L7._Aggregate_Expenditure_and_the_Multiplier

Introduction to Aggregate Expenditure and the Multiplier

Key Concepts

• Develop John Maynard Keynes's model of income determination which explains the relationship between aggregate demand and output.

• Introduce the concept of the multiplier, which illustrates how an initial change in spending can lead to larger changes in overall economic output.

• Include the roles of the government sector in shaping aggregate expenditure and its impact on the economy.

Next Lecture

• An open economy extension will be added, discussing how international trade and foreign investment influence aggregate expenditure.

Previous Lecture Recap

Equilibrium Output

• Equilibrium output is determined by the level of planned expenditure in an economy, where aggregate supply meets aggregate demand.

Aggregate Expenditure (AE)

• Aggregate Expenditure (AE) refers to the total spending in an economy and is directly related to GDP, incorporating consumption, investment, government spending, and net exports.

Aggregate Expenditure (AE) Model

Equation

• The basic equation of the model is: AE = Y = C + I

• C: Consumption, the total value of all consumption expenditures in the economy.

• I: Investment, which includes business investments in equipment and structures as well as residential construction.

Example: Fall in Investment

Scenario

• An initial equilibrium income level falls from I0 to I1 due to a decrease in investment, illustrating how fluctuations can lead to wider economic impacts.

Effects

• As a result, AE decreases, leading to a drop in equilibrium output from Y0 to Y1, showcasing the sensitivity of the economy to changes in investment.

Diagram Analysis

• The AE curve shifts downward, demonstrating the relationship between AE and output. The decrease in output (∆Y) is proportionally larger than the decrease in investment (∆I), indicating the multiplier effect at play.

Multiplier Effect

• The multiplier is defined as the magnified effect on output due to a decrease in investment. It captures how initial changes can propagate through the economy.

Calculating the Multiplier

Multiplier Formula

• k = 1/(1 - b) where 'b' represents the marginal propensity to consume (mpc). This reflects the percentage of additional income that households are likely to spend on consumption.

Example Calculation

• If mpc (b) is 0.75, then:

  • k = 1/0.25 = 4.

  • This indicates that a change in income (∆Y) is four times the change in investment (∆I).

Different mpc Values

• Illustrating different scenarios, if mpc is 0.5, the multiplier becomes 2, highlighting how variations in consumer behavior alter the effectiveness of fiscal policy.

Introducing the Government Sector

Components

• The model incorporates exogenous government spending (G) which signifies the ratio of government expenditures, and net tax revenues (T) which reflects total tax income minus subsidies.

• The revised tax function is given by: T = t0 + tY, where 't' is the marginal propensity to tax, affecting disposable income and consumption.

Government Budget

• Budget Deficit: Defined as G - T, occurring when government expenditures surpass revenues, leading to increased borrowing.

• Budget Surplus: Occurs when T - G, indicating excess revenue over expenditures and the ability to pay down debt or reallocate funds.

Effects on the AE Model

Modified Equation

• The introduction of government activity leads to a modified equation:

  • AE = Y = C + I + G

Consumption Function

• The consumption function is altered to: C = a + b(Y - T), reflecting changes in disposable income due to taxation.

New Equilibrium

• The new equilibrium incorporates the effects of taxes and government spending:

  • Y = (a - bt0 + I + G) / (1 - b(1 - t))

Multiplier with Government Sector

• The multiplier now accounts for government expenditures: kG = 1/(1 - b(1 - t)).

• Effect of Tax on Multiplier: As 't' increases (t > 0), the resultant multiplier (kG) is generally smaller compared to when t = 0, reflecting reduced effectiveness of fiscal stimulus.

Fiscal Policy Implications

Discretionary Fiscal Policy

• Discretionary fiscal policy refers to intentional adjustments in government spending (G) and tax rates (t) to influence economic output. This includes expansionary measures to combat recession through increased spending.

Expansionary Policy

• Increasing government spending aims to stimulate the economy during periods of downturn. For instance, raising G will shift the AE curve upwards, leading to higher output and employment levels.

Numerical Example

• Scenario: If the multiplier is 2 and G increases by £50 million:

  • Output is projected to rise by £100 million, demonstrating the power of government intervention in the economy.

Application of Fiscal Policy

• Governments leverage fiscal policy to sustain high employment, particularly during recessive economic periods.

Effects of Tax Changes on AE

Swiveling AE Line

• Changes in the marginal propensity to consume (b) or the tax rate (t) lead to a shifting of the C + I + G line, modifying potential output levels.

Impact of Increased Tax Rate

• A higher tax rate (t) reduces disposable income, which subsequently lowers AE and diminishes national income, demonstrating a contractionary effect on the economy.

Limitations of Fiscal Policy

Timing Issues

• Timing issues can arise, as delays in recognizing, deciding, and implementing policies complicate swift governmental response to economic fluctuations.

Forecasting Challenges

• Accurately predicting the economic impacts of fiscal policies poses significant challenges, hindering the effectiveness of interventions.

Irreversible Investments

• Some investments, such as infrastructure projects, require completion regardless of fiscal conditions, indicating limitations on flexibility in response to economic changes.

Constraints by Budget Deficits

EU Budget Rules

• The European Union enforces budget rules that limit budget deficits to 3% of GDP and public debt to 60% of GDP. Critics argue these limits can be overly restrictive, undermining active fiscal policies aimed at economic growth.

Country-Specific Cases

• Different nations experience varying levels of budget deficits, suggesting that a one-size-fits-all approach may not reflect individual economic realities.

Conclusions

Fiscal Policy Role

• Fiscal policy serves as a crucial tool for discretionary economic management aimed at maintaining stable economic growth.

Magnitude of Budget Deficit

• Changes in the budget deficit may have lesser magnitude than expected due to the multiplier effect, complicating anticipated outcomes and real economic performance.