Chapter MULTIPLIERS: THE KEYNESIAN MODEL*
C h a p t e r13EXPENDITUREMULTIPLIERS: THEKEYNESIAN MODEL**Chapter Key IdeasEconomic Amplifier or Shock Absorber?A. A voice can be a whisper or fill Central Park, depending on the amplification.B. A limousine with good shock absorbers can ride smoothly over terrible potholes.C. Investment and exports can fluctuate like the amplified voice, or the terrible potholes; does theeconomy react like a limousine, smoothing out the bumps, or like an amplifier, magnifying thefluctuations? These are the questions this chapter addresses.OutlineI.Fixed Prices and Expenditure PlansA. The Keynesian model of this chapter studies the economy in the very short run.1. In the very short run, prices are fixed and the aggregate amount that is sold depends only onthe aggregate demand for goods and services.2. Therefore in this very short run, we focus on what makes aggregate demand fluctuate.B. Expenditure Plans1. The four components of aggregate expenditure—consumption expenditure, investment,government purchases of goods and services, and net exports—sum to real GDP.2.3.Aggregate planned expenditure equals planned consumption expenditure plusplanned investment plus planned government purchases plus planned exports minus plannedimports.A two-way link exists between aggregate expenditure and real GDP:a) An increase in aggregate expenditure increases real GDP.b) Planned consumption expenditure and planned imports depend on real GDP, so anincrease in real GDP increases aggregate planned expenditure.C. Consumption Function and Saving Function1. Consumption and saving depend on the real interest rate, disposable income, wealth, andexpected future income.a) Disposable income is aggregate income minus taxes plus transfer payments.b) To explore the two-way link between real GDP and planned consumption** This is Chapter 29 in Economics.285
286CHAPTER 132.3.expenditure, we focus on the relationship between consumption expenditure anddisposable income when the other factors are constant.The relationship between consumption expenditure and disposable income, other thingsremaining the same, is the consumption function. And the relationship between savingand disposable income, other things remaining the same, is the saving function.Figure 13.1 illustrates the consumption function and the saving function.D. Marginal Propensities to Consume and Save1.2.The marginal propensity to consume (MPC) is the fraction of a change in disposableincome that is consumed. It is calculated as the change in consumption expenditure, C,divided by the change in disposable income, YD, that brought it about. That is:MPC C/ YD.The marginal propensity to save (MPS) is the fraction of a change in disposableincome that is saved. It is calculated as the change in saving, S, divided by the change indisposable income, YD, that brought it about. That is:MPS S/ YD.
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL3.The MPC plus the MPS equals one. To see why, note that, C S YD.Then divide this equation by YD to obtain, C/ YD S/ YD YD/ YD,which means thatMPC MPS 1.E. Slopes and Marginal Propensities1. Figure 13.2 shows that the MPC isthe slope of the consumptionfunction and the MPS is the slopeof the saving function.287
288CHAPTER 13F. Other Influences on Consumption Expenditure and Saving1. When an influence other thandisposable income changes — thereal interest rate, wealth, orexpected future income—theconsumption function and savingfunction shift.2. Figure 13.3 illustrates shifts in theconsumption function and thesaving function.
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL289G. The U.S. Consumption Function1. Data for the United States show thatthe U.S. consumption function hasshifted upward over time becauseeconomic growth has created greaterwealth and higher expected futureincome.2. Figure 13.4 illustrates for 1961 to2003; the assumed MPC in the figureis 0.9.H. Consumption as a Function of RealGDP1. Disposable income changes wheneither real GDP changes or when nettaxes change.2. If tax rates don’t change, real GDP isthe only influence on disposableincome, so consumption expenditureis a function of real GDP.3. We use this relationship to determine equilibrium expenditure.I. Import Function1. In the short run, imports are influenced primarily by U.S. real GDP.2.The marginal propensity to import is the fraction of an increase in real GDP that isspent on imports. In recent years, NAFTA and increased integration in the global economyhave increased U.S. imports. Removing the effects of these influences, the U.S. marginalpropensity to import is probably about 0.2.II. Real GDP with a Fixed Price LevelA. The relationship between aggregate planned expenditure and real GDP can be described by anaggregate planned expenditure schedule, which lists the level of aggregate expenditure planned ateach level of real GDP, or by the aggregate planned expenditure curve, which is a graph of theaggregate planned expenditure schedule.
