system
is imposed such that the government collects $10 billion in taxes at all levels of GDP.
Graph the resulting consumption schedule and compare the MPC and the multiplier with that
of the pretax consumption schedule.
- The size of the MPC is 80/100 or
.8 because consumption changes by 80 when GDP changes by 100.
- The resulting consumption
schedule will be exactly $10 billion below the original at all levels of GDP, because
people now have to pay $10 billion in tax out of each level of income. The multiplier
should be 5 because the MPS is .2 and 1/.2 is 5. We see on the graph that the equilibrium
GDP has fallen to $150 billion. That is equilibrium GDP fell by $50 billion when
expenditures fell by $10 billion, a multiple of 5 times the decline in expenditures.
- 10-7 Explain graphically the
determination of equilibrium GDP for a private economy through the aggregate expenditures
approach. Now add government spending (any amount that you choose) to your graph, showing
its impact on equilibrium GDP. Finally, add taxation (any amount of lump-sum tax that you
choose) to your graph and show its effect on equilibrium GDP. Looking at your graph,
determine whether equilibrium GDP has increased, decreased, or stayed the same in view of
the sizes of the government spending and taxes that you selected.
Question 7 has been changed to
add a lump-sum tax. The figure below shows both the changes in C and the change in T you
could use this in the IM or use the 2 figures from the text on the next pages.
- 10-8 (Key Question) Refer
to columns 1 and 6 of the tabular data for question 5. Incorporate government into the
table by assuming that it plans to tax and spend $20 billion at each possible level of
GDP. Also assume that all taxes are personal taxes and that government spending does not
induce a shift in the private aggregate expenditures schedule. Compute and explain the
changes in equilibrium GDP caused by the addition of government.
Before G is added, private
sector equilibrium will be at 470. The addition of government expenditures of G to our
analysis raises the aggregate expenditures (C + Ig+Xn+ G) schedule
and increases the equilibrium level of GDP as would an increase in C, 1g, or Xn.
Note that changes in government spending are subject to the multiplier effect. In terms of
the leakages-injections approach, government spending supplements private investment and
export spending (Ig+ X + G), increasing the equilibrium GDP to 550.
The addition of $20 billion of government expenditures and $20 billion of personal taxes
increases equilibrium GDP from $350 to $370 billion. The $20 billion increase in G
raisesequilibrium GDP by $100 billion (= $20 billion [!] the multiplier of 5); the $20
billion increase in T reducesconsumption by $16 billion (= $20 billion [!]the MPC
of .8). This $16 billion decline in turn reduces equilibrium GDP by $80 billion (= $16
billion [!]multiplier of 5). The net change from adding government is $20 billion (= $100
billion - $80 billion).
- 10-9 What is the balanced-budget
multiplier? Demonstrate the balanced-budget multiplier in terms of your answer to question
8. Explain: "Equal increases in government spending and tax revenues of ndollars
will increase the equilibrium GDP by ndollars." Does this hold true regardless
of the size of MPS? Why or why not?
The balanced-budget multiplier
stems from the fact that increases in government spending go directly into the flow of
aggregate expenditures. Whereas the tax increase reduces incomes by the amount of the tax,
but spending will be reduced by a fraction of the income reduction (the fraction will be
equal to the MPC), and the multiplier effect will work in opposite directions on the
increase and the reduction in spending. But the reduction will be less than the increase
due to the initial government spending influx, which was not affected by the MPC. Since
this initial "shot" of government spending was not offset by an equal and
opposite effect on the downside from the tax increase, it is an addition to the aggregate
expenditures flow which just equals the change in the budget. Thus, we say the balanced
budget multiplier is equal to 1.
