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KEY IDEAS
•
•
The Keynesian aggregate expend iture model
is a simple model of the econom y and shows
the mult iplied cffte! that changes in governmen! spending, taxes and investment ca n
have on the eco nomy.
used to ill ustrate cha nges in rea l o utput and
the price level of an economy.
•
The margina l propensit y to consu me (MPC)
is the additional consumption spending
from an additional dollar of income. The
margi nal propensity to save (MPS) is the
add itional savings fro m an addi tio nal dolla r
of income.
•
•
•
The marginal propensity 10 consume and
the marginal propensit y to save are related
by MPC + MPS = I. In th e simple model,
an addi tiona l do llar of income will either be
consumed or saved.
The multiplier is a number that shows the
relationship between changes in autonomous spending and maximum changes in
real gross domestic product (real GOP).
•
•
•
The aggregate supply curve can be divided
•
•
In a simple model, the formula forcalcu lating the multip lier is
Income expendit u re
multiplier
•
The dowllv.;ard sloping aggregate d emand
curve is explained by the interest rate effect,
the wealth effect and the net export effect.
The wealth effe ct is also called the rea lba lance effect.
1
~
-MPS
inlo three ranges: the horizontal ran ge, the
upward slopin g or intermediate range, and
the vertica l range.
Sh ifts in aggrega te dem and can change the
level of output, the price level or both. The
determinants of aggregate demand includ e
consumer spending, investment spending,
government spend ing, net export spend ing
and money su pply.
Shifts in aggregate supply can also change
the level of o utpu t and the price level . The
del . minants of AS include changes in input
prices, productivity. the legal institutionOlI
environment and the quantity of available
resources.
•
T h e muhipliereffects result from subsequent rounds ofindl,l ced spen ding thai
occu r when autonomous spending changes.
Investment and its response to changes in
the intcrest rate are important in understanding the rela tionshi p between monetary
policy and GOP.
•
Aggregate demand (AD) an d aggregate supply (AS) cur ves look and operate much like
the suppl y and demand cun'es used in
microeconomics. Howcver, these macroccono mic AD and AS curves depict different
concepts, and they change for d iffere nt reasons than d o microcconomic demand and
suppl y curves. AD and AS curves can be
•
•
Ln the short run , economists think that equili brium levels of GOP can occur at less than.
grealer than or at the full -employment level of
GOP, Economists believe that long-run equilibrium can occur only at fu ll employment.
In a dynamic aggregate demand and aggregate suppl y model of the economy, changes in
wages and prices over time induce the economy to move to the long- run equili b rium.
Fiscal policy consists of government action;;
that may increase or decrease aggregate
demand. These actions involve changes in
government expendi tores and taxation .
The governmen t lIses an expOlnsiona ry fiscal
policy to Ify to increase aggregate demand
during a recessiol;!. The government may
i\.d".ncC'd I'h.<roml E«Inomic. MUI(MC"'nQ miu: Stlldnll ...",...11n CI Notion . ] Counci l on Economw; EducollOll- N<w)b<k, N.Y,
107
KEY IDEAS )
decrease taxes, increase spending or do a
combination of the two.
•
The government uses a contractiona ry fi scal
policy to try to decrease aggregate demand
when th e economy is overheating. The gov·
ernm ent may increase taxes, d ecrease spend·
ing or do 3. combination of the two.
•
Autonomous spending is that part o f AD
thai is independen t o f the curren t ratc of
economic activity.
•
Induced spending is that part of AD that
depends on the cu rrent level of economic
activity.
•
Discretionary fiscal po lic:y means the federa
governmen t mu st take deliberate action or
pass a new law changing taxes or spending.
The automatic o r built-in stabilizers changf
governmen t spending o r taxes without new
laws being pa ssed or deliberate action bein@
ta ken.
•
Stag flat ion. when the economy simultaneously experiences infl at ion and unemployment, can be explained by a decrease in
aggregate supply.
• A change in output can also be illust rated by
the Keynesian aggregate expenditure model.
T h is model differs from the AD and AS
model because in the Keynesian model the
price level is assumed to be constant.
•
108
Th e AD and AS model can be reconci led
with the Keynesian expenditure model. In
the horizo ntal range o f the AS curve. both
models are identical. The models differ in
the intermed iate and ,'erticaJ ranges of the
AS curve.
Ad.lnnd Phu .... n l Uonum,c. M""o.<Odom;cs: S, ud.n l AClivuin C Nat;",,.] Counc Il U\ E«.onomic EduQ lion. N... York. N.
LESSON l '
ACTIVITY 19
•
Keynesian Equilibrium
This activity is designed to give you practice wilh manipulatio ns o f the aggregate expenditure model.
[t shows you how the expenditure schedule is derived and how it helps to determine the equilibrium
level o f income. This activity assumes that the price level is constant with th e consumer price index
o r price level having a value of 100. AJI numbers in Figure 19.1 arc in bi llions of constant doUars.
Figure 19.1
[nco me-Expenditure Schedule
Income
(Output)
Consumption Investment Government
Spending
Spending
Spending
Total Spending
(Aggregate
Expenditure)
52,400
$2,500
$300
$100
2-'100
2,600
2,600
300
100
~OOO
2 ,800
2,700
300
100
'3/00
3,000
2,800
300
100
3~O
3,200
2,900
300
100
3300
3,400
3,000
300
100
-3400
3,600
3,100
300
100
3,800
3,200
300
100
3,,00
:3i.10 0
l. Usc th e data on consumption spending and income to draw the consumption function on tht!'
graph in Figure 19.2. Label the function C
2 Using the consumption fu nction you ha ....e just drawn and the data on In\'estment and government
spending, draw the aggregate expenditure schedule on the same graph. l abel it AE (C + 1+ G).
What is the difference between the aggregate expenditure schedule and th e consu mpt ion
fun ction?
3. Now draw a li ne representing all the points at whi ch total spending and income could be equa l.
Label this the 450 line.
4. The 45° line represents all t)le poin ts that could be the equil ibrium level of tOlal spending. Now
circle the one point that is the equi lil~:'!T~ve l o f total spending. \-I/h at is the equilibrium level of
total spending all your graph? ~3
~~
..L==-
___
Adapted rro m W illiam J. Baumo l and Alan S. Blinder. Economics, Princ;I plff arid PoIKY, 3rd cd . (New York: Harco urt Srace &
Com pany. 1985), p. 55. Jamn; C haS<'y. Home wood· FI<»smoor High 5<- hool, Flossmoo r. III .• contributed to this activity.
Adnncod Pl.o«no..., Economiu M. ",oeconomou: S' uda" An,." ... CI Nal lOn" CoulKi on EconomIC Eduu.u"... New Yo.k, N. ~
L09
• LESSON 1 • ACTIVITY 19
Figure 19.2
Aggregate Expenditure Model
$3,800
(continu
.,,~O
I
C+ T +-G r',. t\
H -I--I-+'-+-!--:-+!-i++-f-H-+ 7
-;)
d
3,600tt:±==tt~jtt±:±jltt-+I··-+-I--+--j,.-~I!"~H
"
\Jf /
3,4001-l----I--~I-I----I--+-H-_+_+_l,--+-+l»
-I,-,JI!!-+--+--j-
U)
~ ~ 3,200H _I-++-rif---i- H-~-..,;_)'I/,--<
-t-++-h.I
r;
i5~
z " 3,oooH--+----L++-+-~4
w~
"'-x w
W
§ 2,800
w_
~~~++_+_~~~~~H-+++_+_~
(!)
wa
....
'" -
1-1- .A<-,+--W4-+-I-I-_+_+---t-+_+_+---t - 1-++-1
~ °2600 ' 1~-+++-+-~~++-~H-+++-+-~1
1,1)'
ffi ~ 2,400~--+--+."""'I---c~H-+++-~H-+H--+-j
c(
2'200I-t::jj~=ttttt=J=jt!:::t=tt:t:ttw
2,000 bd-J(-+-t-I---I--+-H-++-l-l--H
H--+---lH
S. Based on the data in Figure 19.1. ::md assuming that the full -e mployment levcl of total spending is
$3,600 bi ll ion, what concl usions can )'ou draw about the equ ilibrium level of tota l spending?
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It
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(<U«>1i»\ \.0 ~ _
6. Based on the data in Figure 19.1, and assuming tha t the fu ll -employ men t level of tOlal spend ing is
53,200 billion, what conclusions can you d raw abou t the equi li briu m Ic \-eI of total spending?
· 1k>--~II1J~i.. ~b~ ~~ .
~W't''fA~,
7, If government spending increased by $100 billi on, what would be the new equilibrium level o f
total spending? $ $"'00 L"UUty\ For the increase of $100 billion in government spending,
total spending increased by 1&?..Oo \uUu.in
' Explain why this occu rs.
1N.
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r--r-~~ '
.-(.... h1-:-2- ..I~d; 1
"1.00
110
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_
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Advanced Ploc ..... nl Economics M.croecollClmicII! Shld<nl ACliy,'i •• co N.llo ... 1 Counc,1 on Economi< E<luu lion, N.wYork, NY
LESSON 1
ACTIVITY 20
Practice with APC, APS, MPC and MPS
PactA
Average Propensities
The average propensity to consllme (APe) is the ratio of consumption expenditures (e) to disposable
income (Dl). or APC =C I Dr.
The average propemiry to save (APS) is the ratio of savi ngs (5) to disposable income, or APS
=S I Dr.
I. Using the data in Figu re 20. 1, calculate the APe and APS at each level of disposable income given.
The fi rst calculation is completed as an example.
Figure 20.1
Average Propensities to Consume and to Save
Disposable
Income
Consumption
Saving
SO
$2,000
-$2,000
2,000
3,600
-1 ,600
4,000
5,200
-1,200
6,000
6,800
-800
8,000
8,400
-400
10,000
10,000
0
12,000
11 ,600
400
APe
APS
/'
1.8
V-O.8
\.?I -.3
~
-"\
- .13
\. OS IV. I!
1.13
1
0
.q(.. .4
2. How can savings be negative? Explain.
11\.t, ~ io \'t>f~ ~ r~ 'rYl<l1l +W-.
~
IM~ .
Part B
Marg inal Propensities
The margilla/ propcnsily to COllSume (MPC) is the change i 11 consumption divided by the change in disposable income. It is a fraction of anychange in Ollhal is spent on consumer goods: MPC =flC I flO!.
The margil/al propemity to save (MPS) is the fraction saved of any change in disposable income.
The MPS is equa l to the change in saving divided by the change in 01: MPS = flS 1601.
3. Using the data in Figure 20.2, calcu late the MPC and MPS at each level of disposable income. The
first calculation is completed as an example. (TIlis is not a typica l consumption function. Its purpose is to provide practice in calcu lating MPC and MPS. )
Activity written by lohn Morton, National Council o n Economic Education, New York. N.Y., Ind James Spcllicy, Lowdll-ligh School,
San Franci.sco.,Calif.
III
(j(
~c LYI1Y~ 20 l.;bnt;
II MFigure. 20.2I P
a rgm a
Disposable
Income
Consumption
Saving
$12.100
- $100
13,000
13,800
a
200
15,000
14 ,500
500
16,000
15,100
900
17,000
15,600
1,400
$12,000
13,000
Ir
, ~
1"' ,4.000
-
ropen sl'rles I 0 Co nsumea n d I o Save
MPC
0.90
.5?
:::J.
MP~ ..y
~
~Il/~
l>
0.10
. 2-
3
.4
.G
.S .s-
.
1 5~,,()
1'f<JCO
4. 'Y"hy must the sum or MPC and fvlPS always equ31 I?
It's ~ foXW . p~ CWL ~ ~ 0'1 ~
~ !'~ "6 100<4 ~ ~ <L<if"""'\.Jle ~.
ParI C
Figure 20.3
Cha nges in APC and MPC as DI Increases
Disposable
Income
Consumption
Savings
APe
MPC
,.1-- -.2.
$10,000
$12,000
- $2.000
20.000
21.000
-1,000
30.000
30.000
a
40,000
39,000
1,000
.<f-fs
50,000
48.000
2,000
.<1b
60,000
57,000
3.000
.9~
70,000
66,000
1"000
APS
I. OS" - .0'>
1
.'/4
C)
MPS
-
-
,.'1
.\
.'1
'\
.02'> .If
• oJ,
.CJ
.\
,0;)
,()(O
,I
'
.q
\
.I
.'1
S. Com plete Figure 20.3, and answer the questions based on the completed table.
l. 1. At $20 ,0001 1.0)'
'lOt ~==
' A....==.•. ___
What happen s to the APe as 0 1 rises? _::.!.-'
6. What isthe APC at a DJ level 0[$10,0001
7.
8. What is the MPC as OJ goes from 550,000 to S60,OOO?
·1
From 560,000 to S70,OOO? ~
9. What happens to MPC as income rises? ~~ ~
as income rises? ~ ClD\&ftw..st
What happens to
10. What is the conceptual difference between APC and MPC?
1'4 life, fYW./JIJIMRJ>
J~~r
J J2
~'"
~~
MP~
or ~ ~ .Du<L .n-" M~ ~
~~o.lch&-~ i..."""",~ 1iJ.Q. ~.
LESSON 1 • ACTiVITY 21
Th e Magic of the MuLtipLier
Thepeop lc in Econo land live on an isolated island. One year a stranger arrived and built a factory to
make seash ell cha rms. T he fa cto ry is considered an investment on Econoland. If the marginal propen sity to consume on the island were 75 percent, or 0.75, this would mean that Econoland residen ts
..... ould consume o r spend 75 percen t of any change in income and sa ve 25 percent of any change in
income. The addi tional spending would generate addi tional income and eventua ll y a multiple
increase in income. Th is is ca lled the multiplier effea. When they hard about this multiplier effect,
the islanders were thrilled about the new facto ry because they liked the idea o f additio nal income.
T he residents of Econoland wanted to know what wou ld eventuall)' happen to the levels of G OP,
consumptio n and saving on the island as the new spending worked its way through the economy.
LuckiJy there was a retired universit y economist who had set tled on Econoland who offered a brie f
statement of the multiplier. "It's simple," he said: "One pe rson 's spending becomes another person's
income." The economist began a numerica l exa mple. "'This shows the process," he said. Th e rounds
refer to the new spending moving from resident to resident . He stopped his example at four rounds
and added the rest o f the rounds to cover all Econoland's citizens.
Figure 21.1
Changes in Econoland's GDP, Consumption and Saving
Round
Income (GOP)
Consumption Spending
0.75 of $1.000 = $750
Round 1
$1 .000
Round 2
One person's spending
becoming another perso
income: $750
Round 3
2:
The next person'~
becoming another
income: $562.50
Round 4
.
another e
Income: $421.87
0 .25 of $1 .000 = $250
0.25 of 5750
= $167.50
.,/
0.25 of $562.50
- $140.62
V
s
·
·
·
All rounds
,~
's , 25 of $562.50
_ $421.68
The next personE
~e coming
Rounds
continue
.
Sa ving
Final outcome for
income (GOP)
1/(1-0.75) x 51.000=
4 x S1,OOO = S4,000
0.750.!...5121.88
.:.~ l o-.4 1
·
·
0.25 of $421.67
- $'05.47
·
·
·
·
Final outcome for
consumption
.
spending
0.75 of 54,000 53.000
=
Fin al outcome
for sa ving
0.25 of S4.000 51 .000
=
Activi ty wrillen by Clarles BenneU, Gannon UniversilY, Eric, Pa.
It )
LESSON· 1 • ACt VITY 21
(con~nued)
I
The retired economist then summarized the multiplier effect (or the assembled c rowd of
Econolanders. "This shows US that the fa ctory is an investment that has a multiplied effect on OU f
GOP. In th is case, the multiplier is 4." He added, " It appears to be magic. but it is simpl y that olle perSOtl'S spending becomes mlOther person's income," There were some nods of agreement but also many
puuled looks. so the old professor asked the citizens a series of questions. Answer these questions as
if you were an Econolander.
~
I. Would the multiplier be larger or smaller if you saved more of your additional income? ____
2. What do you think would happen if all Econolanders saved all of the change in their incomes?
1k.w.,\V~t1ot h..~~
blc '/WM, 'Wlo.''''''
'6 """~ '- Ni"\
~; would happen if you spent all of th e change in your income?
V~ "'" f1..c.. ollrp~r.
The p rofessor broke out in to a smi le as the answers all came out correct.
The econom ist rem inded the islanders abou t the multip lied effect on GOP that a new road around
the island would have. Tha t new bridge built by the island government over the lagoon would also
have a multiplied effect on GOP. This time there were many more nods of approval and unders t and~
ing.
The economist also indicated that if the governmen t of Econoland lowered taxes, the citizens
would ha ve more income to spend . which would cause a multiplier effect. He sa id there was another
side to this: If the taxes were raised. there would be a multiplier effect. which would decrease income
and GOP by a multiple amount.
The King of Econoland comm issio ned the old economist to write a si mple explana tion about mu ltipliers so all the citizens of Econoland would understand. He to ld the o ld economist "I f you succeed
in helping aU citizens u nderstand the multi plier in simple terms, you will be rewarded. If not, you will
he banished from the island."
The economist slarted banging away on ~n old rusting typewriter since he did
ished fr om this island pa radise. TIle result fo llows:
1I0t
want to be ban-
•
114
II··
~
.
.' .,': -", . The Professo'r 's Tr.e atise on Multipliers
MULTIPLIER FORMULAS AND TERMS ltBl'1E'I't1~G~·.
