Multiplier. Closing the recessionary gap Classical Theory In the Classical Economics, a...
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Transcript of Multiplier. Closing the recessionary gap Classical Theory In the Classical Economics, a...
Multiplier
Closing the recessionary gapClosing the recessionary gap
Classical TheoryClassical Theory In the Classical Economics, a recessionary gap is In the Classical Economics, a recessionary gap is
only temporary. only temporary. Because the surplus in the labor market will Because the surplus in the labor market will
depress the wage ratedepress the wage rate Then cost of production fallsThen cost of production falls Price of products will also fall. Price of products will also fall. Through wealth effect, consumption will go up Through wealth effect, consumption will go up In the income-expenditure diagram, the AE In the income-expenditure diagram, the AE
schedule will shift up. schedule will shift up. Hence the recessionary gap will be closed Hence the recessionary gap will be closed
automatically at reasonable speed.automatically at reasonable speed.
Closing the recessionary gapClosing the recessionary gap
Keynesian TheoryKeynesian Theory Prices and wage rates are rigid to go Prices and wage rates are rigid to go
downwarddownward When the firms and consumers When the firms and consumers
remain pessimistic, even the wage remain pessimistic, even the wage rates and product prices fall, they do rates and product prices fall, they do not increase employment or not increase employment or consumptionconsumption
So the recessionary gap remains for So the recessionary gap remains for long time. Recession is prolonged long time. Recession is prolonged
Recessionary Gap
0 YY*
AE
AE=Y$
Yp
Recessionary gap
Close Recessionary Gap Close Recessionary Gap
Increase total spending AEIncrease total spending AE AE = C + I + G + (X - IM) AE = C + I + G + (X - IM) C, I and X-IM are not controllable C, I and X-IM are not controllable G can be controlled by the G can be controlled by the
governmentgovernment Keynes suggests to increase G thus Keynes suggests to increase G thus
AE to create more demandAE to create more demand
Closing the Recessionary Gap
0 YY*
AE
AE=Y
$
Yp
Recessionary gap
AE’
G
How much should G increase to How much should G increase to close the gap close the gap
A smaller increase in G leads to A smaller increase in G leads to larger increase in Y*larger increase in Y*
Graphically illustration Graphically illustration
Closing the Recessionary Gap
0 YY*
AE
AE=Y
$
Yp
Larger increase in Y*
AE’
Initial increase in G
Numerical illustrationNumerical illustration
The model economyThe model economyC = 100 + 0.9 DIC = 100 + 0.9 DIT = 0T = 0 I = 150I = 150G = 200G = 200X - IM = -50X - IM = -50
Solved: Y* = 4000Solved: Y* = 4000 Suppose: Yp = 5000Suppose: Yp = 5000
Numerical illustrationNumerical illustration
AE = 400 + 0.9 Y AE = 400 + 0.9 Y Equilibrium Y:Equilibrium Y:
Y* = 1/(1-0.9) X 400 Y* = 1/(1-0.9) X 400 = 10 X 400 = 10 X 400 = 4000= 4000
Potential GDP: Yp = 5000Potential GDP: Yp = 5000 The recessionary gapThe recessionary gap
Yp - Y* = 5000 - 4000 = 1000Yp - Y* = 5000 - 4000 = 1000
Numerical illustrationNumerical illustration
Suppose G rises by 100, from 200 to Suppose G rises by 100, from 200 to 300, what happens to Y*? 300, what happens to Y*?
AE = C + I + G + (X - IM)AE = C + I + G + (X - IM) = 500 + 0.9 Y= 500 + 0.9 Y The new equilibrium Y*The new equilibrium Y*
Y** = 1/(1-0.9) X 500 Y** = 1/(1-0.9) X 500 = 10 X 500 = 10 X 500 = 5000 = 5000
Numerical illustrationNumerical illustration
Increase in Y*Increase in Y* Y* = 5000 - 4000 = $1000 Y* = 5000 - 4000 = $1000 G = $100 G = $100 Y* = $1000 Y* = $1000 An increase in G by 100 leads to an An increase in G by 100 leads to an
increase in Y* by 1000. increase in Y* by 1000. Ten times large.Ten times large.
