EC 111 Lecture Notes - Lecture 9: Money Supply, Output Gap, Art Buchwald
4 Jun 2018
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Chapter 10 – Aggregate Expenditures: The Multiplier, Net Exports, and Government
Introduction
• This chapter examines why real GDP might be unstable and subject to cyclical fluctuations.
• The revised model adds realism by including the foreign sector and government in the aggregate
expenditures model.
• Applications of the new model include two U.S. historical periods and the current situation in Japan. The focus
remains on real GDP.
Changes in Equilibrium GDP and the Multiplier
• Equilibrium GDP changes in response to changes in the investment schedule or to changes in the
consumption schedule.Because investment spending is less stable than the consumption schedule, this
chapter's focus will be on investment changes.
• Figure 10-1 shows the impact of changes in investment.Suppose investment spending rises (due to a rise in
profit expectations or to a decline in interest rates).
• Figure 10-1 shows the increase in aggregate expenditures from (C + Ig)0 to (C + Ig)1.In this case, the $5 billion
increase in investment leads to a $20 billion increase in equilibrium GDP.
• Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of
$20 billion to $450 billion.
• The multiplier effect:
• A $5 billion change in investment led to a $20 billion change in GDP.This result is known as the multiplier
effect.
• Multiplier = change in real GDP / initial change in spending.In our example M = 4.
• Three points to remember about the multiplier:
• The initial change in spending is usually associated with investment because it is so volatile.
• The initial change refers to an upshift or downshift in the aggregate expenditures schedule due to a change in
one of its components, like investment.
• The multiplier works in both directions (up or down).
• The multiplier is based on two facts.
• The economy has continuous flows of expenditures and income-a ripple effect-in which income received by
Jones comes from money spent by Smith.
• Any change in income will cause both consumption and saving to vary in the same direction as the initial
change in income, and by a fraction of that change.
• The fraction of the change in income that is spent is called the marginal propensity to consume (MPC).
• The fraction of the change in income that is saved is called the marginal propensity to save (MPS).
• This is illustrated in Table 10-1 and Figure 10-2 which is derived from the Table.
• The size of the MPC and the multiplier are directly related; the size of the MPS and the multiplier are inversely
related. See Figure 10-3 for an illustration of this point. In equation form M = 1 / MPS or 1 / (1-MPC).
• The significance of the multiplier is that a small change in investment plans or consumption-saving plans can
trigger a much larger change in the equilibrium level of GDP.
• The simple multiplier given above can be generalized to include other "leakages" from the spending flow
besides savings.For example, the realistic multiplier is derived by including taxes and imports as well as
savings in the equation.In other words, the denominator is the fraction of a change in income not spent on
domestic output.(Key Question 2.)
International Trade and Equilibrium Output
• Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and
imports contract aggregate spending on domestic output.
• Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced
goods and services.
• Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on
imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S.
produced goods and services.
• The net export schedule (Table 10-2):
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