."
mP<"'+-I\"Il'$== (
Marginal propensity to consume (MPC) = change i n consumption divided by change in income
Marg inal p ropensity to save (MPS) = change in saving divided by change in income
Investment Multipli er - ~ simply 1 IMPS
How to lise tile j"vesrmeut multiplier: change in GOP = change in investment times investment
multiplier
Whe" to /lse the
jnV(!stmelll
multiplier: when there is a change in investment suc h as a new fa ctory or
new equipment
Government Spending Multiplier - ~ simply 1 I MPS
How to use t he governmetll spfmdillg multiplier: change in GOP = change in government spending
limes gove rnment spending multiplier
Wilen to lise the government spellding mliitiplier: when there is a change in government spending such
as a new road o r bridge
Tax Multiplier : .f.,,*,,~""
-
MPC IMPS
H{)".¥ to lise the tax multiplier: change in GOP = change in taxes times tax multiplier
Whe,1 to use rhe (ax multiplier: when there is a change in lump-sum taxes. Remember that the tax
multiplier has a negative sign.
II Figure 21.2
Multiplier Table
(Derived from using the formulas above)
MPC
Investment
Multiplier
0.90
0.80
0.75
0.60
0.50
10.0
5.0
4.0
2.5
2.0
Government
Spending
Mu ltiplier
10.0
Tax
Multiplier
- 9.0
- 4.0
-3.0
- 1.5
- 1.0
5.0
4.0
2.5
2.0
"ALWAYS" RULES [A surefire way to remember multipliers]
• The investmellLmultiplier is always equal to the same va lue as the government spend ing multiplier.
• The investment and government spending mul tipliers arc a/wilys positive.
• The tax multiplier is always negative.
Ad¥.,>«d Pl.coomm1 Econo mic. MocrO«QrlOmiu: S. udrfll AC11",1;.' C
~ .. i_1 Coun<;! on
Econom", EduCllion. N..... Yor k. N. Y.
11 5
.-
LESSON l '
A,cTlVITY 21,
lcontinue<!J
The King took the treatise and had it primed forevery islander. He then ordered the old professor
to make up a series of questions to see if the subjects understood the multiplier.
Answer the questions o n the professor'S test.
~lYI{11Yl~lt..,
"'1C-+-mps ", I
The Econoland Test
1. 'A'hat is the value of the tax multiplier if the MPC is a.SO?
-__t-,-__~'! = i-~
1 What is the value of the government spend ing muhiPlier-fithe MPC is O.67?
3, Wh,t is thet .. multiplie< if the MPS is 0,25?
:-L_~·{.)J
- ~)
.3,-_-,([.
~'. j3)
4. How could the multiplier be used to explain wide swi ngs in income (which could be called busi·
ness cycles) in Econoland?
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~
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~
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5. The numerical va lue for the investment and government spending multiplier increases as the
@
"alueofthe marginal propensity to save decreases.
(6) va lue or the average propensity to consume increases.
(C) value of tbe marginal propensity to consume decreascs.
(0) \'alue of the margina l propensity to save inc reases.
(E) value of the average propensity to consume decreases.
6, If the government spending mu ltipl ier is 5 in Econoland. the va lue of the tax multiplier must be
IA) 5
(B) 4
(C) I
~- 4
(E) - 5
116
LESSON 1 • ACTIVITY 21
[continued)
Econoland has the following values for income and co nsump tion. Use thi s data to answer questions
7,8 and 9.
Income
Consumption
100
200
300
400
500
600
150
225
300
375
450
525
7. The government spendi ng m ultiplier in Econoland is
(A) 3
Ijj\ 4
~
1-1--fi~'bO
2-00-/0 Q
~
'1-0 '
-'00 = • i-<:'
vtlpC.,
~
10'/)
(C)5
(D) 10
MPS
.fs-l-y::=-1
!<-=.V'
le'il
(E) 30
8. I f there i s an increase in taxes o f $200 i n Eco no la nd , the decrease in GO P will be
(A) $100
( H) $200
- 1(.:.T~
\:.LS""
(e) $400
@
) '" -3
$600
(E) $800
9. If there is an increase in government spending of $100 and an increase in taxes 0($100 in
Econo land, then the change in GOP will be
(A) $50
@
SlOO
{OO x "\-\+t!OO)<-3\ -;:: (00
~
'J
~
')
(C) $200
(D) - $100
(E) - $200
10. \Vhy do the people o f Econoland need to understand m ultipliers?
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11 7