Download KEYNESIAN MULTIPLIER EFFECTS

A. Classical economists believed a market system
would ensure full employment of the economy’s
resources (except for temporary, short-term
upheavals)
B. Deviations would be self-correcting
Slumps in output and employment 
reduced prices 
increased consumer spending 
lower wages 
increase employment again 
lower interest rates 
expand investment spending
C. Say’s Law
1) Summarized this classical view:
“Supply creates its own demand.”
2) Think in terms of barter
a.
A woodworker produces furniture
to trade for other needed
goods/services
b. All the products would be traded
for something or there would be
no need to make them
D. The Great Depression
1) Refuted classical economics when markets did
NOT self-correct
2)GDP fell by 40% (in the U.S.) and
unemployment rose to 25%
E. John Maynard Keynes
1) 1936 – published his General Theory of
Employment, Interest, and Money
2) Alternative to classical theory
3) Explained periods of recession
a. Not all income is always spent (contrary to
Say’s law)
b. Producers may respond to unsold
inventories by reducing output instead of
cutting prices.
c. A recession or depression could follow this
decline in employment and incomes
F. The Modern Aggregate Expenditures model is
based on Keynesian economics
1) Saving and investment decisions may not be
coordinated
2)Prices and wages are not very flexible
downward
3) Therefore, internal market forces can cause
depressions
4) Government should play an active role in
stabilizing the economy.
A.“Aggregate” means total
B. The theory assumes:
1) The level of output and employment
depend directly on the level of aggregate
expenditures
2)Changes in output reflect changes in
aggregate spending
C. The Aggregate Expenditure model creates a
simple model of the economy
D. Uses the national income identity:
GDP = C + I + G + NX
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C = Consumption
I = Planned Investment (made by firms on
capital goods, but it does not always occur)
G = Government Spending
NX = Net Exports
E. So what is it used for?
1) To describe the equilibrium between production and
planned expenditures.
2) Investigates the way economic agents react when
planned expenditures do not equal production.
3) If there are unexpectedly large changes in inventories,
firms change their output levels
a.
If inventories fall below target levels, firms increase
production and hire more workers (unemployment falls)
b. If inventories rise above target, firms decrease production
and lay off workers (unemployment rises)
F. Graphing AE
1) 45-degree line
a)
It represents all points where Real GDP = Planned
Aggregate Expenditure (goods produced = total spending)
b) Equilibrium is the intersection of the 45° line and the C + I
+ G + NX line.
c) Equilibrium does not have to be at full-employment real GDP.
What if output is to the right of the Equilibrium
point?
A.
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Firms experience a build-up of inventories.
Firms must produce less and lay off workers.
B. What if output is to the left of the Equilibrium
point?
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Firms do not have inventory.
Respond by increasing production and employment
How do you calculate consumption?
A.
Average Propensity to Consume = APC
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APC = c/Y
Y stands for Income
Marginal (change in) Propensity to Consume = MPC
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MPC = change in C/change in Y
B. Why must the sum of the MPC and the MPS equal
1?
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MPS = change in saving/change in income
When your income changes, you have only 2 options:
spend it or save it.
MPC is the fraction of the change in income spent
MPS is whatever is left, which is saved.
Let’s say you find a dollar in the street. You
now have one dollar you did not have before.
You now have an “income” of one dollar.
What can you do with that dollar?? You can
spend all of it, save all of it, or spend some of
it and save some of it. You have options!

Let’s assume you decide to spend the
WHOLE dollar. Your spending of that dollar
is an EXPENDITURE for you and INCOME for
the person (entrepreneur) you traded with.
How much did GDP increase with this
transaction?
$1.00
(you bought “stuff”)

