Multiplication, Net Multiplication, Net Exports, and GovernmentExports, and Government

I. MultiplierI. Multiplier Multiplier effect: a change in a component Multiplier effect: a change in a component

of agg expenditures leads to a larger of agg expenditures leads to a larger change in equilibrium GDPchange in equilibrium GDP

Multiplier = change rGDP/initial change in Multiplier = change rGDP/initial change in spendingspending

1) initial change usually investment (more 1) initial change usually investment (more volatile), but can be C,G, I, Xvolatile), but can be C,G, I, X

2) initial change: up or downshift in agg 2) initial change: up or downshift in agg expend schedule due to up or downshift in expend schedule due to up or downshift in componentcomponent

3) multiplier can be negative3) multiplier can be negative

Source of MultiplicationSource of Multiplication

1) repetitive, continuous flow of money1) repetitive, continuous flow of money 2) change income2) change income fractional, same fractional, same

direction change in S and Cdirection change in S and C diminishing spending chaindiminishing spending chain ∆∆II ∆wage, rent, interest, profit (spending ∆wage, rent, interest, profit (spending

and receiving income sides same coin)and receiving income sides same coin) Multiplication ends when ∆I matched by Multiplication ends when ∆I matched by

exactly offsetting S: corrects exactly offsetting S: corrects disequilibriumdisequilibrium

MPC and MPSMPC and MPS

Amount of multiplication necessary Amount of multiplication necessary to recreate equilibrium determined to recreate equilibrium determined by MPC and MPSby MPC and MPS

Multiplier = 1/MPSMultiplier = 1/MPS MPS + MPC = 1MPS + MPC = 1 Multipliers = 1/(1-MPC)Multipliers = 1/(1-MPC)

Significance and GeneralizationSignificance and Generalization

Multiplier creates larger fluctuations in Multiplier creates larger fluctuations in economy from biz decisions: greater economy from biz decisions: greater booms, greater bustsbooms, greater busts

Simple multiplier: leakage only into Simple multiplier: leakage only into savings (MPS of .05 = 20x)savings (MPS of .05 = 20x)

Complex: leakage into taxes, imports Complex: leakage into taxes, imports (“fraction of the change in income which (“fraction of the change in income which leaks, or is diverted, from the income-leaks, or is diverted, from the income-expenditure stream”); estimated at 2xexpenditure stream”); estimated at 2x

II. Trade and Equilibrium OutputII. Trade and Equilibrium Output

C + I = private closed economy agg C + I = private closed economy agg expendexpend

C + I + (X-M)= private open economyC + I + (X-M)= private open economy Net exports increase agg expenditure Net exports increase agg expenditure

beyond what closed is capable of, so beyond what closed is capable of, so GDP up; net imports reduce agg ex GDP up; net imports reduce agg ex below closed level, so GDP downbelow closed level, so GDP down

HOWEVER…HOWEVER…

AS determined by input pricesAS determined by input prices Int’l trade generally increases efficiencyInt’l trade generally increases efficiency lower costs of production (of all lower costs of production (of all

resources, including investment capital resources, including investment capital (“money” is the single largest traded (“money” is the single largest traded “good”))“good”))

greater outputgreater output Therefore, GDP higher in open economyTherefore, GDP higher in open economy Also, int’l trade increases international Also, int’l trade increases international

incomes, therefore higher levels of exports incomes, therefore higher levels of exports (partly offsets lower GDP from imports)(partly offsets lower GDP from imports)

Empirical evidence: “beggar-thy-neighbor” Empirical evidence: “beggar-thy-neighbor” tariff wars of 1920s-30stariff wars of 1920s-30s

Exchange ratesExchange rates

Depreciation: dollar losing value Depreciation: dollar losing value (inflation)(inflation)– Effect on net exports?Effect on net exports?

Appreciation: dollar gaining value Appreciation: dollar gaining value (dis- or deflation)(dis- or deflation)– Effect on net exports?Effect on net exports?

Effect on GDP?Effect on GDP?– Where are we on the curve?Where are we on the curve?

III. GovernmentIII. Government

C + I + G + (X-M)C + I + G + (X-M) 1) Continue simplified investment and net 1) Continue simplified investment and net

export schedulesexport schedules 2) G no effect on private spending2) G no effect on private spending 3) Assume tax revenue entirely personal 3) Assume tax revenue entirely personal

taxes; DI<PI; but GDP=NI=PItaxes; DI<PI; but GDP=NI=PI 4) Fixed level of taxes regardless of GDP4) Fixed level of taxes regardless of GDP 5) Price level constant5) Price level constant

Spend and TaxSpend and Tax

G spending increases agg expenditures G spending increases agg expenditures and equilibrium GDP by a multiplierand equilibrium GDP by a multiplier

G is an injection offsetting S and MG is an injection offsetting S and M– No, that’s not what I meanNo, that’s not what I mean

G taxing reduces ae and eGDP by a G taxing reduces ae and eGDP by a multiplier, but multiplier, but indirectlyindirectly by reducing DI by reducing DI C; tax multiplier = tax x MPCC; tax multiplier = tax x MPC

G taxes are a leakageG taxes are a leakage Tax cuts increase ae and eGDP, but less Tax cuts increase ae and eGDP, but less

than an increase in spendingthan an increase in spending

Balanced Budget MultiplierBalanced Budget Multiplier

$20 B in spending + $20 B in higher taxes$20 B in spending + $20 B in higher taxes Increase spending: AE increases by full Increase spending: AE increases by full

$20 B$20 B Increase taxes: AE decreases by 20 x Increase taxes: AE decreases by 20 x

MPC= 20(.95)= 19MPC= 20(.95)= 19 Net Net ∆∆ AE = 1 AE = 1 1 x (1/1-.95) = $20 B 1 x (1/1-.95) = $20 B ∆ GDP∆ GDP Balanced budget multiplier is always Balanced budget multiplier is always

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