Elemental Economics Not Accounting, Not Business, Not Commerce, Not Mathematics  - Economics

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Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

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Launched  1998

Macroeconomics

3. Aggregate Expenditure & Demand (cont'd)

3. 4 The Multiplier (MKM C15/391-5; 366-370; C16/385-389; 362-365)

Introduced by Keynes in his 1936 The General Theory of Employment, Interest and Money, the Multiplier shows by how many times an increase in any autonomous expenditure (I, G or X) increases Y.   In a way, the Multiplier is like throwing a pebble into a pond.  The initial ripple is followed by other ripples that stretch further and further out across the pond (P&B  7th Ed Fig. 27.5; R&L 13th Ed Fig. 21-9).   Thus if investment increases because firms anticipate lower interest rates or higher profits, they invest.  To invest they buy factors of production from households which therefore receive more income some of which they spend (1st ripple).  The goods and services purchased with this new household income are, in turn, made by firms that hire more factors of production to increase production that increases the income of other households some of which, in turn, is spent (2nd ripple).  And so on, and so on....

We begin by assuming that the Aggregate Price Level is fixed in a closed economy and the Marginal Tax Rate (MTR) is zero.  Graphically (Figure 7), the size of the Multiplier depends on the slope of AE curve, i.e., the marginal propensity to consume or 'b'.  In a closed economy this is (1/1-b) where b = MPC and '1' represents total disposable income.  All things being equal, the steeper the slope of the AE curve, the larger the multiplier; the gentler the slope, the lower the multiplier (P&B 7th Ed Fig. 27.7).   Assuming b = .75 (75 cents of each additional dollar in income is spent on consumption) then (1/1-.75) = (1/.25) = 4.  It is important to note that the Multiplier is a process spreading out over time (P&B Fig. 25.8).

The size of the multiplier depends on the slope of AE which, in turn, is determined by the marginal propensity to consume (MPC), the marginal tax rate (MTR) and, in an open economy, the marginal rate of imports (MPM).  All things being equal: the higher MPC, the steeper the slope of AE; the higher MTR, the gentler the slope; the higher MPM, the gentler the slope.

In addition to the general Autonomous Expenditure Multiplier described above these include the:

a) Government Expenditure Multiplier;

b) Autonomous Tax Multiplier;

c) Balanced Budget Multiplier; and,

d) Impact of the Marginal Propensity to Import (MPM)

a) Government Expenditure Multiplier (GEM)

The GEM is the same as the general Autonomous Expenditure Multiplier, i.e.,  GEM = 1/1-b = ∆Y/∆G.  For public policy this means an increase or a decrease in G has a multiplier effect on GDP - up or down.  Government, in other words, can use the Multiplier like a lever to increase or decrease GDP without doing it all itself.  Thus if G increases by \$50 million with a Multiplier of 4 (as above) it causes GDP to increase by \$200 million.  This is true assuming a fixed Aggregate Price Level, a closed economy and the Marginal Tax Rate (MTR) is zero.  As will be seen if P changes or we are in an open economy or the MTR is positive then the multiplier effect is reduced.

b) Autonomous Tax Multiplier (ATM)

There are essentially two kinds of taxes - induced and autonomous.  Induced taxes rise and fall as Y varies.  In this way induced taxes like income tax act as automatic stabilizers of the economy.  If Y goes up then the Marginal Tax Rate rises to a higher level (progressive taxation) and disposable income is reduced cooling the economy; if Y goes down the Marginal Tax Rate falls to a lower level and disposable income rises.

Autonomous taxes do not vary with real GDP but rather are determined by Government.  An increase in taxes decreases disposable income and hence consumption and therefore Y.  The decrease in Y will, however, be greater than the increase in taxes (P&B 4th Ed Fig. 26.9).  The Autonomous Tax Multiplier equals -b/1-b = ∆Y/∆T assuming a fixed Aggregate Price Level, a closed economy and the Marginal Tax Rate (MTR) is zero.  Thus if b = .75 then  ATM = .75/1-.75 = .75/.25 = 3.  Thus an increase in taxes of \$50 million will lead to a decline in Y of \$150 million.

The inverse of the ATM is the Multiplier associated with transfers. Transfers are like negative taxes, i.e., taxes are reduced. The Autonomous Transfer Multiplier is simply the negative of the ATM.  Another related concept  is 'tax expenditures' where Government selectively reduces taxes and losses revenue thereby.

iii - Balanced Budget Multiplier (BBM)
The BBM is the amount by which a change in government expenditures is matched by a change in autonomous taxes.  The result is that the initial balance between government revenue and expenditure (deficit/surplus) is maintained.  The BBM requires that the effect of GEM (1/1-b) should exactly offset the effect of ATM (-b/1-b) so that ∆Y/∆G = ∆Y/∆T.  This is true assuming a fixed Aggregate Price Level, a closed economy and the Marginal Tax Rate (MTR) is zero.

