McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model Chapter 26

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. LAUGHER CURVE “If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions.” Winston Churchill

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model n The multiplier model explains how an initial shift in expenditures changes equilibrium output when the price level is fixed. n An initial expenditure shift causes additional induced (multiplier) effects.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model n The multiplier model quantifies the effect of changes in aggregate expenditures on aggregate output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The AS/AD Model When Prices Are Fixed ? Cumulative shift 20 P0P0 Aggregate supply AD Real output Price level AD Initial shift Induced shift (Multiplier effects)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Production n Aggregate production –the total amount of goods and services produced in every industry in an economy. n Production creates an equal amount of income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Production n Graphically, aggregate production in the multiplier model is represented by a 45° line through the origin

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Production n Real production (in dollars) is on the vertical axis, and real income (in dollars) is on the horizontal axis. n At all points on this curve, income equals production.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Aggregate Production Curve Aggregate production (production = income) A 45º $4,000 0 Real production Real income $4,000 B Potential income C

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Expenditures n Aggregate expenditures – the total amount of spending on final goods and services in the economy: l Consumption – spending by consumers. l Investment – spending by business. l Spending by government. l Net foreign spending on U.S. goods – the difference between U.S. exports and imports.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Autonomous and Induced Expenditures n Autonomous expenditures – expenditures that do not systematically vary with income. n Induced expenditures – expenditures that change as income changes.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Autonomous and Induced Expenditures n Autonomous expenditures is the level of expenditures at zero income. n They remain constant at all levels of income. n A graph of autonomous expenditures is a straight, horizontal line.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Autonomous and Induced Expenditures n Induced expenditures are those that change as income changes. n When income changes, induced expenditures change by less than the change in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Marginal Propensity to Expend n Marginal propensity to expend (mpe) – the ratio of the change in aggregate expenditures to a change in income. n It is composed of the various relationships between the component of aggregate expenditures. n Its value is greater than 0 and less than 1.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Components of the Marginal Propensity to Expend n Marginal propensity to consume (mpc) – the change in consumption that occurs with a change in income. n The mpc is less than 1 because individuals tend to save a portion of an increase in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Components of the Marginal Propensity to Expend n Income taxes reduce people’s incomes which lowers their expenditures. n Individuals spend an increasing portion of their incomes on imports. n Marginal propensity to import – the change in imports that occurs with a change in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Aggregate Expenditures Function n The relationship between aggregate expenditures and income can be expressed mathematically. mpe = marginal propensity to expend Y = income

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expenditures Function n Autonomous expenditures is the sum of the autonomous components of expenditures: AE 0 = C 0 + I 0 + G 0 + (X 0 – M 0 ) n Induced expenditures is the sum of the induced components of expenditures.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Aggregate Expenditures Function n Situation 1: l Autonomous consumption = 100 l Autonomous investment = 40 l Autonomous net exports = 30 l Autonomous government spending = 20 l The marginal propensity to expend = 0.6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Aggregate Expenditures Function n Situation 2: l Autonomous consumption = 100 l Autonomous investment = 40 l Autonomous net exports = 30 l Autonomous government spending = 20 l The marginal propensity to expend = 0.5

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Aggregate Expenditures Function n Situation 3: l Autonomous expenditures = 140 l The marginal propensity to expend = 0.6

Graphing the Expenditures Function (b) Real income AE Slope = 0.6 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. (a) Real income AE Slope = 0.6 (c) Real income AE Slope = 0.5 Situation 1Situation 2 Situation 3

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in the Expenditures Function n The aggregate expenditure curve shifts when autonomous C, I, G, or (X – M) change.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in the Expenditures Function n Shifts in aggregate expenditures lead to a change in income from its existing level. n The curve doesn’t determine income independently of the economy's historical position.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining the Equilibrium Level of Aggregate Income n In bringing AP and AE together in one framework, the following is assumed: l The AP curve is a 45º line until the economy reaches its potential income. l Aggregate expenditures equal aggregate income at all points on the AP curve. l Planned expenditures on the AE line do not necessarily equal production or income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining the Equilibrium Level of Aggregate Income n At equilibrium, planned expenditures must equal production. n Graphically, it is the income level at which AE equals AP.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real income (in dollars) Real expenditures ( AE ) (in dollars) Solving for Equilibrium Graphically 14,000 12,000 10,000 7,000 5,000 4,00010,00014,000 Aggregate production Aggregate expenditures AE 0 = 5,000 AE = 5, Y Equilibrium

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Equation n The multiplier equation tells us that income equals the multiplier times autonomous expenditures. Y = Multiplier X Autonomous expenditures

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Equation n Expenditures multiplier – a number that reveals how much income will change in response to a change in autonomous expenditures.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Equation n As the mpe increases, the multiplier increases:

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Process n When aggregate production do not equal aggregate expenditures: l Businesses change production levels, l Which changes income, which changes expenditures, l Which changes production, which changes income, l Which changes... etc.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Process n The process ends when aggregate production equals aggregate expenditures. n Firms are selling all they produce, so they have no reason to change their production levels.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Process $7,000 5,500 4,750 4,000 2,500 2,000 Real income (in dollars) $1,000 B $4,000 C $7,000 A B1B1 B2B2 A2A2 A1A1 AP AE Real expenditures

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Circular Flow Model and the Multiplier Process n The circular flow model provides the intuition behind the multiplier process. n The flow of expenditures equals the flow of income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Circular Flow Model and the Multiplier Process Aggregate income Aggregate expenditures Households Firms