290CHAPTER 13B. Aggregate Planned Expenditure and Real GDP1. The table in Figure 13.5 shows how the aggregate planned expenditure schedule isconstructed from the components of aggregate planned expenditure.2.Consumption expenditure minus imports, which varies with real GDP, is inducedexpenditure.3. The sum of investment, government purchases, and exports, which does not vary withGDP, is autonomous expenditure. (Consumption expenditure and imports also havean autonomous component.)C. Actual Expenditure, Planned Expenditure, and Real GDP1. Actual aggregate expenditure is always equal to real GDP.2.Aggregate planned expenditure can differ from actual aggregate expenditure because firmscan have unplanned changes in inventories.D. Equilibrium Expenditure1.Equilibrium expenditure is the level of aggregate expenditure that occurs whenaggregate planned expenditure equals real GDP.
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL2.291Figure 13.6 illustrates equilibrium expenditure, which occurs at the point at which theaggregate planned expenditure curve, AE, crosses the 45 line so that there are nounplanned changes in business inventories.E. Convergence to Equilibrium1. Figure 13.6 also illustrates the process of convergence toward equilibrium expenditure. Ifaggregate planned expenditure is greater than real GDP (the AE curve is above the 45 line),an unplanned decrease in inventories induces firms to hire workers and increase production,so real GDP increases.2. If aggregate planned expenditure is less than real GDP (the AE curve is below the 45 line),an unplanned increase in inventories induces firms to fire workers and decrease production,so real GDP decreases.3. If aggregate planned expenditure equals real GDP (the AE curve intersects the 45 line), nounplanned changes in inventories occur, so firms maintain their current production and realGDP remains constant.
292CHAPTER 13III. The MultiplierA. The multiplier is the amount by which a change in autonomous expenditure is magnified ormultiplied to determine the change in equilibrium expenditure and real GDP.B. The Basic Idea of the Multiplier1. An increase in investment (or any other component of autonomous expenditure) increasesaggregate expenditure and real GDP. The increase in real GDP then leads to an increase ininduced expenditure.2. The increase in induced expenditure leads to a further increase in aggregate expenditure andreal GDP. So, real GDP increases by more than the initial increase in autonomousexpenditure.3. Figure 13.7 illustrates the multiplier.C. The Multiplier Effect1. The amplified change in real GDPthat follows an increase inautonomous expenditure is themultiplier effect.2.When autonomous expenditureincreases, inventories have anunplanned decrease, so firmsincrease production and real GDPincreases to a new equilibrium.D. Why Is the Multiplier Greater than 1?The multiplier is greater than 1 becausean increase in autonomous expenditureinduces further increases in expenditure.E. The Size of the MultiplierThe size of the multiplier is the changein equilibrium expenditure divided bythe change in autonomous expenditure.F. The Multiplier and the MarginalPropensities to Consume and Save1.Ignoring imports and income taxes,the marginal propensity to consumedetermines the magnitude of themultiplier.2.The multiplier equals 1/(1 – MPC)or, alternatively, 1/MPS.
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL3.293Figure 13.8 illustrates the multiplierprocess and shows how the MPCdetermines the magnitude of theamount of induced expenditure ateach round as aggregate expendituremoves toward equilibriumexpenditure.G. Imports and Income TaxesIncome taxes and imports both reduce the size of the multiplier. Including income taxes andimports, the multiplier equals 1/(1 – slope of the AE curve). Figure 13.9 shows the relationshipbetween the multiplier and the slope of the AE curve.H. Business Cycle Turning Points1. Turning points in the business cycle—peaks and troughs—occur when autonomousexpenditure changes.2. A decrease in autonomous expenditure brings an unplanned increase in inventories, whichtriggers a recession.
