consumption, investment and the multiplier: chapter 9
TRANSCRIPT
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Consumption, Investment Consumption, Investment and the Multiplier: Chapter 9and the Multiplier: Chapter 9
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What is GDP?What is GDP?
• Gross Domestic Product (GDP)-Gross Domestic Product (GDP)- is the nation’s expenditure on all the final goods and services produced during the year at market price.
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How is GDP calculated?How is GDP calculated?
• You learned one way to calculate GDP is by adding all of Nation’s expenditures.
• Another method used is the income approach (not discussed here).
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Nation’s ExpendituresNation’s Expenditures
Consumption
InvestmentGovernment Spending
Net Exports
CC == GDPGDPII+ GG+ XXnn+
This lecture will concentrate on Consumption
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ConsumptionConsumption
• Consumption is the nation’s expenditures on all final goods and services produced during the year at market prices– Consumption was almost $2 trillion dollars
in 2002
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ConsumptionConsumption
• Americans spend over 95% of their income after taxes
• The total of everyone’s expenditures is called consumption
• Consumption is designated by the letter C
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• C is the largest sector of GDP
• CC is just over two-thirds of GDP
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Consumption Consumption (Continued)(Continued)
• The consumption functions states–As income rises, consumption (C)
rises, but not as quicklyIncome = Consuption + Saving + taxes
Y = C + S + t and, Disposible Income = Consuption + Saving
Yd = C + S or,
Yd = Y - tTherefore, consumption varies with disposable
income (DI)
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Consumption and Disposable Income
As Income rises so does Consumption
NOT AS QUICKLY!NOT AS QUICKLY!BUT
DIDI increases . . . C C increases but by a smaller amount
DIDI decreases . . . CC decreases but by a smaller amount
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Two Ways To View Consumption-Income Relationship
1. As the ratio of total consumption to total disposable income. (APC)
2. As the relationship of changes in consumption to changes in disposable income. (MPC)
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The Marginal Propensity to Consume
• The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.
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Marginal Propensityto Consume (MPC)
MPC = in Consumption
in Income
CHANGECHANGE
CHANGECHANGE
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Marginal Propensityto Consume (MPC)
Table 4
Year DI C S
1998 $30000 $23000 $7000
1999 $40000 $31000 $9000
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Marginal Propensityto Consume (MPC)
Table 4 (continued)
Year DI C S
1998 $30000 $23000 $7000
1999 $40000 $31000 $9000
10000 8000 2000Change
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Table 4 (Continued)Year DI C S
1998 $30000 $23000 $7000
1999 $40000 $31000 $9000
10000 8000 2000Change
MPC =---------------- = ---------- = ------- = .8Change in C 8000 8
Change in DI 10000 10
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Table 4 (Continued) Year DI C S
1998 $30000 $23000 $7000
1999 $40000 $31000 $9000
10000 8000 2000Change
MPC =---------------- = ---------- = ------- = .8Change in C 8000 8
Change in DI 10000 10
MPS = -------------- = ---------- = -------- = .2Change in S 2000 2
Change in DI 10000 10
+
1.0
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The MPC and MPS
MPS = 0.20 MPC = 0.80
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45
$1000
$1000
$6000
?$6000
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Graphing the Consumption Function
If Consumption rose at the same rate as Disposable Income . . . A graph of this function would be a 45 line
Disposable income ($)
45û
1,000
1,000
2,000
3,000
2,000 3,000
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Exp
end
itu
re (
$)
Disposable Income ($)
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C
$6000
5700
$6000
Saving = $300
$2700
$3000
Dissaving = $300
$2700
Saving = - $300
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C
Dissaving
Saving
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Graphing the Consumption Function
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
DI C S
3000 1750
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Exp
end
itu
re (
$)
Disposable Income ($)
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Graphing the Consumption Function
DI C S
3000 1750 1250
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line
Exp
end
itu
re (
$)
Disposable Income ($)
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line
Exp
end
itu
re (
$)
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0
5-37
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is “0” at 1000 DI because there is NO distance between the C line and the 45 degree line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
When DI is “0” the level of Consumption is called Autonomous Consumption (AC)
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line
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Autonomous vs. Induced
• Autonomous means Self Governing
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Autonomous Consumption versus Induced Consumption
• Autonomous consumption (AC) is the level of consumption when disposable income is “0”–It is called autonomous
because it is independent of change in disposable income
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Induced Consumption• Induce consumption (IC) is that
part of consumption which varies with the level of disposable income
–As disposable income rises, induced income rises
–As disposable income fall, induced income falls
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C = Autonomous C + Induced C
So
Induced C = C – Autonomous C
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C
$0
This is your This is your Autonomous Autonomous ConsumptionConsumption
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
DI = 0
What is IC?
