Building [ Simple economy to Complex economy] [C+Ig] ( private-closed )

Building [Simple economy to Complex economy]

[C+Ig] (private-closed)[C+Ig+Xn] (private-open)[C+Ig+G+Xn] (mixed-open)

“ME” = 4

460 500

AE(C+Ig1)AE(C+Ig)

AE(C+Ig2)S

YR Y*

10 Ig

ClosedPrivate

Private

Mixed OpenOpen

390 470 550 630 Real GDP0

AE3 (C+Ig+G+Xn) (Complex Economy) [Open & mixed]

AE2 (C+Ig+Xn) (Open & Private) [X(40)-M(20)]

AE1(C+Ig)[Basic Economy][Private(no G)&Closed(no X or M)]

Consumption

+80+80+80C=390

(AE1)470

(AE2)550

(AE3)630

+20 Xn+20 G

+20 Ig

S

Real GDP

45°45°

45°45°

AE

[C +

Ig

] (b

illion

s o

f d

ollars

)

o45

o

Consumption

C + Ig

Ig = $20 Billion

Equilibrium

370 390 410 430 450 470 490 510 530 550

Building the ModelAE[C+Ig] [“Basic” or “Simple” economy]

C =$450 Billion

$530

510

490

470

450

430

410

390

370 + 20 Ig

+80

S

Private Closed

GDP will increase by a “multiple” of 4 & that is why it is called the “multiplier”.

Real GDP

Multiplier-4

Con

su

mp

tion

Savin

g

o

o45

o

Consumption

S

C1

S

DI2 (Disposable Income)

Disposable Income

SAVING

SAVING

DISSAVING

DISSAVING

Change in (or QS)[Income change, movement from point to point]

So, the key to achange in QC(QS)

is a change in ?

Breakeven

DI1DI3

C2

S

Con

su

mp

tion

Savin

g

o

o45

o

C1

S1

Disposable Income

Disposable Income

C2

S2

Increase in Consumption (Decrease in Saving)[shift/whole curve/non-income]

Increases inconsumptionmeans…

Decreasein saving

May be caused by:Increase in wealthDecrease in PLExpect. PL incr.Expect. of positive YExpect. of shortagesDecrease in debt*Decrease in taxes

*Decrease in taxesincreases both C & S

I’ll buy more and save more.

Con

su

mp

tion

Savin

g

o

o45

o

C1

S0

Disposable Income

Disposable Income

C2

S2

Decrease in Consumption (Increase in Saving)[shift/whole curve/non-income]

Decreases inconsumptionmeans…

Increasein saving

May be caused by:Decrease in wealthIncrease in PLExpect. PL decreaseExpect. neg. future Y Increase in debt*Increase in taxes

*Increase in taxes decreases both C & S

.80 .85 .90 .95 1.0.986

.976

.972

.940

.907

.873

.869

.842

Canada

United States

Netherlands

United Kingdom

Germany

Italy

Japan

France

GLOBAL PERSPECTIVEAverage Propensities to Consume,

Selected Nations, 2000

NON-INCOME DETERMINANTS [Shifters]OF CONSUMPTION AND SAVING

• Wealth Increase or decrease in wealth

• Consumer Expectations

[about future availability, income, & prices]

• Household Debt• Increase/decrease in PL• Taxation increases/decreases

NominalInterest

Rate

RealInterest

Rate

AnticipatedInflation

-

12%

5%7%

Real Interest Rate[Nominal I.R. – inflation rate = Real I.R.]

=

Marginal Efficiency of Investment [MEI][If expected returns equal or exceed the real interest rate of interest, the firm will normally make the investment.]

30%

25%

20%

15%

10%

5%

[QID] Quantity of Investment Demanded (millions)

0 1 2 3 4 5 6

MEI = 27%

Renovate plant

$2 million

MEI=20%

Add newwing to factory$1 mil.

MEI=15%

Purchasemachines$1.5 mil.

MEI=12%

Acquireadditional

powerfacilities$1.5 mil.

MEI = 7%

Install computersystem $1 mil.

[One firm’s demandcurve for investment]

Change in QID[interest rate change, point to point movements]

QID1 QID2

DI (MEI) [Economy’s AD curve for Ig]

I.R. QID

100 200

Firms borrow to invest.25%

20%

15%

10%

5%

[A 20% cost offunds attract $100 billion ofinvestment

A 5% cost of fundsattracts $200 B Ig

0 50 150 250

[MEI]

Should A New Drill Press Be Purchased?

