Prepared By: Rsel Samuelson & Nordhaus. Economics. 17 Ed. Chapter 24

Prepared by: RSEL Samuelson & Nordhaus. Economics. 17th ed. Chapter 24

What exactly is the Multiplier Model?  It is a Macroeconomic theory used to explain how

output is determined in the short-run.  The name “multiplier” comes from the finding that

each dollar change in exogenous expenditure leads to more than a dollar change in GDP.  It explains how shocks to investment, foreign trade

and government tax & spending policies can affect output and employment in an economy.

Key Assumptions:  Wages and prices are fixed  There are unemployed resources  We suppress the role of monetary policy

 We assume that there are no financial market

reactions to changes in economy

First Approach: OUTPUT DETERMINATION WITH

SAVING AND INVESTMENT How investment and saving are equilibrated in the multiplier model?

Recall: Consumption Function

Savings Function

Consumption Function  Each

point on the consumption function shows desired or planned consumption at that level of disposable income.

Saving Function  Each point on the saving

schedule shows desired or planned saving at that income.  The two schedules are close

related since C+S = DI.  They are mirror twins that

will always add up to the 45° line.

Savings and Investment  Depends on different factors:

Savings ◊ Disposable Income

Investment ◊ Output ◊ Interest rates ◊ Tax policies ◊ Business Confidence

Investment as an exogenous variable –determined outside the model.

Assume the investment will be exactly the same per year regardless of the level of GDP. This will mean horizontal line.

it

is

At this level of output, desired S of HH equals desired I of Firms

a

The saving & investment schedules intersects at pt. E. This corresponds to a level of GDP given at pt. M & represents equilibrium level of output in the multiplier model.

At equilibrium: No inventories piling up on their shelves, nor will their sales be so brisk as to force them to produce more goods. Production, employment, income, spending will remain the same.

Disequilibrium GDP is higher than E At point A, GDP is to the right of M at an income level where the saving schedule is higher than the investment schedule. HH: Saving > F: Investment What will happen? Firms will have too few customers and larger inventories of unsold goods. What to do? Cut production  lay off workers  GDP  equilibrium.

Second Approach: OUTPUT DETERMINED BY

TOTAL EXPENDITURES

TOTAL EXPENDITURE

Total desired Expenditure (TE) – desired expenditure of consumers & businessmen at each level of output

TE = Consumption Function + desired investment (C+I) At any point on the 45° line, total desired expenditure is equal to total desired output. The economy is equilibrium if TE crosses the 45° line, in this case point E.

At point E, the level of desired expenditure on consumption and investment is equal to the level of total output.

Consumption Function – desired consumption at each level of income

To answer the question…  We need to examine how a change in exogenous

investment spending affects GDP.  We all know that an increase in investment will

increase level of output and employment.  But by how much?

Multiplier  Impact of a 1-dollar change in exogenous expenditures

on total output.  In the simple C+I model, the multiplier is the ratio of

the change in total output to the change in investment.  Example:  An increase in investment by P100B, can cause an increase in output of P300B, thus the multiplier is 3.

Suppose we hire carpenters to build a waiting shed that costs $ 1000. (1) This carpenters will earn an extra income of $1000. (2) If they have MPC of 2/3, they will now spend $666.67 on new consumption goods. (3) The producer of this goods, will now have an income of $666.67. (4) If their MPC is also 2/3, they will spend $444.44 or 2/3 of $666.67. (5) The process will go on with each round of spending being 2/3.

 This will result to an endless chain of secondary

consumption spending which is set in motion by the primary investment of $1000. Eventually it adds up to a finite amount.  Using arithmetic: $1000 1 x $1000 + + $666.67 2/3 x $1000 + + $444.44 (2/3)² x $1000 + = + $296.30 (2/3)³ x $1000 + + 197.53 (2/3)⁴x $1000 + + …____ … $3,000 1 x $1000, or 3 x $1000 1- 2/3

 This shows that, with an MPC of 2/3, the multiplier

is 3; it consist of the 1 of primary investment plus 2 extra of secondary consumption spending.  The size of the multiplier thus depends upon how

large is the MPC.  It can also be expressed in terms of the twin concept,

the MPS. If MPS is ¼, the MPC is ¾ , and the multiplier is 4. Multiplier Formula:

1 x change in investment 1 - MPC

Can we get the same result using the graphical analysis of saving and investment? Change in Investment

New equilibrium

Yes. Suppose the change in investment is $100B, MPS is 1/3, therefore, multiplier is 3. What will be the new equilibrium GDP? The answer is $3,900B.