294CHAPTER 133.An increase in autonomous expenditure brings an unplanned decrease in inventories, whichtriggers an expansion.IV. The Multiplier and the Price LevelA. In the equilibrium expenditure model, the price level remains constant. But real firms don’t holdtheir prices constant for long. When they have an unplanned change in inventories, they changeproduction and prices. And the price level changes when firms change prices. The aggregatesupply-aggregate demand model explains the simultaneous determination of real GDP and theprice level. The equilibrium expenditure and aggregate supply-aggregate demand models arerelated.B. Aggregate Expenditure and Aggregate Demand1. The aggregate expenditure curve is the relationship between aggregate planned expenditureand real GDP, with all other influences on aggregate planned expenditure remaining thesame.2. The aggregate demand curve is the relationship between the quantity of real GDPdemanded and the price level, with all other influences on aggregate demand remaining thesame.C. Aggregate Expenditure and the PriceLevel1. When the price level changes, awealth effect and substitution effectchange aggregate plannedexpenditure and change the quantityof real GDP demanded.a) An increase in the price leveldecreases aggregate plannedexpenditure.b) A decrease in the price levelincreases aggregate plannedexpenditure.2. Figure 13.10 illustrates the effects ofa change in the price level on the AEcurve, equilibrium expenditure, andthe quantity of real GDP demanded.a) Points A, B, and C on the ADcurve correspond to theequilibrium expenditure pointsA, B, and C at the intersection ofthe AE curve and the 45 line.b) In Figure 29.10(a), a rise in pricelevel from 105 to 125 shifts theAE curve from AE0 downward toAE1and decreases theequilibrium level of real outputfrom 10 trillion to 9 trillion.In Figure 13.10(b), the same risein the price level that lowers
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL295equilibrium expenditure, brings a movement along the AD curve from point B to pointA.c)3.A fall in price level from 105 to 85 shifts the AE curve from AE0 upward to AE2 andincreases equilibrium l real GDP from 10 trillion to 11 trillion. The same fall in theprice level that raises equilibrium expenditure brings a movement along the AD curvefrom point B to point C.Figure 13.11 illustrates the effectsof an increase in autonomousexpenditure. An increase inautonomous expenditure shifts theaggregate expenditure curve upwardand shifts the aggregate demandcurve rightward by the multipliedincrease in equilibrium expenditure.
296CHAPTER 13D. Equilibrium Real GDP and the Price Level1. Figure 13.12 shows the effect of anincrease in investment in the shortrun when the prices level changesand the economy moves along itsSAS curve.2.3.The rise in the price level decreasesaggregate planned expenditure andlowers the multiplier effect on realGDP.In Figure 13.12(b), the AD curveshifts rightward by the amount ofthe multiplier effect butequilibrium real GDP increases byless than this amount because ofthe rise in the price level. In Figure13.12(b) real GDP increases from 10 trillion from 11.3 trillion,instead of to 12 trillion as itwould with a fixed price level.
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL4.297Figure 13.13 illustrates the longrun effects of an increase inautonomous expenditure at fullemployment. If the increase inautonomous expenditure takes realGDP above potential GDP, themoney wage rate rises, the SAScurve shifts leftward, and realGDP decreases until it is back atpotential real GDP. The long-runmultiplier is zero.Reading Between the LinesThe article discusses how firms started rebuilding depleted inventories in 2003, suggesting a boost inproduction and the start of the multiplier process in an expansion. Inventories were depleted in 2003because planned expenditure exceeded real GDP. As firms sought to replenish inventories, productionincreased, which set in motion the multiplier effect that is part of a business cycle expansion.New in the Seventh EditionThe data have been updated, and the scales for disposable income and real GDP made more appropriate.Reading Between the Lines (pages 250-251) examines the role of inventory changes in an expansion.
