Chapter 10 The Multiplier, Net Exports, & Government

Introduction We will examine why is GDP unstable and subject to cyclical fluctuations. We will examine why is GDP unstable and subject to cyclical fluctuations. We will also introduce the Government & the foreign sector into the aggregate spending model. We will also introduce the Government & the foreign sector into the aggregate spending model. We will then apply the model into both the Vietnam War & the Great Depression We will then apply the model into both the Vietnam War & the Great Depression

Changes in Equilibrium & the Multiplier GDP responds to changes in both consumption & investment. The primary focus for this chapter will be investment GDP responds to changes in both consumption & investment. The primary focus for this chapter will be investment Increase in investment spending leads to an exponential increase in equilibrium GDP. Increase in investment spending leads to an exponential increase in equilibrium GDP. This is known as the Multiplier Effect This is known as the Multiplier Effect

Continuing the Multiplier Initial change in spending is usually associated w/ investment due to volatility Initial change in spending is usually associated w/ investment due to volatility The “initial change” is represented by upward or downward movement on the graph (Aggregate Expenditure Schedule) The “initial change” is represented by upward or downward movement on the graph (Aggregate Expenditure Schedule) Multiplier works in both directions (up or down) Multiplier works in both directions (up or down)

Basic Facts of the Multiplier The Economy has continuous flows of expenditures and income – a ripple effect The Economy has continuous flows of expenditures and income – a ripple effect Change in income will cause consumption and savings to change in the same direction Change in income will cause consumption and savings to change in the same direction The size of the MPC and the Multiplier are directly related, the MPS is inversely related to the multiplier The size of the MPC and the Multiplier are directly related, the MPS is inversely related to the multiplier

Significance Small changes in investment plans or consumption can trigger large changes in equilibrium GDP. Small changes in investment plans or consumption can trigger large changes in equilibrium GDP. Simple Multiplier vs. Complex Simple Multiplier vs. Complex Simple does not include the effect of savings, taxes, & imports Simple does not include the effect of savings, taxes, & imports

Net Exports Positive Net Exports increase aggregate spending and then GDP as well Positive Net Exports increase aggregate spending and then GDP as well Negative Net Exports decrease both Negative Net Exports decrease both What relationship would tariffs have on GDP? What relationship would tariffs have on GDP? What about depreciation of the dollar? What about depreciation of the dollar? Prosperity abroad typically indicates prosperity at home. Prosperity abroad typically indicates prosperity at home.

Questions What is the multiplier effect? What is the multiplier effect? What relationship does the MPC bear to the size of the multiplier? The MPS? What relationship does the MPC bear to the size of the multiplier? The MPS? Calculate the multiplier if the MPS is 0,.4,.6, and 1 Calculate the multiplier if the MPS is 0,.4,.6, and 1 Calculate the multiplier if MPC is 1,.9,.67,.50, and 0 Calculate the multiplier if MPC is 1,.9,.67,.50, and 0 How much will GDP increase if investment increases 8 billion and the MPC is.8? How much will GDP increase if investment increases 8 billion and the MPC is.8? What is the difference between the complex & simple multiplier? What is the difference between the complex & simple multiplier?

The Public Sector Government spending boosts aggregate expenditures yet reduce disposable income Government spending boosts aggregate expenditures yet reduce disposable income Government purchases also subject to the multiplier Government purchases also subject to the multiplier Taxes will cause disposable income to fall short Taxes will cause disposable income to fall short How short is determined by multiplying the MPC and MPS by the total tax revenue How short is determined by multiplying the MPC and MPS by the total tax revenue

Injections, Leakage, & Unplanned Inventory Savings, Imports, Taxes are all considered leakages to the stream of spending Savings, Imports, Taxes are all considered leakages to the stream of spending Investments, Exports, & Government Purchases are all considered injections Investments, Exports, & Government Purchases are all considered injections At equilibrium GDP, these two will equal each other (Injections = =GDP) At equilibrium GDP, these two will equal each other (Injections = =GDP)

Balanced Budget Multiplier Equal increases in Government spending and taxation increase the equilibrium GDP. Equal increases in Government spending and taxation increase the equilibrium GDP. Changes in government spending affects aggregate spending more powerfully than a tax change of the same size. Changes in government spending affects aggregate spending more powerfully than a tax change of the same size. Balanced Budget Multiplier is always one Balanced Budget Multiplier is always one

Equilibrium & Full GDP Recessionary gaps exists when equilibrium GDP is below full employment GDP. In other words, we are capable of making more Recessionary gaps exists when equilibrium GDP is below full employment GDP. In other words, we are capable of making more Inflationary Gaps exist when aggregate expenditures cannot achieve equilibrium at full employment. Inflationary Gaps exist when aggregate expenditures cannot achieve equilibrium at full employment.

Limitations of the Model The Aggregate Spending model does not measure inflation – It will show an inflationary gap, it will not however show the exact price level increase The Aggregate Spending model does not measure inflation – It will show an inflationary gap, it will not however show the exact price level increase Does not allow for GDP to increase once full employment is reached Does not allow for GDP to increase once full employment is reached Does not allow for cost push inflation Does not allow for cost push inflation