IC = C - AC
IC = 625 - 625
IC = 0
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
DI = 1000
What is IC?
IC = C - AC
IC = 1000 - 625
IC = 375
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
DI = 2000
What is IC?
IC = C - AC
IC = 1440 - 625
IC = 815
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
DI = 3000
What is IC?
IC = C - AC
IC = 1750 - 625
IC = 1125
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Determinants of ConsumptionDeterminants of Consumption1. Disposable Income
The most important determinant of consumption
2. Credit Availability
3. Stock of Liquid Assets in the hands of consumers
4. Stock of Durable Goods in the hands of consumers
5. Keeping up with the Jones's
6. Consumer Expectations
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Permanent Income Hypothesis
(Milton Friedman)• People gear their consumption to
their expected lifetime average earnings more than to their current income– Apparently there are quite a few deviations
from the behavior predicted by the permanent income hypothesis
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The Determinants of Saving
• There is no single reason why people save
• Some spend virtually all of their disposable income
• Some spend more than they earn• Americans now save less than 5% of
disposable income• Americans used to save 7-10% of
disposable income
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Investment
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InvestmentInvestment
• “Investment” is the thing that really makes our economy go and grow!
• Investment is any NEW– Plant and equipment
• Investment is any NEW– Additional inventory
• Investment is any NEW– Residential housing
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Inventory Investment
Includes only net change
Date Level of Inventory
Jan. 1, 2003 $120 million
July 1, 2003 145 million
Dec. 31, 2003 130 million
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Inventory Investment
Includes only net changeDate Level of Inventory
Jan. 1, 2003 $120 million
July 1, 2003 145 million
Dec. 31, 2003 130 million
Started the year with $120 million
Ended the year with 130 million
The net change is a (+) 10 million
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Inventory Investment (Continued)
Includes only net changeDate Level of Inventory
Jan. 1, 2003 $130 million
July 1, 2003 145 million
Dec. 31, 2003 120 million
Started the year with $130 million
Ended the year with 120 million
The net change is a (-) 10 million
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Investment in Plant and Investment in Plant and EquipmentEquipment
• Investment in plant and equipment is more stable than inventory– Even in bad years companies will still
invest a substantial amount in new plant and equipment• This is mainly because old and obsolete
factories, office buildings, and machinery must be replaced
– This is the depreciation part of investment
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Residential Construction
• Involves replacing old housing as well as adding to it
• Fluctuates considerably from year to year
• Has mortgage interest rates play a dominant role
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Investment• Investment is the most volatile sector in
our economy
GDP = C + + G + Xn
• Fluctuations in GDP are largely fluctuations in investment
II
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Investment (Continued)
• Recessions are touched off by declines in investment
• Recoveries are brought about by rising investment
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How Do Savings Get Invested?
• Money saved is put into stocks and bonds
• Banks loan money based on their demand deposits and reserve requirements
• Businesses take this money and buy new plant and equipment, and add to their inventory
• Corporations also use “retained earnings” and “depreciation allowances”
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Gross Investment vs Net Investment
• In the equation:
GDP = C + GDP = C + II + G + Xn + G + Xn• The “I”“I” represent gross investment
Gross investment - depreciation = net investmentGross investment - depreciation = net investment– Depreciation is taking into account for the fact
that plant & equipment wear out and houses deteriorate
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Gross Investment - Depreciation = Net Investment– Depreciation is taking into account for the fact
that plant & equipment wear out and houses deteriorate.