298CHAPTER 13Te a c h i n g S u g g e s t i o n s1.2.Fixed Prices and Expenditure PlansThe consumption function and saving function. In Chapter 8, the student learned about theinfluences on saving. They learned there that households divide their disposable income betweenconsumption expenditure and saving. And they learned that the factors that affect saving are the realinterest rate, disposable income, wealth, and expected future income. These same ideas repeat in thischapter but with a different emphasis. Be sure that the students see that they are talking about exactlythe same stuff by they are looking at it from a different angle. In Chapter 8, the focus was on thesaving part of the allocation; here it is primarily on the consumption part. In Chapter 8, we helddisposable income constant and studied the saving supply curve—the relationship between savingand the real interest rate, other things remaining the same. Here, we hold the real interest rateconstant and study the saving and consumption functions—the relationships between saving (andconsumption) and disposable income, other things remaining the same.An analogy might help. Ask the students if they have ever been to a ball game (could be any fastmoving game) and disagreed with a referee’s (or umpire’s) ruling. Almost everyone has. Both thereferee and the spectator were at the same event, but they viewed it from a different angle. That’swhat we’re doing here. We’ve viewing the allocation of disposable income between saving andconsumption from a different angle. But we’re at the same ball game that we were at in Chapter 8.The 45 line. Don’t assume that the student immediately understands the 45 line! Spend a bit oftime explaining how to “read” it. Fundamentally, the line is that along which x y. This line happensto be a 45 line when the scales along the x-axis and the y- axis are the same. Then point out that thehorizontal distance to a point along the x-axis equals the vertical distance from that point to the 45 line. So at all points along the 45 line, x y. If you wish, you can go on to show the students howthe x y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scaleon the x-axis constant. Emphasize that x and y can be anything. In Figure 13.1, x is disposableincome and y is consumption expenditure; in Figure 13.6(a), x is real GDP and y is aggregateplanned expenditure.Marginal and average propensities. The text defines the MPC and MPS, and shows that they sum toone because disposable income can only be consumed or saved. The textbook does not define andexplain the APC and APS. The reason is that these concepts have no operational significance. Theyare not worth any of the student’s attention.Real GDP with a Fixed Price LevelHistorical background. If you want to talk about Keynes and his contribution to economics, this isprobably the best place to do it. A comprehensive Keynes biographical sketch can be found m.The model, now generally called the aggregate expenditure model, presented in this section is theessence of Keynes General Theory. According to Don Patinkin, a leading historian of economicthought and Keynes scholar says that the innovation of the General Theory was to replace price withincome (GDP) as the equilibrating variable. This version of the model cannot be found in theGeneral Theory, mainly because Keynes was writing before the national income accounting systemhad been developed. So he made up his own aggregates, based on employment and a money wagemeasure of the price level. But the words and equations of the General Theory can be translatedreadily into the textbook version of the model. This version of the model first appeared in TheElements of Economics, a textbook authored by Lorie Tarshis published in 1947. It was popularized byPaul Samuelson in the first edition of his celebrated text published in 1948.The main difference between the Keynesian cross model of the 1940s and the aggregate expendituremodel of today is that from the 1940s through the mid-1960s, economists believed that the fixedprice level assumption was an acceptable (if not exactly accurate) description of reality, so the model
EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL3.299was seen as actually determining real GDP, and the multiplier was seen as an empirically relevantphenomenon. In contrast, today, we see the model as part of the aggregate demand story. The valueof the model today—and it is valuable today and not, as some people claim, eclipsed by the AS-ADmodel and irrelevant—is that it explains the multiplier that translates a change in autonomousexpenditure into a shift of the AD curve and it explains the multiplier convergence process that pullsthe economy toward the AD curve. (When an unintended change in inventories occurs, the economyis off the AD curve but moving toward it.)Convergence toward equilibrium. The treatment of the aggregate expenditure model in this textbookplays up Patinkin’s modern interpretation the role of changes in income signaled by unintendedinventory changes, as the force that generates equilibrium expenditure. Figure 13.5 that generates theAE curve and Figure 13.6 that explains convergence toward equilibrium are the core of the model.The MultiplierThe basic idea and practice. Students need quite a lot of practice using multipliers. One goodproblem involves working out the effects on consumption as well as GDP of a change in investment(when the price level is fixed). The best way to present this problem to the students seems to besequentially. Begin by giving them the data necessary to deduce how real GDP changes from anincrease in investment. Tell them there is no foreign trade, so that there are no exports or imports,and no income taxes. Tell them that the marginal propensity to consume is b (pick any valid numberyou like), and that investment has changed by I (pick any valid number you like).Then, after the students have computed the change in GDP, ask them what the change inconsumption expenditure is.Review their attempts to answer this question as follows: The change in GDP, Y, is given by theequation: Y C I. Given I from the initial statement of the problem and Y from the firstset of calculations, the students can readily calculate C. Focusing the students’ attention on thechange in consumption is important because it reinforces the point that a change in autonomousexpenditure (investment in this example) leads to an induced change in consumption expenditure andthat
290 CHAPTER 13 B. Aggregate Planned Expenditure and Real GDP 1. The table in Figure 13.5 shows how the aggregate planned expenditure schedule is . The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the .
13 EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL* * This is Chapter 29 in Economics. Fixed Prices and Expenditure Plans Topic: Keynesian Model Skill: Recognition* 1) In the Keynesian model of aggregate expenditure, real GDP is determined by the A) price level. B) level of aggregate demand. C) level of aggregate supply. D) level of taxes. Answer: B
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Part One: Heir of Ash Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Chapter 30 .