Positive profit expectations and the real interest rate are the most important determinants of investment.

Drill Press - $1,000A. Expected gross profits = $1,100 or a 10% return. [$100/$1,000 x 100 = 10%] [At 8%, invest; at 12%, don’t invest]

B. Real interest rate [nominal interest rate-inflation]

Single Firm

Investment (billions)

Exp

ecte

d r

ate

of

retu

rn,

r,

an

d in

tere

st

rate

, i

(perc

en

ts)

16

14

12

10

8%

6

4%

2

05 10 15 20 25 30 35 40 QID QID

Change in Quantity of Investment Demanded [QID](Interest rate change, point to point movement)

DI Firms will undertake all investments[additions to plant, equipment, inventory,and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest.

Monetary Policy – by loweringinterest rates, the Fed can increase Ig & employment.

[Inverse relationship between real interest rate and QID]

CHANGE [Shift] IN INVESTMENT [curve]

8%

QID1

I1 I2

QID2

Increase in Investment1. Positive profit expectations2. Scarcity of inventory3. Technology [innovation]4. Decrease in production costs5. Decrease in business taxes

INVESTMENT DEMAND & SCHEDULE

Exp

ecte

d r

ate

of

retu

rn,

r, a

nd

real in

tere

st

rate

, i (p

erc

en

ts)

Investm

en

t(b

illion

s o

f d

ollars

)Investment

(billions of dollars)

20

8

20

Real Domestic Product, GDP(billions of dollars)

DI

Ig

InvestmentDemand Curve

InvestmentSchedule

Ig independent of Y

20

20

Y1 Y2 Y3

In constructing the AE graph, Ig will be independent [not influenced]by income. Investment decisions are made months ahead.

1. The most important determinant of consumer spending is (wealth/indebtedness/income).2. As aggregate income increases, consumption and saving both (increase/decrease).3. The (consumption/saving) schedule shows how much households plan to consume at various income levels.4. Dissaving occurs where consumption (exceeds/is less than) Y.

5. If the consumption schedule shifts upward [not caused by a tax change], the saving schedule will shift (upward/downward).

6. (The expectation of a recession/A change in consumer incomes/

An expected change in the price level) will not cause the consumption curve to shift.

NS 1-6

“Closed” and “private” [C+Ig] “Simple Economy”

“Open” & “private” [C+Ig+Xn] “Open” & “mixed” [C+Ig+G+Xn] “Complex Economy”C+Ig Assumptions: No internat. trade or “G” ; no business saving;depreciation & NFFIEUS are 0; PL is constant [Keynesian] [GDP = DI]

Closed

APC = C/Y(DI) = $48,000/$50,000 = .96APS = S/Y(DI) = $2,000/$50,000 = .04 1

APC = C/Y = $52,000/$50,000 = 1.04APS = S/Y = -$2,000/$50,000 = -.04

1

APC - percentage of income (“Y”) consumed.

AE=GDPAPC=C/Y

“High maintenanceEcon teacher”

APS – percentage of income (“Y”) saved.

APS = S/Y

“Econ,Econ,

APS=S/Y

APC and APS

MPC, MPS, & the Multiplier

*The ME is The reciprocal of the MPS.

The “M” works like a concentric circle.

MPC-% change in Y consumed. MPS-% change in Y saved.

MPC = C/ Y = $750/$1,000 = .75MPS = S/ Y = $250/$1,000 = .25Multiplier = 1/.25 = $1/.25 = “M” of 4[MPC is important for G in policy making decisions.]

M=1/MPS

The First Round of Government

Spending Causes The Biggest Splash MPC of 75%G spends $200 billion on the highways.

Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats.

Boat makers save 25% of $150 bil. [$37.50 bil.] & spend 75% or $112.50 bil. on iPod Minis, etc.