Now what happens to that dollar in the
possession of the entrepreneur? They have
the same options you had:
Spend it or Save it.
Let’s assume the entrepreneur spends the
WHOLE dollar at another business.
This expenditure for the entrepreneur is now
INCOME for another entrepreneur.
How much did GDP increase with this
transaction?
$1.00
Does this sound familiar??
This “found” dollar has now purchased $2.00
worth of goods and/or services.
The original dollar appears to be cloning
itself!!
If we repeat this pattern, it would go on
FOREVER and GDP would increase INFINITLEY.
Is this possible? Unlikely…Why?
People have a TENDENCY TO SAVE some
portion of each dollar they receive.
Keynes had a fancy name for this: Marginal
Propensity to Save (MPS). In layman’s terms
this means people have a TENDENCY TO
SAVE A PORTION OF EACH ADDITIONAL
DOLLAR they receive.
The flip side of this is people have a
TENDENCY TO SPEND (or CONSUME) some
portion of each dollar they receive.
Keynes had a fancy name for this: Marginal
Propensity to Consume (MPC). In layman’s
terms this means people have a TENDENCY
TO CONSUME A PORTION OF EACH
ADDITIONAL DOLLAR they receive.
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
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Example: If I get an additional dollar I may
consume .90 and save .10.
My Marginal Propensity to Consume (MPC)
that dollar is then: 90%.
My Marginal Propensity to Save (MPS) that
dollar is then: 10%.



Example: If I get an additional dollar I may
consume .80 and save .20.
My Marginal Propensity to Consume (MPC) is
then: 80%.
My Marginal Propensity to Save (MPS) is then:
20%.
Do you notice a pattern?
MPC + MPS = 1.00 (or 100%)


Let’s see how this works in practice.
Assume the Government wants to increase
their spending by $10 billion dollars.
Assume that the MPC in the economy is 90%
and the MPS is 10% (remember these must
equal 100%). What is going to be the effect
on the GDP when we consider the Multiplier
effect of EACH of those dollars?

The Government initially spends $10 billion
in the economy to purchase goods and
services. Does the Government SAVE any of
this money? NO. They spend the whole
shebang! What is the immediate effect of this
transaction on GDP? It INCREASES by $10
billion.


What is now going to happen to that $10
billion now in the hands of people in the
economy? Keynes says that people in general
will spend 90% of it and save 10%.
So when people spend 90% of $10 billion,
how much is GDP going to increase by? $9
billion.

With these initial two transactions, how much
has GDP increase by?
$10B + 9B = 19B

Once again the original $10B has “magically”
turned into $19B in GDP .


Now when people who receive the $9B, they are
going to spend 90%, or $8.1B and save 10%, or
$900 Million.
GDP is now growing again!
$10B + $9B + $8.1B = $27.1 Billion
It does not stop here. Each time the money is
spent it keeps reducing by the 90% and 10% ratio
UNTIL it gets to ZERO and GDP is some much larger
number.


Do you want to do all that math to arrive at
how much GDP is going to increase in the
end. I did not think so.
Keynes came up with a simple formula to do
the math for you. Remember in the
beginning it was GOVERNMENT that started
this buying frenzy. This is very IMPORTANT
to remember.
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The Keynesian Government Spending Multiplier is
1/MPS.
Let’s use the information we have already been
given: The MPC is 90% and the MPS is 10%.
We can plug the appropriate number into the
Government Spending Multiplier and come up with
a useful number.
Govt. Spending Multiplier =
1/MPS = 1/10% = 1/.10 = 10


Now this is AMAZING! According to KEYNES when government
spends a dollar in the economy it is going to purchase a multiple of
10 times itself in GDP.
If Government increases spending by 10 Billion, then the eventual
impact on GDP is going to be an increase of:
$10 Billion X 10 = $100 Billion
NOTE: This works in REVERSE as well. If Government DECREASES
spending by $10 Billion, it will serve to DECREASE GDP by a multiple
of 10!
SUBTLETY ALERT!!
Notice in the VERY FIRST round of spending by the
Government that NOTHING is SAVED. The economy has the
benefit of the FULL impact of the $10Billion in new spending.
In subsequent rounds of spending people are saving a
portion of the money they receive, therefore REDUCING the
impact on the economy. When we do the TAX CUT
MULTIPLIER next, this distinction will be important. It forms
the foundation of why Keynes suggested that in times of
severe economic crisis it should be the role of Government to
be “active” in the economy.
TAX CUT MULTIPLIER
 Instead
of Government
changing its spending, they
could change TAXES instead.
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
Assume in the economy the MPC and the
MPS are still 90% and 10% respectively.
Assume the Government decides to REDUCE
taxes by $10 Billion. This means that $10B
is now in the hands of people and NOT in
the hands of the Government. According to
Keynes, what is the first thing that people in
the economy are going to do with that new
$10Billion?? They are going to Spend 90%
and Save 10%!!


