ECO 121 Macroeconomics Lecture Ten Aisha Khan Section L & M Spring 2010 Aisha Khan Section L & M Lecture Ten

Recap - Aggregate Expenditures M&B - Chapter 10 Changes in AE  due to investment changes Multiplier effect Introduce Net exports and Government Purchases S+T+M=I+G+X

Taxation Government also collects taxes Suppose it imposes a lump sum tax Tax of a constant amount Yielding a constant amount of tax revenue at each eq GDP An increase in taxes lowers AE according to the MPC

Balanced budget muiltiplier Curious result Equal increases in G and T simultaneously cause an equal rise in equilibrium GDP Increase in G by $20 billion and an offsetting increase in T by $20 bullion cause Equilibrium GDP to rise by $20 billion

Rationale Increase in G is direct and adds $20 billion to AE An increase in T has an indirect effect through the C and S schedules (T reduces disposable income and then C falls by the amount of the tax times MPC) Balanced budget multiplier = 1 Different MPC/ multipliers yield the same balanced budget multiplier

Equilibrium vs Full employment GDP Recessionary gap When equilibrium GDP is less than full employment GDP The amount by which the AE must shift upwards to achieve full-employment GDP Inflationary gap When AE exceed full employment GDP The amount by which the AE must shift downwards to achieve full-employment GDP

Recessionary gap AE0 C+I = GDP Aggregate expenditure AE1 C+ I 45 GDP Full-employment GDP

Inflationary gap AE2 C+I = GDP AE0 Aggregate expenditure C+ I 45 GDP Full-employment GDP

Limitations to the Model Model can account for demand pull inflation but does not indicate the extent of inflation when there is an inflationary gap Doesn’t explain how inflation is possible before reaching full employment levels

Doesn't indicate how output beyond full-employment is possible Model doesn’t address the possibility of cost-push inflation

Read at home Read section : Application to the Model