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

2. 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

3. 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

4. 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

5. 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

6. 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

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

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

9. 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

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

11. Read at home
Read section : Application to the Model