Chapter 7 Multipliers, Government Budgets and Net Exports

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Chapter 7 Multipliers, Government Budgets and Net Exports Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Learning Objectives Analyse the impact of changes in the level of investment on equilibrium real GDP, income and employment—the multiplier effect. Discuss the rationale for the presence of the multiplier. Examine the difference that may exist between the equilibrium level of output and that corresponding to the full-employment level of output. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Learning Objectives (cont.) Discuss the nature of recessionary and inflationary gaps. Analyse the impact of government purchases and taxes on equilibrium GDP. Introduce the macroeconomic effects of foreign trade on equilibrium GDP. Apply our model to explain the concept of the balanced-budget multiplier. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Equilibrium GDP Fluctuates widely Investment and consumption of durables is inherently unstable Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Autonomous Expenditure Changes Shifts in the AE curve due to changes in autonomous expenditure result in new equilibrium levels of output (GDP) how much output changes by depends on the size of the expenditure multiplier Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Expenditure Multiplier A change in autonomous expenditure results in a change in equilibrium income that is a multiple of the initial change The multiplier is defined as the ratio of the change in GDP arising from a change in autonomous spending Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Changes in Equilibrium GDP and the Multiplier (C + I ) 1 (C + I ) 0 510 490 470 450 430 Equilibrium GDP at I1 level of investment Private spending (billions of dollars) 45 o Real GDP 390 450 470 490 510 I1 If I increases... S Saving and investment (billions of dollars) 20 I0 Real GDP 390 450 470 490 510 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Changes in Equilibrium GDP and the Multiplier 510 490 470 450 430 (C + I ) 0 (C + I ) 2 Private spending (billions of dollars) Equilibrium GDP at I2 level of investment 45 o Real GDP 430 450 470 490 510 Saving and investment (billions of dollars) I2 If I decreases... S 20 I0 Real GDP 430 450 470 490 510 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia The Multiplier Effect A change in autonomous spending gives rise to a larger change in GDP The multiplier effect arises because initial increase in aggregate expenditure will induce successive rounds of increased expenditure Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Multiplier and Marginal Propensities A relationship exists between the MPS (the amount of leakage) and the multiplier Multiplier = 1/MPS = 1/(1 – MPC) The simple multiplier is defined as 1/MPS, when the leakage in the economy is only saving Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Recessionary Gap The amount by which aggregate expenditures are deficient to that required to generate the full employment level of GDP Produces a concretionary impact upon the economy Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Recessionary Gap (cont.) (C + I )0 (C + I )1 } Recessionary Gap spending (billions of dollars) Private Full Employment 45 o 470 490 510 Real GDP (billions of dollars) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Inflationary Gap Is the amount by which aggregate spending exceeds that required to achieve full employment Produces an inflationary effect on the economy Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Inflationary Gap (cont.) (C + I )1 { Inflationary Gap (C + I )0 spending (billions of dollars) Private Full Employment 45 o 470 490 510 Real GDP (billions of dollars) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Discretionary Fiscal Policy Deliberate manipulation of taxes (T ) and spending (G ) by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Government Purchases (G) Added to AE Changes to autonomous government expenditure impact equilibrium real GDP through the multiplier Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Three-Sector Equilibrium C + I + G = real GDP and S = I + G where C is after-tax consumption S is after-tax saving Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Government Expenditure and Equilibrium GDP spending $20 billion C + I + G C + I C (billions of dollars) C + I + G 45 o Real GDP (billions of dollars) 470 510 550 S 40 20 I + G (billions of dollars) S, I + G I Real GDP (billions of dollars) 470 510 550 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Taxes and Equilibrium GDP Taxes are assumed to be lump-sum A tax that collects the same amount at each level of GDP Reduces levels of both saving and consumption How much S and C are affected depends on the MPC and MPS Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Taxes and Equilibrium GDP (cont.) C + I + G $15 billion decrease in consumption Ca + I + G (billions of dollars) C + I + G 45 o Real GDP ($ billions) 490 550 S Sa + T $20 billion increase in taxes $5 billion decrease in saving Sa 40 20 I + G (billions of dollars) S + T, I + G I Real GDP ( $billions ) 490 550 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Fiscal Policy over the Business Cycle Expansionary fiscal policy Increased G Decreased T or both Moves Budget towards a deficit in recessionary times Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Fiscal Policy over the Business Cycle (cont.) Contractionary fiscal policy Decreased G Increased T or both Moves Budget towards a surplus in inflationary times Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

The Multiplier and Fiscal Policy If the tax function is of the form T = TLS + MPT(Y ) where MPT = marginal propensity to tax , Multiplier = 1 [MPT + MPS (1 – MPT)] Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Foreign Trade and Equilibrium GDP Exports (X ) and imports (M ) are introduced into the model Net exports (NX) = X – M AE = C + I + G + NX Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Exports (X) Level of X depends on foreign countries’ income, not domestic income Therefore X is an autonomous variable in the model Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Slides prepared by Muni Perumal, University of Canberra, Australia Imports (M) Level of M is dependent on domestic income or GDP Given autonomous exports, a rise in imports due to a rise in income results in a fall in NX Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Equilibrium GDP with a rise in NX (C + I + G + NX)2 (C + I + G) (C + I + G + NX)0 510 490 470 450 Spending (billions of dollars) 45 o Real GDP ($ billions) 450 470 490 510 530 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Open-Economy Multiplier The introduction of foreign trade reduces: the expenditure multiplier the slope of the AE curve The open-economy multiplier = 1/[MPS + MPM], if taxes are lump sum with no marginal propensity to tax Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

The Complex Multiplier for an Open Economy The multiplier that arises when all leakages—savings, taxes, and imports—are taken into account: 1 k = [MPT + MPS (1 – MPT) + MPM] Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Balanced-Budget Multiplier The effect of an equal increase (or decrease) of both the level of government expenditure and taxation Increases (decreases) the level of equilibrium GDP by exactly the amount of the increase (or decrease) in G and T Thus, equal increases in G and T are expansionary Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia

Next Chapter: Aggregate Demand and Aggregate Supply Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia