3.7 The multiplier model: aggregate demand shocks cause business cycle fluctuations

demand shock

unexpected or exogenous change in aggregate demand

**displaces equilibrium in multiplier model —> also alters level of output and employment

multiplier model reason for name

an initial fall in demand by $15B will result in a change in output 2.5x larger than the initial change in investment for example

multiplier model key points summary

• fall in demand leads to fall in production and an equivalent fall in income which leads to a further smaller fall in demand and so on

• the multiplier is the sum of all the successive decreases in production - eventually output has fallen by a larger amount than the initial change in demand, output is a multiple of the initial change

• production adjusts to demand: firms supply the amt of goods demanded at the prevailing price

• multiplier in the model is always > 1

for the multiplier process to work the same way in response to a rise in investment, our assumption of spare capacity and fixed wages is important

means no costs will rise when output goes up so firms supply more w;out adjusting prices

**without this, multiplier would be smaller

if the current income, Y, of a country is $100T and the MPC equals 0.6, then aggregate consumption spending, C, is $60T

no - because C = c₀ + c₁Y so there would also be autonomous investment included

ALSO, MPC just represents the variating spending based on changes in income

multiplier equation

k = 1 / (1-c₁)

how to calculate change in output

k x change in I

**if investment changes by a certain amount