In question 8, the added government spending alone would increase GDP by 5 [!]$20 billion,
and the tax increase would reduce GDP by 5 [!]$16 billion, for a net change of ($ 100 -
$80) billion or $20 billion. This is equal to 1 [!] the change in G and T so the balanced
budget multiplier is 1 in this example. (Note: The multiplier is 5 because MPS = .2 and
1/.2 = 5. The tax increase reduces consumer spending by $16 billion because the tax
reduces incomes by $20, and this will reduce spending by a factor equal to the MPC, or 8
[!] $20 billion.)
The quote does hold true regardless of the size of the MPS. This is true because the only
increase in expenditures that will occur is a result of the initial change in government
spending. Beyond that, increases in spending from the "ripple" effect of the
initial change in G will be exactly offset by decreases in spending which result from the
"ripple" effect caused by the higher taxes. It doesn't matter whether the
multiplier is 10 or 2, the offsetting effect will occur on all changes except the initial
increase in government spending.
- 10-10 (Key Question) Refer
to the accompanying table in answering the questions which follow:
[Ca+ Ig+ Xn+ G],
- If full employment in this
economy is 130 million, will there be an inflationary or recessionary gap? What will be
the consequence of this gap? By how much would aggregate expenditures in column 3 have to
change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
- Will there be an inflationary or
recessionary gap if the full-employment level of output is $500 billion? Explain the
consequences. By how much would aggregate expenditures in column 3 have to change at each
level of GDP to eliminate the inflationary or recessionary gap? Explain.
- Assuming that investment, net
exports, and government expenditures do not change with changes in real GDP, what are the
sizes of the MPC, the MPS, and the multiplier?
- A recessionary gap. Equilibrium
GDP is $600 billion, while full employment GDP is $700 billion. Employment will be 20
million less than at full employment. Aggregate expenditures would have to increase by $20
billion (= $700 billion -$680 billion) at each level of GDP to eliminate the recessionary
- An inflationary gap. Aggregate
expenditures will be excessive, causing demand-pull inflation. Aggregate expenditures
would have to fall by $20 billion (= $520 billion -$500 billion) at each level of
GDP to eliminate the inflationary gap.
- MPC = .8 (= $40 billion/$50
billion); MPS = .2 (= 1 -.8); multiplier = 5 (= 1/.2).
- 10-11 (Advanced analysis)
Assume the consumption schedule for a private open economy is such that C= 50 + 0.8Y.
Assume further that investment and net exports are autonomous (indicated by the Igand
Xn); that is, planned investment and net exports are independent of the
level of income and in the amount Ig= 30 and Xn= 10.
Recall also that in equilibrium the amount of domestic output produced (Y) is equal
to the aggregate expenditures: Y= C+ Ig+ Xn.
- Calculate the equilibrium level
of income for this economy. Check your work by expressing the consumption, investment, and
net export schedules in tabular form and determining the equilibrium GDP. What will happen
to equilibrium Yif Igchanges to 10? What does this tell you about
the size of the multiplier?
- Y= C+ Ig+
Xn= $50 + 0.8Y + $30 +$10 = 0.8Y+ $90
- Therefore Y- 0.8Y=
$90, and 0.2Y= $90, so Y= $450 at equilibrium.
(GDP = YI)
- If Igdecreases
from $30 to $10, the new equilibrium GDP will be at GDP of $350, for with Ignow
$10 this is where AE also equals $350. This indicates that the multiplier equals 5, for a
decline in AE of $20 has led to a decline in equilibrium GDP of $100. The size of the
multiplier could also have been calculated directly from the MPC of 0.8 .
- 10-12 (Last Word) What is
the central economic idea humorously illustrated in Art Buchwald's piece, "Squaring
the Economic Circle"?
The central idea illustrated is
the multiplier effect that exists in a market economic system. One independently
determined change in spending has an effect on another's income, which then sets in motion
a chain of events whereby spending changes directly with the income changes. A decline in
spending begins a chain of declines, or, in other words, the initial decrease in spending
is multiplied in terms of the final effect of this single decision. This occurs because of
the observation that any change in income causes a change in spending that is directly
proportional to it.