AE[C

+Ig

+G

] (b

illion

s )

o45

o

AE[C+Ig]

AE[C+Ig+G]

G = $10 Billion

Equilibrium

+ 10 G

800 840 Yr Y*

ME = 1/MPS, 1/.25 = $1/.25 = M of 4M is 4 & we are short of Y*[$840] by $40 billion

Recess. Spending gap

Recessionary GDP Gap

Real GDP

“M” = Y/ E = 40/10 = 4

Recess. Gap

+40

AE[C

+Ig

+G

] (b

illion

s o

f d

ollars

)

o45

o

AE[C+Ig]

AE[C+Ig+G]

G = $20 Billion

Equilibrium

+ 20 G

800 840 Yr Y*

ME = 1/MPS, 1/.50 = $1/.50 = M of 2M is 2 & we are short of Y*[$840] by $40 billion

Recess. Spending gap

Real GDP

Recess. Gap

+40

“M” = Y/ E = 40/20 = 2 Recessionary GDP Gap

800YR

AE[C

+Ig

+G

] (b

illion

s o

f d

ollars

)

o45

o

AE[C+Ig-G]Equilibrium

800 840 880 Yr Y* Yi

ME = 1/MPS, 1/.50 = $1/.50 = M of 2M is 2 & we are beyond Y*[$840] by $40 billion

Inflationary Spending gap=$20 B

Inflationary GDP Gap

Real GDP

AE [C+Ig+G]

Inflat. Gap

-40

2 x -? = -40

-20 G

MPC 1/MPS = M.90 1/.10 = 10.80 1/.20 = 5.75 1/.25 = 4.60 1/.40 = 2.5.50 1/.50 = 2

ME [Change in G, Ig, or Xn] = 1/MPS

MPC MPC/MPS = M.90 MPC/.10 = 9.80 MPC/.20 = 4.75 MPC/.25 = 3.60 MPC/.40 = 1.5.50 MPC/.50 = 1

MT [Change in Taxes] = MPC/MPS

MT

4

3

1.5

1

9

The 2000 Olympics resulted in $3 1/2 billion to Australia’s economy over a year’s time.The Texas-Oklahoma game brings $21 mil to D-FW.2005 Cotton Bowl brought $30 million to D-FW.Super Bowl brought $166 million to Houston.Fiesta Bowl for national title brought in $85 million.Big 12 Tournament brought $45 million to D-FW

OU

MT = MPC/MPSME = 1/MPS

MPC ME

.9 10

.8 5

.75 4

.60 2.5

.5 2

The larger the MPC, the smaller the MPS, and the greater the multiplier. This is the “simple multiplier”because it is based on a “simple model of the economy”.

Notice the 2nd round

with .9 versus .5

90%

50%

Super Bowl - $166 Million For Houston• $150 - Parking rates around the stadium

• $500-$600 per Super Bowl ticket

[$2,000-$6,000 on E-Bay for a seat]• $12,000 – cost of Super Bowl trophy

• $2.3 million – 30 second ad• $50,000 – Super Bowl Ring• 68,000 to each player on the winning team• $36,500 to each player on the losing team. • $3.35 million to the winning team• $2.59 million to the losing team• Hotels - $69 M; bars & restaurants-$27 M; entertainment-$15 M;

transportation-$15 M; and retail sales-$41 M

Reliant Stadium

$1,000.00 500.00 250.00 125.00 62.50 31.25 15.625 7.8125 3.90625 1.953125 .9765625 .48828125 .244140625 .1220703125 .06103515625 .030517578125 .015258789062

$2,000,000,000

Step by Step Working of “Multiplier” [MPC is .5]

[Increased by a multiple of 2]

“Come on over.”

Government increases spending by $1 billion with a multiplier of 2

On new highwaysHighway workers buy new boatsBoat builders buy plasma TVsTV factory workers buy new carsAuto workers buy “wife beater shirts”Apparel workers spend $ on moviesMovie moguls spend money on Christina Agulera’s “Come On Over.”

Let’s Go To Padre Island and Party With The Multiplier

• During spring break, college students like to head to Padre Island. The “multiplier” is getting ready to work.

• With dollars in their pockets, the students spend money on food and drink, motel rooms, dance clubs, etc. These dollars raise total income there by some multiple of itself.

• College students buy pizzas, beer, and sodas. The people who sell these items find their incomes rising. They spend some fraction of their increased income, which generates additional income for others.

• If the students spend $8 million at Padre and the MPC is .60, then college students will increase income in Padre by $20 million.

• When the networks show scenes on the beach, the average person simply sees college students having a good time.

• But – economists see the multiplier at work, generating higher levels of income for many of the residents of Padre Island.

UT student

These areTexas A&M

studentsAt Padre.

