Download Chapter 26: The Multiplier Model

Chapter 26: The Multiplier Model
Chapter 26: The Multiplier Model
Questions for Thought and Review
If planned expenditures are below actual production, income will decline. Here’s how:
when planned expenditures are below actual production, firms will see that their
inventories are building up faster than they’d like. In response, they cut production. As
production falls, so does income. Consumption falls by a fraction of the decline in
income, leading to a further decline in planned expenditures. This process continues until
planned expenditures equal actual production.
4.
The aggregate expenditures curve shifts down by the decline in autonomous
expenditures.
6.
Equilibrium income is $500.
8.
Shocks to aggregate expenditures are any sudden changes in factors that affect C, I, G, X,
or M. This includes consumer sentiment, business optimism, foreign income, and
government policy. It is possible that people could change their marginal propensities to
consume and save, and this could also have an effect on the economy.
10.
If the mpe is 0.5, the multiplier is 2. Every $1 increase in autonomous expenditures will
raise income by $2. To close a recessionary gap of $200 the government needs to
generate $100 of additional autonomous spending. It can accomplish this by increasing
government expenditures by $100, or by cutting taxes by somewhat more than that (about
$200).
12.
The effects of this invention on the economy would be manifold and in many ways
unpredictable because such major shocks have social, institutional, and political effects,
as well as economic effects. The obvious effect is that the demand for the pill would
likely be tremendous (after people were sure it was safe), and so production of the pill
would gear up to meet the demand. Market structure and pricing decisions will play a big
role in determining the new effect of the change. Alternative forms of transportation
would suffer decreases in demand (cars, mass transit, airplanes, etc.), and levels of
production of those goods and services would adjust, as would employment in those
industries and related industries. Measured GDP might actually fall.
14.
A mechanistic model states the equilibrium independent of where the economy has been
or where people want it to be. A mechanistic model is used as a direct guide for policy
prescriptions. An interpretive model is used as a guide that highlights dynamic
interdependencies and suggests the possible response of aggregate output to various
policy initiatives.
Chapter 26: Problems and Exercises
16.
If the mpe is .8, then the value of the multiplier is 1/.2 or 5.
If autonomous expenditures are $4,200, the equilibrium
level of income in the economy is 5 x $4,200 = $21,000.
This is demonstrated in the accompanying graph.
Real expenditures
2.
AP
AE
$4,200
$21,000
Real income
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Chapter 26: The Multiplier Model
18. a. Given the mpe is 0.8 and autonomous investment has risen by 20, income will increase
by 100 (the multiplier is 1/.2 or 5, and 5 X 20 is 100).
b. With an mpe of .8, the multiplier is now only 2 (1/.5), and so the change in investment
causes income to change by 40.
c. The decrease in exports and increase in investment cancel each other out so that
autonomous expenditures in the aggregate are unchanged.
d. See the graphs below. The graph on the left corresponds to (a) and the accompanying
graph corresponds to (b). The graph to (c) would show the AE curve not moving at all.
AP
AE0
20
E0
100
Re al income
AP
AE1
Real expenditures
Real expenditures
E1
AE1
E1
AE0
20
E0
40
Real income
Real expenditures
20. a. A likely culprit was a decline in investment
AP
spending, partly due to increased bank regulation
and Federal Resolution Trust Corporation scrutiny
AE0
AE2
of loans in the wake of the failed S&Ls and liquidity
problems of commercial banks in the late 1980s and
AE1
early 1990s. This was commonly known as the
credit crunch, where lower interest rates failed to
increase investment spending in the early 1990s.
This is shown as a shift down of the AE curve from
Real income
AE0 to AE1 and a decline in real income.
b. An improvement would be graphically represented
by a shift up of the AE curve shown in the graph as the shift from AE1 to AE2 and a rise
in real income. The improvement occurred most likely as a result of expectations of an
improving economy and further reductions in interest rates increasing consumption and
investment expenditures. Government expenditures did not change much in this period
and probably did not contribute to the economic improvement.
c. President Bush would have had to increase government expenditures or reduce taxes
significantly to stop the slowdown, but given the political atmosphere regarding the high
deficit and debt, it is unlikely he could have done so.
d. President Clinton faced the same political imperatives to decrease the size of the deficit,
so he implemented some policies designed to affect potential output (the supply side). He
lowered some taxes, calling them ‘supply-enhancing tax cuts,’ changed the composition
of government spending calling the changes ‘supply-enhancing changes’, and raised
other taxes (discounting their effects on the economy).
22. a. If the mpe is .5, the multiplier is 2. Because there is a recessionary gap of $800,
government spending would have to increase by $400 to bring the economy back to longrun equilibrium.
b. If the mpe is .8, the multiplier is 5. Because there is an inflationary gap of $1500,
government spending would have to decrease by $300 to bring the economy back to
long-run equilibrium.
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Chapter 26: The Multiplier Model
c. If the mpe is .2, the multiplier is 1.25. Because there is an inflationary gap of $1,200, the
government will want to reduce expenditures by $960.
d. If the mpe is .7, the multiplier is 3.33. Because there is a recessionary gap of $1,500, the
government will want to increase expenditures by $450.
Chapter 26: Web Questions
2. Answers will depend on the time at which the student answers the question.
a. Inventories were up 4.3 percent above current levels one year ago.
b. Rising inventories either mean that consumer expenditures, and therefore aggregate
demand, are falling, or that production is rising faster than aggregate demand is rising (or
a combination of the two). Either way, production is outpacing expenditures. Unless
expenditures pick up, eventually producers will want to cut production. In terms of the
multiplier model, it is possible that the economy is going to slow or experience a
recession.
Chapter 26: Appendix A
2.
We would recommend increasing expenditures by 80.
4.
This makes the multiplier 2.08. This means that we would increase expenditures by about
192 or cut taxes by about 213.
6.
This would make the multiplier = 1/(1 - c + ct + m - mt). It would be a slightly higher
multiplier. (The difference between the two assumptions is whether we are assuming
government imports.)
Chapter 26: Appendix B
2. a. The AD curve will become steeper.
b. An increase in the size of the multiplier makes the AD curve flatter because the effect of
changes in the price level on aggregate demand will be augmented even more by the
multiplier.
c. An increase of $20 in autonomous expenditures has no effect on the slope of the AD
curve; the increase only affects the position of the curve.
d. A decline in the price level disrupting the financial market will make the AD curve
steeper because it decreases the price-level interest rate effect.
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