Expenditure MultiplierExpenditure Multiplier Expenditure multiplierExpenditure multiplier Also called “income multiplier”Also called “income multiplier”
Increase in Y*Increase in Y* Expenditure Multiplier = ------------------Expenditure Multiplier = ------------------
Increase in GIncrease in G
Y*Y* EE = ---------- = ----------
GG
Expenditure MultiplierExpenditure Multiplier
Y*Y* 1000 1000
EE = ---------- = -------- = 10 = ---------- = -------- = 10
GG 100 100
Expenditure MultiplierExpenditure Multiplier
Y* Y* Y* Y* Y* Y* Y*Y*
EE = ----- = ---- = ---- = ----- = ----- = ---- = ---- = -----
GG C C I I X-IMX-IM
Economic insight of the multiplier Economic insight of the multiplier
The trickling down effectThe trickling down effect– The multiplier is greater than 1 because The multiplier is greater than 1 because
one person’s spending is another one person’s spending is another person’s income.person’s income.
spending spending income income– A portion of the increase in income is A portion of the increase in income is
spent on consumption, creating more spent on consumption, creating more income, which in turn creates more income, which in turn creates more consumption spending, and so on consumption spending, and so on
Insight of multiplierInsight of multiplier Suppose the government increases G by Suppose the government increases G by
100 (b$)100 (b$) 1st round, government spending:1st round, government spending:
G = G = AE = 100AE = 100 2nd round, contracted firms:2nd round, contracted firms:
C = C = AE = AE = DI X 0.9 = 100 X MPC DI X 0.9 = 100 X MPC = 100 X 0.9 = 90= 100 X 0.9 = 90
3rd round, the shopkeepers,3rd round, the shopkeepers,C = C = AE = AE = DI X 0.9 = 90 X MPC DI X 0.9 = 90 X MPC = 90 X 0.9 = 81= 90 X 0.9 = 81
How the Multiplier Builds
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Spending Round
20 15 10 8 6 4 2
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pen
din
g T
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l $4.0
2.0
3.0
1.0
0
Insight of Multiplier
Round Number
Increase in Spending in this round (b$)
Cumulative total(b$)
1 100 100
2 90 190
3 81 271
4 72.9 343.9
5 65.61 409.51
... ... ... ... ... ...
Infinity 0 1,000
Insight of multiplierInsight of multiplier Cumulative increase in Y*:Cumulative increase in Y*:
100 + 90 + 81 + 72.9 + 65.61 + ...100 + 90 + 81 + 72.9 + 65.61 + ...= 100 + 100 X 0.9 + 100 X (0.9)= 100 + 100 X 0.9 + 100 X (0.9)22 + 100 X + 100 X
(0.9)(0.9)33 + 100 X (0.9) + 100 X (0.9)44 +... +...
= 100 X ( 1+0.9+0.9= 100 X ( 1+0.9+0.922+ 0.9+ 0.933 + 0.9 + 0.944 + ... ) + ... ) 11
= 100 X ---------= 100 X --------- 1 - 0.91 - 0.9
= 100 X 10= 100 X 10= 1000= 1000
Geometric Progression and Geometric Progression and solutionsolution
1 + x + x1 + x + x22 + x + x33 + x + x44 + ... + ...
11
= ---------- ( x < 1 )= ---------- ( x < 1 )
1 - x1 - x
Expenditure multiplierExpenditure multiplier
11
EE = ---------- = ----------
1 – MPC1 – MPC
"oversimplified multiplier" formula"oversimplified multiplier" formula
Larger MPC, larger Larger MPC, larger EE
Autonomous changes in AEAutonomous changes in AE
Autonomous increase in C, I, or X-IMAutonomous increase in C, I, or X-IM
refers to an increase in C, I, or X refers to an increase in C, I, or X - IM, which is independent of income - IM, which is independent of income Y. Y.
In graph, an autonomous increase In graph, an autonomous increase shifts the AE schedule up.shifts the AE schedule up.
Any autonomous increase generates Any autonomous increase generates a multiplier effect on Y*a multiplier effect on Y*
Induced changes in AEInduced changes in AE
Induced increase in C, I, or X – IMInduced increase in C, I, or X – IM refers to an increase in C, I or X - IM refers to an increase in C, I or X - IM
due to an increase in income Y. due to an increase in income Y. In graph, an induced increase In graph, an induced increase
produces a movement along the AE produces a movement along the AE schedule. schedule.
Autonomous and induced changes
0 YY*
AE
AE=Y
$
Yp
Autonomous change
AE’Induced change
The Paradox of ThriftThe Paradox of Thrift
If everyone tries to save more in If everyone tries to save more in recessionrecession
Then C fallsThen C falls Then causes a multiple decrease in Then causes a multiple decrease in
Y* Y* Then each individual ends up with Then each individual ends up with
less saving in absolute term. less saving in absolute term.
The Paradox of Thrift
Saving
GDP before recession
GDP in recession