macroeconomics, maclachlan 11/1/04 1 principles and policies i: macroeconomics chapter 10: the...
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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
20
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
Aggregate production
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
Aggregate production
90 AE3
AE0.66-1
1 Y
0
0
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Fighting Recession: Expansionary Fiscal Policy
Potentialoutput
Aggregate production
AE0
AE1
E1
mpe = 0.67
Recessionary gap
∆G = $60
$1,000 $1,180 Real income
AE1 = 333 + 0.67Y
$1,000 $1,180 Real income
SAS
LAS
AD1AD0
E2
AD1΄$180
$60 $120
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Initial expenditures increaseMultiplier effect
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Fighting Inflation: Contractionary Fiscal Policy
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Potentialoutput
Aggregate production
AE0
AE1
E2
mpe = 0.8
E1
Inflationary gap
∆G = $200
$4,000 $5,000 Real income
AE1 = 800 + 0.8Y
B
A
$4,000 $5,000 Real income
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.