Increase in income is exactly 3 times the increase in investment.

Fiscal Policy  Instrument in deciding how the nation’s output

should be divided between collective and private consumption and how the burden of payment for collective goods should be divided among the population.  This has impacts on the short-run movements of

output, employment & prices.

HOW GOVERNMENT FISCAL POLICIES

AFFECTS OUTPUT?

New Total Expenditure  To understand the role of government in economic

activity, we need to look at government purchases and taxation, along with the effects of those activities on private sector spending.  We now modify our earlier analysis by adding G to

C+I.  TE = C+I+G  New Total Expenditure: this can now

describe the new equilibrium when government, with its spending and taxing, is in the picture.

Consumption Changes when TAXES are present The consumption function changes when taxes are present. In the original CF, GDP = DI; 3,000=3,000. With introduction of taxes amounting to 300, at DI of 3,000, GDP = 3,300 200 is the result of multiplying a decrease in income of 300 times MPC 0f 2/3.

Decrease in Income

Original CF

Tax CF with Tax

Effects of including government purchases This figure is just like the previous diagrams. Here we added a new expenditure stream, G, to the consumption & investment. We place this on top of C+I. Why? 1. It has same macroecon impact as spending on private buildings. 2. Collective expenditure involve in buying government vehicle. 3. Has same effect on jobs as private consumption expenditures on automobiles.

New equilibrium when G is added

Impact of Taxation on Aggregate Demand  Extra taxes lower DI reduce consumption spending.  If investment and government purchases remain the

same, a reduction in consumption spending will then reduce GDP & employment.  Thus, in the multiplier, higher taxes without

increase in government spending will reduce real GDP.

FISCAL-POLICY

MULTIPLIERS

 The multiplier

analysis shows that government fiscal policy is high powered spending much like investment.

 It should have a multiplier effects upon output.

Government Expenditure Multiplier  An increase in GDP resulting from an increase of $1

in government purchases of goods & services.  An initial government purchase of a good or service

will set in motion a chain of spending.  If government builds a road, the road-builders will

spend some of their incomes on consumption goods, which in turn will generate additional incomes, some of which will be spent.

 The ultimate effect of on GDP of an extra dollar of G

will be the same as the effect of an extra dollar of I.  The multipliers I equal to 1 1-MPC An increase of $100B in G will have an ultimate increase in GDP equal to $100B primary spending times the expenditure multiplier.

In this case, because MPC = 2/3, the equilibrium level of GDP is $300B. This example tells us that Gov’t expenditure multiplier is the same as the investment multiplier. They are both EXPENDITURE multiplier.

Tax Multiplier  Taxes also have an impact upon the equilibrium GDP,

although it is tax multiplier is smaller than expenditure multipliers.  Thus, offsetting an increase in government purchases

requires an increase in tax larger than the increase in G.  Tax multiplier = MPC x expenditure multiplier

Multipliers in Action

 A realistic understanding of the size of multipliers is a

crucial part of diagnosis and prescriptions in economic policy. (like physicians must know the effect of different dosages of their medicines).  They have to know the magnitude of expenditure and tax

multipliers.  When economy is growing too rapidly and a dose of fiscal

austerity is prescribed, the economic doctor needs to know the actual size of multipliers before deciding how large a dose of tax increases or expenditure reductions to order.

Beyond the Multiplier Model  Macroeconomics

understanding requires understanding not just the models but also their strengths and weaknesses.  Among the simplifications of the simplest multiplier model are the following:  The MM ignores the impact of money and credit

upon consumption & investment.  The simplest MM ignores the way foreign trade affects output at home & abroad.  Aggregate supply is left out of the story, so we have no way of analyzing how increases in spending are divided between prices and output.