Multiplier – As the money goes from one person, to another, to another…

NS 7 – 107. The APC indicates the percent of total income that will be (consumed/saved). 8. The MPC is the fraction of a change in income which is (spent/saved).9. The greater is the MPC, the (larger/smaller) the MPS, and the (larger/smaller) the multiplier.10. With a MPS of .4, the MPC will be (.4/.2/.6) and the multiplier will be (2/2.5/4).

Building [Simple economy to Complex economy]

[C+Ig] (private-closed)

[C+Ig+Xn] (private-open)

[C+Ig+G+Xn] (mixed-open)

“ME” = 4

ClosedPrivate

Private

Mixed Open

Open

390 470 550 630 Real GDP0

AE3 (C+Ig+G+Xn) (Complex Economy) [Open & mixed]

AE2 (C+Ig+Xn) (Open & Private) [X(40)-M(20)]

AE1(C+Ig)[Basic Economy][Private(no G)&Closed(no X or M)]

Consumption

+80+80+80C=390

(AE1)470

(AE2)550

(AE3)630

+20 Xn

+20 G

+20 Ig

S

Injections Leakages1. Investment[20] = 1. Saving[20]2. Exports[10] = 2. Imports[10]3. Government[20]= 3. Taxes[20]

Notice that the injections are autonomous (independent) of Y

45°45°

Con

su

mp

tion

o45

o

Consumption

C1

F

SAVING

E

C2

S

How to figure the MPC & MPS [MPC = C/ Y] [MPS = S/ Y]

Disposable Income

B

C

D

A

H

Dissaving

MPC=? BC/EF

MPS=? CD/EF

S

200 400 1,000 bil. 0 N Q K

$1,000$700$400 J

P

I

HAE1[C+Ig]

Consumption

Real GDP

AE

[C+

Ig]

With Ig [C+Ig], the MPC is? PI/QK

The MPS is ? HI/QK

What income level represents “dissaving”? $200

Consumption will be equal to income at income level ? $400

Review

45°45°

NS 11-16

11. The APC is one at letter (A/B/C/D).12. The MPC is equal to (AE/OE or CB/AB). [moving from OE to OF]13. At income level “OF” the volume of saving is (CB/CD).14. Consumption will be equal to income at income level (OH/OE).

15. The economy is dissaving at income level (OH/OF).16. The MPS is (CD/EF or CB/EF).

[moving from OE to OF]

Consumption

Con

su

mp

tion

Income0 H E F

AB

C

D

45°45°

YR F* 500 580

An Increase in G of $20B is more expansionary than a decrease in T of $20 B

[If the MPC is .75, ME is 4 but the MT is only 3]

AE

AE

+80

YR Y*500 580

+60+20T

AE1(C+Ig)AE2(C+Ig+G)

AE1

AE2

Incr G spending by $20 bil.“ME” of 4 [1/.25]

[20 x 4 = $80]

“Tax cut” of $20 billion“MT” = 3 [.75/.25] x 20 = $60

[Need a 25% larger “Tax cut” to get to $580]“Tax cut of $25.67 billion x 3 = $80]

Let’s see, anyone’s spending (G,Ig, or Xn) becomes someone else’s income, so there will be an increase in “C”.

+20G

S

S

560

“Big 12” Tournament brings $45million to the DFW economy.

AAC

Increase in G of $40 Billion with MPS of .5

1st Round = $40 billion spent on the highways

2nd Round=$20 billion on motorcycles

3rd Round,only $10 billion spent on corvettes

The multiplier is the multiple in which an initial change in aggregate spending will alter total spending after an infinite # of spending cycles.

Total spending change = M X new spending injection.

Decrease in Taxes of $40 B with MPS of .5

With MPS of .50, $20 is saved & & only $20 bil is spent 1st round.

2nd Round: only$10 bil. is spent.

3rd Round

only $5 bil.is spent.

Leakage of 50%[saving of $20 bil.]in the first round

ME of “10” [So MT is “9”]

[+20]


[+20]


[+20]

Balanced Budget Multiplier (“1”)$20 G $20 T

$600 $620

S

+20 G&T

AE1[C+Ig]AE2[C+Ig]

[Increase G & T by $20 billion]

40“G”“T”-20

“G”

“G”

“T”

“T”

100

200

-80

-180

AE

ME of 2 & MT of 1

+$20

ME of 5 & MT of 4

ME of 10 & MT of 9

Balanced Budget Multiplier [$20 billion][“T” affects AD indirectly thru “C”; “G” affects AD directly]

GDP = $80

Net Change in GDP = The increase in “T” means we would have consumed $15 and kept $5 in our pockets.

