Macroeconomics, Maclachlan 11/1/04 1 Principles and Policies I: Macroeconomics Chapter 10: The...

Macroeconomics, Maclachlan 11/1/04

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Principles and Policies I: Macroeconomics

Chapter 10: The Multiplier Model


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Chapter 10 Learning ObjectivesYou should be able to …

• Explain the difference between induced and autonomous expenditures.

• Show how the level of income is graphically determined in the multiplier model.

• Use the multiplier equation to determine equilibrium income.

• Explain how the multiplier process amplifies shifts in autonomous expenditures.

• Demonstrate how fiscal policy can eliminate recessionary and inflationary gaps.

• List six reasons why the multiplier model might be misleading.


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The AS/AD Model When Prices Are Fixed

?

Cumulative shift

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P0 Aggregate supply

AD

Real output

Price level

AD

Initial shiftInduced shift (Multiplier effects)


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The Circular Flow


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The Aggregate Production Curve

Aggregate production(production = income)

A

45º$4,0000

Real production

Real income

$4,000

B

Potential income

C


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Multipler Model

Aggregate Production curve meets …

Aggregate Expenditure

= C + I + G + (X-M)


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Building Aggregate Expenditure Function: Autonomous and Induced Expenditures

• Autonomous expenditures – expenditures that do not systematically vary with income.

• Induced expenditures – expenditures that change as income changes.


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Building Aggregate Expenditure Function: The Marginal Propensity to Expend

• Marginal propensity to expend (mpe) – the ratio of the change in aggregate expenditures to a change in income.

• It is composed of the various relationships between the component of aggregate expenditures.

• Its value is greater than 0 and less than 1.• It is the slope of the aggregate expenditure curve.


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Expenditures Function

• Autonomous expenditures is the sum of the autonomous components of expenditures:

AE0 = C0 + I0 + G0 + (X0 – M0)

• Induced expenditures is the sum of the induced components of expenditures.


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Real income (in dollars)

Real

exp

endi

ture

s (A

E) (i

n do

llars

)Solving for Equilibrium

Graphically

14,000

12,000

10,000

7,000

5,000

4,000 10,000 14,000

Aggregate production

Aggregate expenditures

AE0 = 5,000

AE = 5,000 + 0.5Y

Equilibrium


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The Multiplier Equation

• Expenditures multiplier – a number that reveals how much income will change in response to a change in autonomous expenditures.

mpe-1

1Multiplier


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The Circular Flow Model and the Multiplier Process

• Not all of the flow of income is spent on domestic goods (the mpe < 1).

– This represents a leakage from the circular flow.

• Autonomous expenditures are injections into the circular flow.– They offset the leakages.


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The First Five Steps

Multiplier = 1/(1-0.4) = 1.7

100

40

16 6.4 2.56Multiplier = 1/(1-0.5) = 2

100

50

2512.5 6.25

mpe = .4 mpe = .5


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An Upward Shift of AE


1,052.5

AE1

30

30

4,090

$4,090

$4,210

$4,210

$120

Real expenditures

0 Real income

1,022.5

AE0

120 AE4

AE0.75-1

1 Y

0

0


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$90

$4,152

$4,152

$4,062

4,062

AE0

1,412

AE1

1,382

An Downward Shift of AE

Real expenditures

30

30

0 Real income


90 AE3

AE0.66-1

1 Y

0

0

Fighting Recession: Expansionary Fiscal Policy

Potentialoutput


AE0

AE1

E1

mpe = 0.67

Recessionary gap

∆G = $60

$1,000 $1,180 Real income

AE1 = 333 + 0.67Y


SAS

LAS

AD1AD0

E2

AD1΄$180

$60 $120

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Initial expenditures increaseMultiplier effect

Fighting Inflation: Contractionary Fiscal Policy

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Potentialoutput


AE0

AE1

E2

mpe = 0.8

E1

Inflationary gap

∆G = $200


AE1 = 800 + 0.8Y

B

A


SAS

LAS

AD0

AD1

P1

P0

$1,000


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Limitations of Multiplier Model

1. It’s incomplete: needs info on where economy starts and potential output.

2. It over emphasizes shifts in AE.3. It assumes a fixed price level.4. It doesn’t consider expectations.5. It ignores possibility of desired shifts in

AE.6. It ignores permanent income hypothesis.


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Problem 10-1

The mpe is 0.8. Autonomous expenditures are $4,200. What is the equilibrium income in the economy?

AEmpe

Y

1

1

$21,000


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Problem 10-4

mpe = .6

Multiplier = 2.5

A = 1,000 + 8,000 +

10, 000 + 1,000

= 20,000

Y = 50,000

Increase in A of 2,000

Y increases by 5,000 (or 10%)

Unemployment decreases by 5 percentage points.

mpe = .5

Multiplier = 2

Y= 40,000

Y increases by 4,000 (or 10%)

Unemployment decreases by 5 percentage points.

Macroeconomics, Maclachlan 11/1/04 1 Principles and Policies I: Macroeconomics Chapter 10: The...

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