If, in a closed economy, we assume a MPC of .75, i.e., 75 cents of every dollar is spent on consumption then GEM is 1/1-.75 = 1/.25 = 4.  If, however, the economy is open and MPM is .1, i.e., 10 cents on every dollar is spent on imported goods then, AEM is 1/1-.75-.1 = 1/.65 = 2.86.  This again assumes a fixed Aggregate Price Level and the Marginal Tax Rate (MTR) is zero

Economist study the business cycles - the ups and downs of the economy.  As will be seen the Multiplier plays a significant role in Government's management of the cycle.  According to the Dictionary of Economics and Business (Erwin Esser Nemmers, Littlefield, Adams, Totowa, New Jersey, 3rd Ed., 1976, pp. 54-5), the business cycle is:

Rhythmic changes which take place in business conditions over a period of time.  The phases of the cycle are called prosperity (peak, upswing, expansion), crisis (down-turn), depression (trough, downswing, contraction), and recovery (upturn, revival).  Various explanations for the business cycle have been developed.  In analyzing cyclical statistics a number of different cycles have been found, each named after the man who developed knowledge of it.  Thus the Kitchin cycle is about 40 months, the Juglar cycle is from 8 to 14 years, the Spiethoff cycle about 20 to 30 years and the Kondratieff cycle (long wave) about 50 years.

There are a many explanations for the business cycle including the:

animal spirits theory

endogenous theory

exogenous theory

innovation theory

interaction of multiplier & accelerator theory

inventory theory

monetary theory

overinvestment-oversaving theory

psychological theory

underconsumption theory

weather (sunspots) theory

3.5 Aggregate Demand (MKM C14/340-7; 316-324; 328-333; 305-310)

Aggregate Expenditure is calculated assuming a fixed Aggregate Price Level (P)   At a given P the various economic actors - households, firms, governments, exporters and importers - make their expenditure decisions: Y = C + I + G + X – M.  Change P and there is a different result.  For each level of P a different level of Y exists.  Plotting all different levels of P (graph below) with corresponding levels of Y and we can plot the Aggregate Demand Curve (ADC). The implications of changes in P for the multiplier effect will be explored later.

The ADC is downward sloping.  The Law of Demand holds as in Microeconomics: The lower the price, the higher the demand; the higher the price, the lower the demand.  Principal factors causing the ADC to shift include:

i - Price Level;

ii - Expectations;

iii - Fiscal & Monetary Policy; and,

iv - Global Economy.

All things being equal: the higher P the lower Y measured as real GDP (P&B 7th Ed Fig. 26.4; R&L 13th Ed Fig. 23-1 & 23-2; MKM Fig 14.3).  And, as in Micro, there are income and substitution effects associated with price changes.

In Macroeconomics, the income effect is called 'the wealth effect'.  If prices rise, wealth falls as financial assets (bank accounts, stocks and bonds) buy less.  People feel poorer and buy less.  There is movement up the ADC with declining Y and vice versa.

In Macro the substitution effect (shifting from the more to less expensive) involves future prices (expectations) and foreign prices (imports).   If prices are expected to go down tomorrow people will buy less today.  At the extreme, this delay in spending can lead to deflation (the expectation of ever lower prices) with associated costs including the

Similarly, if Canadian prices go up but foreign prices remain constant then foreign prices (imports) become relatively less expensive and Canadians buy more foreign and fewer Canadian goods & services.  Domestic factors of production are not employed and less income is earned.  At the extreme, this shift can lead to and associated costs including the decreased potential GDP of a Nation-State.

It is primarily expectations about future income, prices and profits that determine aggregate demand today.  The expectation of an increase in future income leads consumers to increase aggregate demand today and vice versa.  The expectation of increase future profits leads firms to increase their investment today shifting the ADC and vice versa.  Similarly, the expectation of higher prices tomorrow (inflation) leads households and firms to increase purchases today and vice versa.  Again, Keynes' : People live in the future but act in the present.

Fiscal policy involves taxation and government spending including transfers to households and firms.  If government spending goes up, aggregate demand shifts up and vice versa.  Taxation takes income from households to fund government spending.  If taxes go down, disposable income goes up and, all things being equal, aggregate demand shifts up and vice versa.   Monetary policy involves changes in the money supply and interest rate (the cost of money).  If interest rates go down investment goes up shifting the ADC up and vice versa.  Similarly, if the quantity of money increases households, firms and/or government can spend more shifting the ADC up and vice versa More will be said in 5.0 Fiscal & Monetary Policy.

Growth or decline in population obviously affects AD.  More or fewer households generate more or less demand shifting the ADC accordingly.

Two principal global factors influencing domestic aggregate demand are the exchange rates (\$Cdn) and foreign income (GDPf).    If the exchange rate goes down, the dollar buys less foreign goods. Imports go down.  Domestic goods & services become less expensive to foreign buyers and exports increase.  Both cause the domestic ADC to shift up and vice versaSimilarly, if foreign GDP goes up they can buy more domestic goods & services increasing exports shifting the ADC up and vice versa.  More will be said in 6.0 The Global Economy.

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