The increase in “G” flows directly into the economy.

ME = 1/MPS

ME = 1/.25 = 4

So, 4 x $20 = $80

G $20

MT = MPC/MPS=.75/.25=3So, 3 x -$20 = -$60

GDP = -$60

Ca= -$15

Sa= -$5

T $20

$470 billion

AS

AD1

$490 billion

PL

AD2

+$20

The ME, MT, & MBB MultipliersME[G, Ig, or Xn] = 1/MPS = 1/.25 = 4So, G increase of $10 bil. will incr Y by $40 bil. [$10x4=$40]And a G decrease of $10 bil. will decrease Y by $40 bil. [-$10x4=-$40 bil.]

MT = MPC/MPS = .75/.25 = 3So, T decrease of $10 bil. will incr Y by $30 bil. [$10 x 3=$30]And a T increase of $10 bil. will decr Y by $30 bil. [-$10x3=-$30]

MBB = 1So, an increase in G&T of $10 bil. will incr Y by $10 bil. [$10x1=$10]

And a decrease in G&T of $10 bil. will decr Y by $10 bil.[-$10x1=-$10]

Any increase in expenditures x the M will increase GDP.Any decrease in expenditures x the M will decrease GDP.

1. We will start at $500 equilibrium GDP on each.

2. Of the three items (equilibrium GDP, change in expenditures, and MPC), you will be given two and if you know two you can always figure out the 3rd. For instance if you knew that equilibrium GDP increased by $400 and the multiplier was 4, then the change in expenditures was obviously $100.

3. Except for 6, 9, 15, & 18, you will increase equilibrium GDP above $500, because there is an increase in G, or a decrease in T, or an equal increase in G&T. Ex: With MPC of .75 & therefore a ME of 4, an increase in G of $20 means $20 x 4 = $5804. On questions 6, 9, 15, & 18, you will decrease equilibrium GDP below $500 because you are either decreasing G, increasing T, or there is an equal decrease in G & T. Ex: With MPC of .75 & therefore a ME of 4, a decrease in G of $20 means -$20 x 4 = $420.

INSTRUCTIONS FOR THE NEXT FOUR AE SLIDES

AE

E1

E3

E2AE2

AE1

AE3

500Recessionary spending gap

Inflationary spending gap

Recessionary

GDP gap

InflationaryGDP gap

$10ME__MT___MBB___

$100 Y with ME

___Y with MT

___Y with MBB

19010

.9?

10

1 9

$200 Y with ME

_____Y with MT

_____Y with MBB

15050

____ Y with ME

____Y with MT

____Y with MBB

___ Y with ME

____Y with MT

____Y with MBB

124860

$12 $50

$20Change in Expenditures

MPC[So MPS &ME, MT, & MBB]

Chg inEquilibrium GDP

The Multiplier & Equilibrium GDP

[Give the correct equilibrium GDP [start from $500] using the ME, MT, MBB]

45°45°

$500

AE1AE2AE3

E2

E1

E3

RecessionarySpending gap

InflationarySpending gap

AE

ME=1/MPS [chg in G, Xg, or Xn] MBB = 1 [G&T ]

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

.75.80

.50

134

1

54

2

11

MT = MPC/MPS [Chg in T ]

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

ME’s[G,Ig,Xn]MPC M.90 = 10.87.5= 8.80 = 5.75 = 4.60 =2.5.50 = 2

540520520

40

2020

MT’sMPC M.90 = 9.87.5= 7.80 = 4.75 = 3.60 =1.5.50 = 1

700650550512

548560 600

510590

S

32

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

[-G] 1. ME =___[+T] 2. MT =___[-G&T]3.MBB=___

2.51.5

1

503020

211

5050

87

1

541

756015

43

1

300100

1091

-200

300

-180

320

-20

480

$100

$50

[-G] 1. ME = ___[+T] 2. MT =___[-G&T]3.MBB=___

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

550530520

600550550

460

495465

575560515

900800600

___ Y with ME____Y with MT____Y with MBB





-40-35-5

100

$15 -$20

-$5$20

400___ Y with ME____Y with MT____Y with MBB

4 5 6

7 8 9

.60 .50 87.5

.80 .75 .9

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

[-G] 1. ME =___[+T] 2. MT =___[-G&T]3.MBB=___

2.51.5

1

1257550

2019

1

382

54

1

431

604515

21

1

100100

871

-80

420

-70

430

-10

490

$100

$2

[+G] 1. ME = ___[-T] 2. MT =___[+G&T]3.MBB=___

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

625575550

540538502

550

510540

560545515

700600600


504010

40

$15 -$10

$10$50

200

10 11 12

13 14 15


.60 .95 ??