When they spend 90% it is going to INCREASE
GDP by $9Billion in the FIRST ROUND of
Spending (how does that compare when in
the previous example Government spent
FIRST).
This transaction INCREASED GDP by $9B.


The people who receive the $9B are going to
SPEND 90%, or $8.1Billion and SAVE $900
Million.
This transaction will INCREASE GDP by
$8.1Billion.
GDP is now $9B + $8.1B = $17.1Billion.

The people who receive the $8.1Billion are going to SPEND
90%, or $7.290 Billion and SAVE 10%, or $810 Million

This transaction will INCREASE GDP by $7.290 Billion.
GDP is now $9B + $8.1B + 7.29B = 24.390Billion.

Once again, it does not stop here. Each time the money is
spent it keeps reducing by the 90% and 10% ratio UNTIL it
gets to ZERO and GDP is some much larger number.

Keynes came up with a simple formula to
do the math for you. Remember in the
beginning it was PEOPLE in the Economy
that start this buying frenzy. This is very
IMPORTANT to remember.
The KEYNESIAN TAX CUT MULTIPLIER
-MPC/MPS or
= -MPC/(1-MPC)
=



Example:
We know the MPC is 90% and the MPS is 10%.
We can plug the appropriate number into the Tax
Cut Multiplier and come up with a useful
number.

Tax Cut Multiplier
-MPC/MPS = 90%/10% = -.90/.10 = -9



According to Keynes if the Government REDUCED
TAXES (-) and you multiply by the TAX CUT
MULTIPLIER, that is how much GDP will INCREASE.
In our example, the Government DECREASED taxes
by 10Billion (-) and you multiply this by the tax cut
multiplier of -9, then GDP will eventually INCREASE
(two negatives make a positive) by $90Billion.
NOTE: This works in REVERSE. If Government INCREASE TAXES by $10Billion
then this will serve to DECREASE GDP by a multiple of –9.
(+10billion X -9 = -90Billion).
NOT SO “SUBTLE” ALERT!!!
Do you notice the different effects of the Government
Spending Multiplier and the Tax Cut Multiplier? The
Government Spending Multiplier appears to ALWAYS come out
ahead of the Tax Cut Multiplier in terms of how much GDP is
eventually impacted.
THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!!
According to Keynes, INCREASED Government spending
“outperforms” DECREASES in Taxes to stimulate (“prime the
pump”) the economy.


Let’s put these Keynesian Multipliers
together and see how it all washes out
Assume the Government wants to do the
right thing when they INCREASE
Government spending they ALSO INCREASE
Taxes to pay for it, so they won’t have to
borrow to pay for the spending. Novel idea,
I know, but it could happen…


Assume Government wants to INCREASE
spending by $20 Billion and the MPC is 80%
and the MPS is 20%. If they don’t want to
create a budget deficit they must INCREASE
Taxes by $20 Billion to pay for the new
spending.
What is going to be the NET EFFECT of this
action on the Economy?


Calculate the Government Spending Multiplier
(1/MPS = 1/20% = 1/.20 = 5)
If government spending INCREASES by $20B
and the multiplier is 5 then, GDP is going to
INCREASE by $100B ($20B X 5 = $100B).




This is only half the story…Now we have to take
$20B OUT of the Economy in TAXES to pay for the
new spending.
Calculate the TAX CUT MULTIPLIER
(-MPC/MPS = -80%/20%=-.80/.20 = -4)
If TAXES are INCREASED by $20B and the tax cut
multiplier is -4 then GDP is going to DECREASE by
$80B ( +20B X -4 = -80B)
The multiplier effect is working in REVERSE to
DECREASE GDP by a multiple of 4!




