Chapter 11Econ104 Parks

The Output MultiplierThe Output Multiplier

The multiplier effect

• When an autonomous component of Aggregate Demand changes, equilibrium output (Y) will change.

• The change in output will be even larger than the initial change in Aggregate Demand.

• This result for the change in Y to be greater than the initial change in Aggregate Demand is known as the multiplier effect.

• When an autonomous component of Aggregate Demand changes, equilibrium output (Y) will change.

• The change in output will be even larger than the initial change in Aggregate Demand.

• This result for the change in Y to be greater than the initial change in Aggregate Demand is known as the multiplier effect.

Calculating the Size of the Multiplier Effect

• The size of the multiplier effect is given by:

where the (simple) output multiplier is defined as 1/(1-MPC).

• The size of the multiplier effect is given by:

where the (simple) output multiplier is defined as 1/(1-MPC).

The simple output multiplier

• The simple output multiplier assumes– there are no taxes based on income– all expenditures are for domestically produced

goods and services– the price level is fixed

• The simple output multiplier assumes– there are no taxes based on income– all expenditures are for domestically produced

goods and services– the price level is fixed

How and Why the Multiplier Works

• When Aggregate Demand rises, output and hence income rise.

• The rise in income allows people to consume more goods and services.

• This is called "income-induced" consumption and it raises Aggregate Demand even more.

• When Aggregate Demand rises, output and hence income rise.

• The rise in income allows people to consume more goods and services.

• This is called "income-induced" consumption and it raises Aggregate Demand even more.

Example: University builds a new residence hall worth $100 million. MPC=0.8

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• Comments:

• This is a period by period analysis. A book exercise.

• The change in investment must be a permanent change of $100 to get the increase in output of $500. We do not know the effect of changing investment by $100 in period 1 and no change thereafter – economic recovery act anyone?

• Comments:

• This is a period by period analysis. A book exercise.

• The change in investment must be a permanent change of $100 to get the increase in output of $500. We do not know the effect of changing investment by $100 in period 1 and no change thereafter – economic recovery act anyone?

The Output Multiplier with Proportional Taxes

• A proportional tax is a constant percent of income tax– If income is taxed at a 20 percent rate, then t =

0.20.

• The formula for the output multiplier when proportional taxes are present, is:

• A proportional tax is a constant percent of income tax– If income is taxed at a 20 percent rate, then t =

0.20.

• The formula for the output multiplier when proportional taxes are present, is:

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• APE = C + I + G + (N-X)

• C = CA + mpc*DI

• DI = Y*(1-t)

• Equilibrium at Y = APE

• Yeq = Autonomous expeditures/(1-mpc*(1-t))

• APE = C + I + G + (N-X)

• C = CA + mpc*DI

• DI = Y*(1-t)

• Equilibrium at Y = APE

• Yeq = Autonomous expeditures/(1-mpc*(1-t))

Proportional taxes reduce the size of the multiplier effect.

The Output Multiplier with Imports

• When income rises, demand for foreign goods and services also rises, lowering the demand for U.S. goods & services and dampening the multiplier effect.

• The marginal propensity to import (MPI) is the change in imports divided by the change in disposable income.

• The output multiplier without proportional taxes but accounting for imports is:

• When income rises, demand for foreign goods and services also rises, lowering the demand for U.S. goods & services and dampening the multiplier effect.

• The marginal propensity to import (MPI) is the change in imports divided by the change in disposable income.

• The output multiplier without proportional taxes but accounting for imports is:

The Output Multiplier with Price Level Change

• For this slide only, we relax the assumption that the price level is fixed.

• When the AD curve shifts and the AS curve is upward sloping, the multiplier effect is smaller.

• The economy moves from point A to point C, instead of point B.

• For this slide only, we relax the assumption that the price level is fixed.

• When the AD curve shifts and the AS curve is upward sloping, the multiplier effect is smaller.

• The economy moves from point A to point C, instead of point B.

The Output Multiplier with Price Level Change

• For this slide only, we relax the assumption that the price level is fixed.

• When the AD curve shifts and the AS curve is upward sloping, the multiplier effect is smaller.

• The economy moves from point A to point C, instead of point B.

• For this slide only, we relax the assumption that the price level is fixed.

• When the AD curve shifts and the AS curve is upward sloping, the multiplier effect is smaller.

• The economy moves from point A to point C, instead of point B.

The Multiplier Effect and a Temporary Change in Aggregate Demand

• If the change in Aggregate Demand is temporary, then the change in output is temporary.

• Examples include road or building repairs.

• If the change in Aggregate Demand is temporary, then the change in output is temporary.

• Examples include road or building repairs.

The Multiplier Effect and a Temporary Change in Aggregate Demand

•Equilibrium output rises initially, but the impact dampens out over time.

•Equilibrium output rises initially, but the impact dampens out over time.

The Multiplier Effect and a Permanent Change in Aggregate Demand

• If the change in Aggregate Demand is permanent, the equilibrium level of output in the economy is permanently higher.

• Examples: new school or prison.

• If the change in Aggregate Demand is permanent, the equilibrium level of output in the economy is permanently higher.

• Examples: new school or prison.

The Multiplier Effect and a Permanent Change in Aggregate Demand

• The overall equilibrium level of output in the economy rises by the initial change in AD times the size of the output multiplier.

• The overall equilibrium level of output in the economy rises by the initial change in AD times the size of the output multiplier.