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E4-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Extension Chapter 4
Aggregate expenditure model and multipliers
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E4-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Learning Objectives• Describe the assumptions underlying the aggregate
expenditures model.• Explain the consumption–income and saving–income
relationships upon which the aggregate expenditures model is based.
• Examine the determinants of the level of investment (firms’ purchases of capital equipment), and analyse the impact of changes in its level on equilibrium real GDP, income and employment.
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E4-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Learning Objectives (cont.)• Discuss the rationale for the presence of the
multiplier and the multiplier effect.• Apply the aggregate expenditures model to a
discussion of the paradox of thrift.• Examine the difference that may exist between the
equilibrium level of output and that corresponding to the full-employment level of output, allowing discussion of the nature of recessionary and inflationary gaps.
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E4-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Learning Objectives (cont.)• Analyse the macroeconomic impacts of the
government sector and foreign trade on equilibrium GDP.
• Apply the aggregate expenditures model to explain the concept of the balanced-budget multiplier.
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E4-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Aggregate Expenditures Model
Assumptions:1. Two sectors, i.e. closed economy with no
government.2. All savings are treated as personal savings.3. Depreciation and net Australian income earned
abroad are zero.4. Businesses make investment decisions.5. Real interest rates influence investment (I).6. All prices are fixed, including wages, i.e.
price-wage inflexibility exists.
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E4-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Aggregate Expenditures (AE)• Sum of expenditures on consumption (C), investment
(I), government spending (G) and net exports (NX).• Determines the level of output and employment in the
economy.
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E4-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Consumption and Savings• Both consumption and savings level are determined
by household disposable income (DI).• Households consume most of their DI.• DI that is not consumed is called savings.
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E4-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Consumption ScheduleA schedule of the income–consumption relationship• shows the various amounts households plan or
intend to consume at various possible level of disposable income.
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E4-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Saving ScheduleA schedule of the income–saving relationship• shows the various amounts households plan or
intend to save at various levels of disposable income.
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E4-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
425410405400
375
Consumption & Saving Schedules
Consumptionschedule
Savingschedule
Co
nsu
mp
tio
nS
avin
g
0
045
o
C
S
Disposable Income
Disposable Income370 390 410 430 450
370 390 410 430 450
Dissaving $5 billion
Saving $5 billion
Saving $5 billionDissaving $5 billion
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E4-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Consumption and Household Disposable Income 2004–05
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E4-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Average Propensity to Consume (APC)
• The fraction of any total income that is spent on consumption is:
APC =Consumption
Income
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E4-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Average Propensity to Save (APS)• That fraction of total income that is saved is:
APS =
APC + APS = 1
Saving
Income
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E4-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Marginal Propensity to Consume• That fraction of each additional dollar of income that
is consumed is:
MPC =
• Represented as the slope of the consumption schedule.
Change in consumption
Change in income
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E4-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Marginal Propensity to Save• That fraction of each additional dollar of income that
is saved is:
MPS =
• Represented as the slope of the saving schedule.• Therefore MPC + MPS = 1
Change in saving
Change in income
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E4-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
The Marginal Propensity to Consume and the Marginal Propensity to Save
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E4-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Non-Income Determinants of Consumption and Savings• wealth• price level• expectations• consumer indebtedness• taxation.• Changes in these determinants cause a shift (up
or down) of the curves.
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E4-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Shifts in the Consumption & Saving Schedules
Co
ns
um
pti
on
Sa
vin
g
0
0 45o
C0
S0
C
S
Disposable Income
Disposable Income
C
C1
Anincrease in
consumption...
S1
S
Meansa decreasein saving
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E4-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Shifts in the Consumption & Saving Schedules
Co
ns
um
pti
on
Sa
vin
g
0
0 45o
C
S
C
S
Disposable Income
Disposable Income
S
S
Meansan increase
in saving
Adecrease in
consumption...
C1
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E4-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Determinants of InvestmentTwo determinants of investment are:• The expected rate of net profits that businesses hope
to realise from investment spending.• The real rate of interest.
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E4-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Expected Rate of Net Profit• Businesses are motivated by profit.• Businesses invest if they expect a net profit from this
investment.
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E4-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Real Rate of Interest• The inflation-adjusted cost associated with borrowing
money.• Equals nominal interest rate minus the inflation rate.• Investment projects will only be undertaken if net
expected profit rate exceeds real interest rate.
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E4-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Investment Demand Curve• shows graphically the investment–interest rate
relationship• shows cumulative levels of investment at possible
levels of investment at some point in time.
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E4-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Investment Demand Curve
Investment (billions of dollars)
Exp
ect
ed
ra
te o
f ne
t pro
fits
and
inte
rest
rat
e (p
er c
ent
)
16
14
12
10
8
6
4
2
05 10 15 20 25 30 35 40
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E4-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Shifts in Investment Demand
Other determinants of investment are:• acquisition, operation and maintenance costs• business taxes• technological change• business expectations• stock of capital goods on hand• expectations.
Changes in these factors shift the investment demand curve.
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E4-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Investment and Income• An autonomous investment is
– the desired level of investment based upon long-term profit expectations
• An induced investment is– the level of investment induced by the current level of
income.
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E4-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Inve
stm
ent
(bil
lio
ns
of
do
llar
s)
Real domestic product, GDP (billions of dollars)
60
40
20
0370 390 410 450 430 450 490 510
AutonomousInvestment Schedule
II′
InducedInvestment Schedule
The Investment Schedule: Two Possibilities
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E4-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Instability of Investment• Consumption (especially non-durables) is relatively
stable BUT• investment is unstable: Why?
– durable and therefore postponable purchases– irregularity of innovation– profit variability– variable expectations (consider the new global competitive
environment!).
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E4-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
The Volatility of Investment
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E4-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Equilibrium Income/GDPThe two approaches to determine the equilibrium levels
of output and income are:
• Expenditures–Output approach• Leakages–Injections approach.
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E4-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Expenditures–Output Approach• Utilises the relationship between AE and income.• In a two-sector economy, AE = C + I.• Equilibrium occurs where the total output (measured
by GDP) and aggregate expenditures (C + I ) for a two sector economy are equal.
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E4-32Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Equilibrium GDP:Expenditures–Output Approach
Pri
vate
sp
end
ing
(bill
ion
s o
f d
olla
rs)
045
o
CC
C
GDP (billions of dollars)
370 390 410 430 450 470 490 510
(C + I = GDP) C + I
C + I
Equilibrium
C + I
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E4-33Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Leakages–Injections Approach• This approach utilises the relationship between
leakages and injections back to the expenditure flow.• Two sectors: S = I at all levels I = total investment.• At equilibrium: S = planned investment.
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E4-34Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Equilibrium GDP:Leakages–Injections Approach
S = I S
avi
ng
an
d In
ves
tmen
t(b
illio
ns
of
do
llars
)
S
S
Real domestic product, GDP (billions of dollars)
370 390 410 430 450 470 490 510 530 550
60
40
20
0
–5
I I
(S = I = $20)
Equilibrium
{
UnplannedInventoryDecrease
At this levelof GDP
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E4-35Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Equilibrium GDP:Leakages–Injections Approach
S = I S
avi
ng
an
d In
ves
tmen
t(b
illio
ns
of
do
llars
)
S
S
Real domestic product, GDP (billions of dollars)
370 390 410 430 450 470 490 510 530 550
60
40
20
0
-5
I IS{}
UnplannedInventoryIncrease
At this levelof GDP
(S = I = $20)Equilibrium
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E4-36Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Planned vs Unplanned Investment• Investment has two components:
– Planned investment as determined by investment demand schedule
– Unplanned investment is unintended changes in the level of inventories
– Actual investment = sum of planned and unplanned investment
• At equilibrium: Unplanned investment = zero
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E4-37Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Achieving Equilibrium• Difference in savings and planned investment causes • Mismatching of production and spending causes • Revision of production plans by firms until equilibrium
is once again re-established• The level of GDP would be stable only where savings
and planned investment are equal
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E4-38Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Changes in Equilibrium GDP• GDP is seldom stable. It is characterised by cyclical
fluctuations• Changes in investment schedule or the saving-
consumption schedule will lead to changes in equilibrium GDP
• Investment expenditures are generally less stable due to changes in the expected rate of net profit
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E4-39Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
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E4-40Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 41: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/41.jpg)
E4-41Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Changes in Equilibrium GDP
Pri
va
te s
pe
nd
ing
(b
illi
on
s o
f d
oll
ars
)S
av
ing
an
d i
nv
es
tme
nt
(bil
lio
ns
of
do
lla
rs)
0
045
o
510510
490490
470470
450450
430430
2020I0
390 450 470 490 510390 450 470 490 510
Equilibrium GDPat I1 level of investment
S
(C + I ) 0
390 450 470 490 510390 450 470 490 510
(C + I ) 1
I1
If I increases...
Real GDP
Real GDP
![Page 42: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/42.jpg)
E4-42Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Changes in Equilibrium GDP
Pri
vate
sp
end
ing
(b
illio
ns
of
do
llars
)
Sav
ing
an
d in
vest
men
t(b
illio
ns
of
do
llars
)
0
045
o
510510
490490
470470
450450
430430
2020 I0
430 450 470 490 510430 450 470 490 510
Equilibrium GDPat I2 level of investment
(C + I ) 0
S
430 450 470 490 510430 450 470 490 510
(C + I ) 2
I2
If I decreases...
Real GDP
Real GDP
![Page 43: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/43.jpg)
E4-43Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
• The multiplier = Changes in real GDP/Changes in I
![Page 44: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/44.jpg)
E4-44Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 45: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/45.jpg)
E4-45Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
S, I & the Paradox of Thrift• Paradox of thrift:
– If society attempts to save more, it may end up actually saving the same amount or even less, as a result of the multiple decline in equilibrium GDP caused by the withdrawal of aggregate expenditure
• For savings to be beneficial it must be matched by injection, especially I
![Page 46: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/46.jpg)
E4-46Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
S2
S2
The Paradox of Thrift
Sa
vin
g a
nd
Inv
estm
ent
(bill
ion
s o
f d
olla
rs)
S
Real domestic product, GDP (billions of dollars)
370 390 410 430 450 470 490 510
60
40
20
0
–5
I I
S1
S1
![Page 47: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/47.jpg)
E4-47Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 48: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/48.jpg)
E4-48Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Recessionary Gap (cont.)
Real GDP (billions of dollars)
045
o
470 490 510470 490 510
(C + I )0
Full Employment
Pri
vate
sp
end
ing
(b
illi
on
s o
f d
oll
ars)
(C + I )1
} RecessionaryGap
![Page 49: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/49.jpg)
E4-49Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Inflationary Gap• Is the amount by which aggregate spending exceeds
that required to achieve full employment• Produces an inflationary effect on the economy
![Page 50: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/50.jpg)
E4-50Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Inflationary Gap (cont.)
Real GDP (billions of dollars)
045
o
470 490 510470 490 510
(C + I)0
Full Employment
Pri
vate
spen
din
g (
bil
lio
ns
of
do
llar
s)
(C + I)1
{{
InflationaryGap
![Page 51: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/51.jpg)
E4-51Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 52: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/52.jpg)
E4-52Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Government Purchases (G)• Added to AE• Changes to autonomous government expenditure
impact equilibrium real GDP through the multiplier
![Page 53: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/53.jpg)
E4-53Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Three-Sector Economy Equilibrium
• Aggregate expenditure = C + I + G = real GDP
and• S = I + G
where• C is after-tax consumption• S is after-tax saving
![Page 54: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/54.jpg)
E4-54Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Government Expenditure and Equilibrium GDP
Governmentspending$20 billion
C + I + G
0 45o
4040
2020
00
470 510 550470 510 550
C + I
Real GDP (billions of dollars)
470 510 550470 510 550
C
S
C
+ I
+
G(b
illi
on
s o
f d
oll
ars)
S, I
+ G
(bill
ion
s o
f d
olla
rs)
I
Real GDP (billions of dollars)
I + G
![Page 55: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/55.jpg)
E4-55Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 56: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/56.jpg)
E4-56Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
$5 billion decreasein saving
SaSa + T
$20 billion increasein taxes
Taxes and Equilibrium GDP
C +
I +
G(b
illi
on
s o
f d
oll
ars)
S +
T, I
+ G
(bill
ion
s o
f d
olla
rs)
045
o
4040
2020
00
490 550490 550
II + G
S
490 550490 550
$15 billiondecrease in
consumptionCa + I + G
C + I + G
Real GDP ( $billions )
Real GDP ($ billions)
![Page 57: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/57.jpg)
E4-57Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Fiscal Policy over the Business CycleExpansionary fiscal policy• Increased G• Decreased T• or both• Moves Budget towards a deficit in recessionary
times
![Page 58: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/58.jpg)
E4-58Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Fiscal Policy over the Business Cycle (cont.)Contractionary fiscal policy• Decreased G• Increased T• or both• Moves Budget towards a surplus in inflationary
times
![Page 59: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/59.jpg)
E4-59Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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)
![Page 60: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/60.jpg)
E4-60Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 61: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/61.jpg)
E4-61Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 62: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/62.jpg)
E4-62Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Exports (X)
• Level of X depends on foreign countries’ income, not
on domestic income
• Therefore X is an autonomous variable in the model
![Page 63: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/63.jpg)
E4-63Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
![Page 64: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/64.jpg)
E4-64Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Equilibrium GDP with a rise in NX
Sp
end
ing
(b
illio
ns
of
do
llars
)
045
o Real GDP ($ billions)
510510
490490
470470
450450
450 470 490 510 530450 470 490 510 530
(C + I + G)
(C + I + G + NX)2
(C + I + G + NX)0
(C + I + G + NX)1
![Page 65: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/65.jpg)
E4-65Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
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
MPM is the marginal propensity to Import
![Page 66: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/66.jpg)
E4-66Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
The Complex Multiplier for an Open Economy• The multiplier that arises when all leakages—
savings, taxes, and imports—are taken into account:
1k = [MPT + MPS (1 – MPT) + MPM]
![Page 67: E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate](https://reader035.vdocuments.mx/reader035/viewer/2022062320/56649c7e5503460f949338a8/html5/thumbnails/67.jpg)
E4-67Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal
Next Chapter:
The economics of growth