– start the year with 10 machines
– bought 6 machines (gross investment)
– worn out/obsolete - 4 machines (depreciation)
– end the year with 12 machines– actual gain of 2 machines (net investment)
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Calculate Gross Investment and Net Investment
Date Date level of level of inventoryinventory
Jan 1 $60 billionJan 1 $60 billion
July 1 55 billionJuly 1 55 billion
Dec 31 70 billionDec 31 70 billion
Expenditures on new plant & equipmentExpenditures on new plant & equipment
$120 billion$120 billion
Expenditures on new residential housingExpenditures on new residential housing
$ 90 billion$ 90 billion
Depreciation on plant & equipment andDepreciation on plant & equipment and
residential housing $30 billionresidential housing $30 billion6-27
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Solution
Date level of inventory
Jan1 $60 billion
July 1 55 billion
Dec 31 70 billion inventory investment $ 10
Expenditures on new plant & equipment new P & E 120
$120 billion new RH 90
Expenditures on new residential housing gross investment 220
$ 90 billion - depreciation - 30
Depreciation on plant & equipment and net investment $ 190
Residential housing $30 billion
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Building Capital• Investment involves sacrifice (on
someone’s part)
• To invest– We must work more– We must consume less (save)
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Determinants of the Level of Investment
• Sales outlook
• Capacity utilization rate
• Interest rate
• Expected rate of profit (ERP)
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The Sales OutlookThe Sales Outlook• You won’t invest if the sales outlook is
bad
– If sales are expected to be strong the next few months the business is probably willing to add inventory
– If sales outlook is good for the next few years, firms will probably purchase new plant and equipment
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Capacity Utilization Rate
• This is the percent of plant and equipment that is actually being used at any given time
• You won’t invest if you have a lot of unused capacity– During recessions, why build more when
you are not using all of what you have
• Other factors– Manufacturing is a shrinking part of U.S.
economy due to imports and increasing investment overseas by U.S. Companies
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The Interest Rate
• You won’t invest if interest rates are too high
Interest rate = The interest paid / The amount borrowedInterest rate = The interest paid / The amount borrowed
Assume you borrow $1000 for one year @ 12 %, how much interest do you pay?
.12 = X
$1000
X = $120
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The Interest Rate• You won’t invest if interest rates are too
high
Interest rate = The interest paid / The amount borrowed
X = $120
$1000
X = .12 = 12 %
Assume you borrowed $1000 for one year and paid $120 interest. What was the interest rate?
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You Won’t Invest If Interest Rates Are Too High
• In general, the lower the interest rate, the more business firms will borrow
• To know how much they will borrow and whether they will borrow, you need to compare the interest rate with the expected rate of profit
• Even if they are investing their own money they need to make this comparison
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Why Do Firms Invest?
• Firm’s will only invest if the expected profit rate is “high enough”
• Firms invest when– Their sales outlook is good– Their capacity utilization rate is high– Their expected profit rate is high
• Even if firm’s invest their own money, the interest rate is still a consideration
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45
$1000
$1000
$6000
?$6000
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C
C+I
This Distance EqualsGrossGross
InvestmentInvestment
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Disposable income ($)
45û
C
1,000
1,000
2,000
3,000
2,000 3,000Disposable income ($)
45û
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
Graphing the C + I Line
To keep things simple so we can read the graph we’re going to assume the level of investment stays the same for all levels of income
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Simplifying Assumption
C
C+I
C line and the C+I line are parallel
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Disposable income ($)
45û
C
1,000
1,000
2,000
3,000
2,000 3,000Disposable income ($)
45û
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
Graphing the C + I Line
How much is I when disposable income is 1000, 2000, and 3,000?
The C line and the C+I line are parallel. Therefore I is about 480 at every level of disposable income.
480
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Government Spending
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Government Purchases versus Transfer Payments
• The government spends trillions of dollars a year– GDP = C + I + GDP = C + I + G G + Xn+ Xn
• The GG in our formula refers to Government purchases
• It does NOT refer to transfer payments.
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What is a transfer payment?
Transfer payments is the government taking money from one group and giving it to another group in the economy.
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Transfer Payments Include
• Social Security– Transferring between the generations
• Veteran Benefits– Transferring money to veterans
• Unemployment Benefits– Transferring from the employed to the
Unemployed.
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Government Purchases vs. Transfers
– Approximately half is “transfer payments”• The largest transfer payment is social security• These payments eventually end up in the “C”
part GDP (after they are spent)
– Approximately half is “government purchases”
• The largest government purchase is defense• These end up in the “G” part of GDP
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Graphing in “G”
C
C+I
C+I+G
G
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Graphing the C + I + G + Xn Line
Disposable income ($)
45û
2,000 3,0001,000
1,000
2,000
C
3,000
C +I+G
C +I
How much is G?