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Circular Flow Model and the Multiplier Process n Not all of the flow of income is spent on domestic goods (the mpe < 1). l This represents a leakage from the circular flow. n Autonomous expenditures are injections into the circular flow. l They offset the leakages.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Circular Flow Model and the Multiplier Process n The multiplier process is much like a leaking bathtub. l The water in the tub represents income in the economy. l The economy is in equilibrium when water leaking out equals water flowing in (leakages equal injections).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model in Action n The multiplier model illustrates how a change in autonomous expenditures changes the equilibrium level of income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model in Action n Autonomous expenditures are determined outside the model and are not affected by changes in income. n When autonomous expenditures shift, the multiplier process is called into play.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Steps of the Multiplier Process n The income adjustment process is directly related to the multiplier. n Any initial shock (a change in autonomous AE) is multiplied in the adjustment process.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Steps of the Multiplier Process n The multiplier process repeats and repeats until a new equilibrium level is finally reached.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in the Aggregate Expenditure Curve C, I $4,200 4, ,160 4, Real income$4,060$4,160 $ E1E1 E0E0 Aggregate production AE 0 = Y AE 1 = Y E1E1 100 E0E0 D AE A = $20 $20 $ D AE A = $16 D AE A = $12.8

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The First Five Steps of Four Multipliers Multiplier = 1/(1-0.4) = Multiplier = 1/(1-0.5) = mpe =.4mpe =.5

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. mpe =.8 The First Five Steps of Four Multipliers Multiplier = 1/(1-0.6) = Multiplier = 1/(1-0.8) = mpe =.6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of the Effect of Shifts in Aggregate Expenditures n There are many reasons for shifts in autonomous expenditures: l Natural disasters. l Changes in investment causes by technological developments. l Shifts in government expenditures. l Large changes in the exchange rate.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An Upward Shift of AE Aggregate production 1,052.5 AE ,090 $4,090 $4,210 $120 Real expenditures 0Real income 1,022.5 AE 0

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. $90 $4,152 $4,062 4,062 AE 0 1,412 AE 1 1,382 An Downward Shift of AE Real expenditures 30 0Real income Aggregate production

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The United States at the Turn of the Millennium n The economy boomed from and fell into a recession after September l Substantial increases in consumer confidence increased autonomous consumption through mid l Consumer spending and investment fell after the terrorist attacks in September 2001.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Japan in the 1990s n Aggregate income and production fell during the 1990s. l A dramatic rise in the yen cut Japanese exports. l Autonomous consumption decreased as consumers confidence fell l Suppliers responded by laying off workers and cutting production.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy in the Multiplier Model n Policymakers believe they can use government policies to shift the AE curve in an attempt to achieve the desired level of output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fighting Recession: Expansionary Fiscal Policy n Expansionary fiscal policy is appropriate when the economy is in a recessionary gap. n The increased spending leads to a multiple increase in aggregate expenditures, thereby closing the gap.

Fighting Recession: Expansionary Fiscal Policy Potential output Aggregate production AE 0 AE 1 E1E1 mpe = 0.67 Recessionary gap ∆G = $60 $1,000$1,180 Real income AE 1 = Y $1,000$1,180 Real income SAS LAS AD 1 AD 0 E2E2 AD 1 ΄ $180 $60$120 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial expenditures increase Multiplier effect

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fighting Inflation: Contractionary Fiscal Policy n Contractionary fiscal policy is appropriate when the economy is in an inflationary gap. n The decreased spending leads to a multiple decrease in aggregate expenditures, thereby closing the gap.

Fighting Inflation: Contractionary Fiscal Policy McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Potential output Aggregate production AE 0 AE 1 E2E2 mpe = 0.8 E1E1 Inflationary gap ∆G = $200 $4,000$5,000 Real income AE 1 = Y B A $4,000$5,000 Real income SAS LAS AD 0 AD 1 P1P1 P0P0 $1,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Limitations of the Multiplier Model n On the surface, the multiplier model makes a lot of intuitive sense. n Surface sense can often be misleading.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model Is Not a Complete Model n The multiplier model does not determine income from scratch. n At best, it can estimate the directions and rough sizes of autonomous demand or supply shifts.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts Are Not as Great as Intuition Suggests n The aggregate expenditure shifts that occur in response to a shift in autonomous expenditures may be overemphasized.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price Level Will Often Change in Response to Shifts in Demand n The multiplier model assumes that the price level is fixed. n The price level can change in response to changes in aggregate demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forward-Looking Expectations Complicate the Adjustment Process n People's forward-looking expectations make the adjustment process much more complicated. n Most people, however, act upon their expectations of the future.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forward-Looking Expectations Complicate the Adjustment Process n Business people may not automatically cut back production and lay-off workers if they think a fall in sales is temporary.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forward-Looking Expectations Complicate the Adjustment Process n Rational expectations model – all decisions are based upon the expected equilibrium in the economy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand n Shifts in demand can occur for many reasons. n Many shifts can reflect desired shifts in aggregate production which are accompanied by shifts in aggregate demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand n Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers' responding to changes in demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand n Expansion of this line of thought has led to the real business cycle theory of the economy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Shifts in Expenditures Might Reflect Desired Shifts in Supply and Demand n Real business cycle theory of the economy – fluctuations in the economy reflect real phenomena such as simultaneous shifts in supply and demand, not simply supply responses to demand shifts.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expenditures Depend on Much More Than Current Income n People may base their spending on lifetime income, not yearly income. n The marginal propensity to consume out of changes in current income could be very low, even approaching zero.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expenditures Depend on Much More Than Current Income n The expenditures function would essentially be a flat line. n The multiplier would be one. n There would be no secondary effects of an initial shift.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expenditures Depend on Much More Than Current Income n This set of arguments is called the permanent income hypothesis. n Permanent income hypothesis -- the hypothesis that expenditures are determined by permanent or lifetime income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Multiplier Model End of Chapter 26