.75 .50 87.5



ME__MT___MBB___

ME__MT___MBB___

ME__MT___MBB___

54

1

431

109

1$8

[-G] 1. ME = ___[+T] 2. MT =___[-G&T]3.MBB=___

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

[+G] 1. ME = ____[-T] 2. MT = ____[+G&T] 3. MBB =____

625600525

532524508

400

490410


-$10$25

16 17 18

.80 .75 .9


___ Y with ME____Y with MT____Y with MBB25100125 32

248

-100-90-10

U.S. Consumption and Income

DISPOSABLE INCOME (billions of dollars per year)

$1000 2000 3000 4000

Actual consumer spending

6000

5000

4000

3000

2000

1000

0 5000 6000 7000

45°

$7000

198019811982198319841985198619871988198919901991199219931994199519961997

19981999

2000

CONS

UMPT

ION

(billi

ons

of d

olla

rs p

er y

ear)

C = YD

The Consumption Function: How large we expect the basic flow of consumer spending to be at different levels of GDP (income)

1929 – Saving = $4 bil.

1933 – Dissaving

1944 – Saving = 20%

Dissaving During The Great Depression

“C” = $4,425“S” = $375

C/Y = $4,425/$4,800 = 92%1993 Saving= $375.0 billion

Con

su

mp

tion

(b

illion

s o

f d

ollars

)

o45

o

Consumption

Disposable Income (billions of dollars)370 390 410 430 450 470 490 510 530 550

$530

510

490

470

450

430

410

390

370

S

Consumption Schedule [direct relationship between income & consumption]

Consumption/Saving Schedules

MPC and MPS

Equilibrium in a Closed-Private Economy

Leakage (S of $20 B) = Injection (Ig of $20 B)

AE

[C +

Ig

] (b

illion

s o

f d

ollars

)

o45

o

Consumption

C + Ig

Ig = $20 Billion

Equilibrium

370 390 410 430 450 470 490 510 530 550

Building the ModelAE[C+Ig] [“Basic” or “Simple” economy]

C =$450 Billion

$530

510

490

470

450

430

410

390

370 + 20 Ig

+80

S

Private Closed

GDP will increase by a “multiple” of 4 & that is why it is called the “multiplier”.

Real GDP

M = 4

At Equilibrium, Any Injections = Any Leakages

Injections = LeakagesC+Ig Ig(20) = S(20)

[Private-closed]

C+Ig+Xn Ig(20)+X(10) = S(20)+ M(10) [Private-open]

C+Ig+G+Xn Ig(20)+G(20)+X(10) = S(20)+T(20)+M(10)

[Mixed-open]

Autonomous v. Induced Investment

Autonomous Investment“Independent of” or “not stimulated by Y”

Investment induced by income(dependent” or “stimulated by Y”

Volatility of Investment

R R R R R R R

•Durability of Capital [can postpone]

•Variability of Profits

•Variability of Expectations

•Irregularity of Innovation

Reasons for Instability of Investment

Pri

ce L

evel

AS

AD2

Inflation and the Multiplier [4]

GDP1 GDP2

MULTIPLIER WITH PRICE-LEVEL CHANGES

P1

AD1

AD3

GDP3

P2

Full Multiplier EffectReducedMultiplierEffect Dueto Inflation

+20

+ 80 bil.

+20

+ 40 bil.

M(4)=chg.Y/chg.E [80] [20]

M(2)=chg.Y/chg. E [40] [20]

Pri

ce level

Real GDP (billions)

EXPANSIONARY FISCAL POLICY

Full $25 billionincrease in AD

AD2AD1

$5 billion initial direct increase in spending

[MPS=.20] the multiplier at work...

P1

$475 500

Documents

Building [ Simple economy to Complex economy] [C+Ig] ( private-closed )