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What is the NET EFFECT after the TWO MULTIPLIERS
do their work?
The INCREASED Government Spending has
INCREASED the GDP by $100B
The Tax INCREASE has DECREASED the GDP by 80B.
BOTTON LINE: GDP (AGGREGATE DEMAND) has
INCREASED by $20B!! The Miracle of the Keynesian
Multiplier…
NOTE: This works in REVERSE as well. If Government Spending DECREASED
by $20B and DECREASED Taxes by $20B, then the NET EFFECT on the
Economy will be a Net DECREASE in GDP of -$20B. THE HORRORS!!
Think about this: Government INCRESED
spending by $20B and INCREASED Taxes by
$20B to pay for the spending and the
economy came out AHEAD by $20B in
INCREASED GDP. Notice a pattern??
NOT SO SUBTLE ALERT:
Pick any dollar amount that Government
could increase its spending by and increase
taxes by the SAME amount to maintain a
BALANCED BUDGET. The result will be an
INCREASE in GDP by the SAME amount that
you increased spending and increased
taxes. Cool, huh!!


Keynes called this the BALANCED BUDGET
MULTIPLIER
The BALANCED BUDGET MULTIPLIER is 1
Take whatever you INCREASE Government
Spending and INCREASE Taxes by and
Multiply by 1 you will get what the NET
INCREASE is in GDP.
Note: THIS WORKS IN REVERSE AS WELL

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Let’s Do Some Examples…
Assume we can determine there is a
recessionary gap in the Economy of $100
Billion.
Assume the MPC is 75% and the MPS is 25%
If the Govt. decides to change spending,
would they INCREASE or DECREASE
spending? By How Much?

Determine the Govt. Multiplier.
1/MPS = 1/25% = 1/.25 = 4
This means that ANY dollar the Govt spends in the economy
is going to multiply on itself 4 TIMES
The Recessionary Gap is $100B
$100/4 = $25 Billion
This is the amount Govt. would INCREASE spending to close
this $100B gap (move closer to Full-Employment)



Assume we can determine there is a
recessionary gap in the Economy of $100
Billion.
Assume the MPC is 75% and the MPS is 25%
If the Govt. decides to change TAXES would
they INCREASE or DECREASE Taxes? By How
Much?

Determine the TAX CUT MULTIPLIER.
-MPC/MPS = -75%/25% = -.75/.25 = -3
This means that ANY dollar received in Tax Cuts in the economy is
going to multiply on itself 3 TIMES
The Recessionary Gap is $100B
$100/-3 = -$33.33 Billion
(-$33B X -3 = $100B)
This is the amount Govt. would DECREASE TAXES by to close
this$100B gap (move closer to Full-Employment)
A.
Definition
1. Machinery and buildings that a firm uses to
produce output.
2. NOT stocks/bonds
B. Determinants of Investment
1. Expected returns (profits)
2. Interest rate
C. When do businesses invest?
1. They must have the money (profits or borrowed)
2. Determine profitability
3. Compare the interest rate to the expected profit
rate of the investment
a. As Interest rates go down, the level of
investment goes up.
b. If the interest rate goes down, the aggregate
expenditure curve will shift up
A.
Introduction
1. Definition - Sum of planned consumption (C),
investment (I), government expenditures (G), and
net exports (NX)
2. Aggregate Demand is an inverse function between
price level and output – price level rises, level of
output demanded decreases
B. Factors that affect aggregate demand
1. Interest-Rate Effect
a.
Decrease in households’ and businesses’ plans to
buy capital and consumer durables because a price
level increase will increase the interest rate.
b. A price level increase decreases the purchasing
power of money.
c. With a smaller amount of real money available,
financial institutions raise the interest rate.
B. Factors that affect aggregate demand, Cont.
2. Wealth Effect (Real Balance Effect)
a.
Decrease in the real value of cash balances as the
price level increases.
b. Faced with this decrease in real wealth, people
decrease consumption and increase savings to
restore their real wealth to the desired level.
B. Factors that affect aggregate demand, Cont.
3. Net Export Effect
a.
Decrease in domestic output demanded with an
increase in the domestic price level.
b. Domestic products are more expensive to foreign
buyers and foreign goods are less expensive to
domestic consumers.