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Chapter 7 Multipliers, Government Budgets and Net Exports Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-1 Learning Objectives • Analyse the impact of changes in the level of investment on equilibrium real GDP, income and employment—the multiplier effect. • Discuss the rationale for the presence of the multiplier. • Examine the difference that may exist between the equilibrium level of output and that corresponding to the full-employment level of output. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-2 Learning Objectives (cont.) • Discuss the nature of recessionary and inflationary gaps. • Analyse the impact of government purchases and taxes on equilibrium GDP. • Introduce the macroeconomic effects of foreign trade on equilibrium GDP. • Apply our model to explain the concept of the balanced-budget multiplier. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-3 Equilibrium GDP • Fluctuates widely • Investment and consumption of durables is inherently unstable Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-4 Autonomous Expenditure Changes • Shifts in the AE curve due to changes in autonomous expenditure – result in new equilibrium levels of output (GDP) – how much output changes by depends on the size of the expenditure multiplier Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-5 Expenditure Multiplier • A change in autonomous expenditure results in a change in equilibrium income that is a multiple of the initial change • The multiplier is defined as the ratio of the change in GDP arising from a change in autonomous spending Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-6 Changes in Equilibrium GDP and the (C + I ) 1 Multiplier (C + I ) 0 Private spending (billions of dollars) 510 490 Equilibrium GDP at I1 level of investment 470 450 Saving and investment (billions of dollars) 430 0 45 o Real GDP 390 450 470 490 If I S I1 increases... I0 Real GDP 20 0 510 390 450 470 490 510 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-7 Saving and investment (billions of dollars) Private spending (billions of dollars) Changes in Equilibrium GDP and the Multiplier (C + I ) 0 510 (C + I ) 2 490 Equilibrium GDP at I2 level of investment 470 450 430 0 45 o 430 450 470 490 510 Real GDP S 20 I0 I2 0 430 450 470 490 If I decreases... Real GDP 510 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-8 The Multiplier Effect • A change in autonomous spending gives rise to a larger change in GDP • The multiplier effect arises because initial increase in aggregate expenditure will induce successive rounds of increased expenditure Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-9 Multiplier and Marginal Propensities • A relationship exists between the MPS (the amount of leakage) and the multiplier • Multiplier = 1/MPS = 1/(1 – MPC) • The simple multiplier is defined as 1/MPS, when the leakage in the economy is only saving Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-10 Recessionary Gap • The amount by which aggregate expenditures are deficient to that required to generate the full employment level of GDP • Produces a concretionary impact upon the economy Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-11 Recessionary Gap (cont.) Private spending (billions of dollars) (C + I )0 (C + I )1 } Recessionary Gap Full Employment 0 45 o 470 490 510 Real GDP (billions of dollars) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-12 Inflationary Gap • Is the amount by which aggregate spending exceeds that required to achieve full employment • Produces an inflationary effect on the economy Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-13 Inflationary Gap (cont.) (C + I )1 Private spending (billions of dollars) Inflationary Gap (C + I )0 { Full Employment 0 45 o 470 490 510 Real GDP (billions of dollars) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-14 Discretionary Fiscal Policy • Deliberate manipulation of taxes (T ) and spending (G ) by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-15 Government Purchases (G) • Added to AE • Changes to autonomous government expenditure impact equilibrium real GDP through the multiplier Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-16 Three-Sector Equilibrium • C + I + G = real GDP and • S=I+G where • C is after-tax consumption • S is after-tax saving Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-17 Government Expenditure and Equilibrium GDP C+I +G S, I + G (billions of dollars) C +I +G (billions of dollars) Government spending $20 billion 0 45 C+I C o 470 510 550 Real GDP (billions of dollars) S 40 I +G 20 I 0 470 510 550 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Real GDP (billions of dollars) 7-18 Taxes and Equilibrium GDP • Taxes are assumed to be lump-sum – A tax that collects the same amount at each level of GDP • Reduces levels of both saving and consumption • How much S and C are affected depends on the MPC and MPS Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-19 Taxes and Equilibrium GDP (cont.) C+I +G C+I+G (billions of dollars) $15 billion decrease in consumption S + T, I + G (billions of dollars) 0 45 Ca + I + G o 490 550 Sa + T 40 S Sa I +G I 20 0 Real GDP ($ billions) $20 billion increase in taxes 490 $5 billion decrease in saving 550 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Real GDP ( $billions ) 7-20 Fiscal Policy over the Business Cycle Expansionary fiscal policy • Increased G • Decreased T • or both • Moves Budget towards a deficit in recessionary times Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-21 Fiscal Policy over the Business Cycle (cont.) Contractionary fiscal policy • Decreased G • Increased T • or both • Moves Budget towards a surplus in inflationary times Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-22 The Multiplier and Fiscal Policy If the tax function is of the form T = TLS + MPT(Y ) where MPT = marginal propensity to tax, Multiplier = 1 [MPT + MPS (1 – MPT)] Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-23 Foreign Trade and Equilibrium GDP • Exports (X ) and imports (M ) are introduced into the model • Net exports (NX) = X – M • AE = C + I + G + NX Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-24 Exports (X) • Level of X depends on foreign countries’ income, not domestic income • Therefore X is an autonomous variable in the model Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-25 Imports (M) • Level of M is dependent on domestic income or GDP • Given autonomous exports, a rise in imports due to a rise in income results in a fall in NX Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-26 Equilibrium GDP with a rise in NX Spending (billions of dollars) (C + I + G + NX)2 (C + I + G) 510 (C + I + G + NX)0 490 470 450 45 0 o 450 470 490 510 Real GDP ($ billions) 530 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-27 Open-Economy Multiplier • The introduction of foreign trade reduces: – the expenditure multiplier – the slope of the AE curve • The open-economy multiplier = 1/[MPS + MPM], if taxes are lump sum with no marginal propensity to tax Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-28 The Complex Multiplier for an Open Economy • The multiplier that arises when all leakages—savings, taxes, and imports—are taken into account: 1 k= [MPT + MPS (1 – MPT) + MPM] Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-29 Balanced-Budget Multiplier • The effect of an equal increase (or decrease) of both the level of government expenditure and taxation • Increases (decreases) the level of equilibrium GDP by exactly the amount of the increase (or decrease) in G and T • Thus, equal increases in G and T are expansionary Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-30 Next Chapter: Aggregate Demand and Aggregate Supply Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 7-31