Answer: 400
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The Export-Import Sector
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The Basis for International Trade• The basis for international trade is that
a nation can import a particular good or service at a lower cost than if it were produced domestically– In other words, if you can buy it cheaper
than you can make it you should buy it– This maxim is true for individuals and
nations
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A Summing Up: C + I + G + Xn
Net exports = Xn
Xn = Exports - Imports
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C
C+I
C+I+G
C+I+G+(X-M)C+I+G+(X-M)
Due to Imports being greater than Exports
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45û
8,000
10,000
8,000 10,000
6,000
6,000
4,000
4,0002,000
2,000
C +I +G
Disposable income ($)
45û
8,000
10,000
8,000 10,000
6,000
6,000
4,000
4,0002,000
2,000
C +I +G
Disposable income ($)
C +I +G +Xn
C + I + G + Xn
Why is the C + I + G + Xn line lower than the C + I + G line?
Answer: It is lower because net exports (Xn) are negative
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100 200 300 400 500 600 700
United States
Germany 520
Japan 388
China 214
South Korea 133
Mexico 118
Canada 358
Taiwan 110
Singapore 110
Switzerland 79
(billions of dollars)
683
The World’s Top Ten Exporting Nations, 1999
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The GAPS & The Multiplier
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The Multiplier and Its Applications
• Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP
GDP = C + I + G + Xn
How much the multiplied change is depends on the MPC and MPS
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Calculating the Multiplier
• RememberMPC + MPS = 1, therefore, MPS = 1 - MPC
Multiplier = -----------------------1
1 - MPC
Multiplier = ----------------------1
MPS
Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula)
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Calculating the Multiplier
• The MPC is .5. Find the multiplier
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Calculating the Multiplier(Continued)
• The MPC is .5. Find the multiplier
Multiplier = ---------------- = -------- = ----- = 21
1 - MPC
1
1 – .5
1
.5
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Calculating the MultiplierStep-by-Step Working of the Multiplier When MPC is .5
$1,000.00 $ 500.00 $ 250.00 $ 125.00 $ 62.50 $ 31.25 $ 15.625 $ 7.813 $ 3.906 $ etc. $ etc. $2,000.00
It is surely much easier to use the multiplier of 2 (2 X $1,000 = $2000) than to go through this process and add up all the figures
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Calculating the Multiplier(Continued)
• The MPC is .75. Find the multiplier
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Calculating the Multiplier(Continued)
• The MPC is .75. Find the multiplier
Multiplier = ---------------- = -------- = ----- = 411 1
1 - MPC 1 – .75 .25
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Applications of the Multiplier
• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP
GDP = 2,500; Multiplier = 3; C rises by 10
What is the new level of GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = 2500 + ( 10 x 3)GDPNew = 2500 + ( 30)GDPNew = 2530
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Applications of the Multiplier
• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP
GDP = X; Multiplier = 3; C rises by 10
What happens to GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = X + ( 10 x 3)GDPNew = X + ( 30)GDP increases by 30
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Applications of the Multiplier
• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP
GDP = X; Multiplier = 7; G falls by 5
What happens to GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = X + ( -5 x 7)GDPNew = X + ( -35)GDP decreases by 35
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Applications of the Multiplier• How big is the multiplier (M)?
1 2 3 4 5 6 7 8 9
9
8
7
6
5
4
3
2
1
Deflationary gapC +I +G +Xn
2
GDP (in trillions of dollars)
Full-employment GDP
M = distance between the equilibrium GDP and the full-employment GDP / by the gap
M = 2 / 2 = 1
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Applications of the Multiplier• How big is the multiplier (M)?
2,000
1,500
1,000
500
0
Inflationary gap
500 1,000 1,500 2,000
C +I +G +Xn
500
Full-employment GDP
GDP (in trillions of dollars)
M = distance between the equilibrium GDP and the full-employment GDP / by the gap
M = 500 / 200 = 2.5
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Graphing the C + I + G + Xn Line
Disposable income ($)
45û
2,000 3,0001,000
1,000
2,000
C
3,000
C +I+G
C +I
To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income
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The Relationship Between Total Planned Expenditures and the Aggregate Demand
Pric
e Le
vel
Real GDP
Tot
al P
lann
ed
Con
sum
ptio
n
C,
G,
I, N
, X
Real GDP
200
100
TPE100p
TPE200p
600 800