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### Transcript of Multiplier. Closing the recessionary gap Classical Theory ïµ In the Classical Economics,...

• Multiplier

• Closing the recessionary gapClassical TheoryIn the Classical Economics, a recessionary gap is only temporary. Because the surplus in the labor market will depress the wage rateThen cost of production fallsPrice of products will also fall. Through wealth effect, consumption will go up In the income-expenditure diagram, the AE schedule will shift up. Hence the recessionary gap will be closed automatically at reasonable speed.

• Closing the recessionary gapKeynesian TheoryPrices and wage rates are rigid to go downwardWhen the firms and consumers remain pessimistic, even the wage rates and product prices fall, they do not increase employment or consumptionSo the recessionary gap remains for long time. Recession is prolonged

• Recessionary Gap0YY*AEAE=Y\$YpRecessionary gap

• Close Recessionary Gap Increase total spending AEAE = C + I + G + (X - IM) C, I and X-IM are not controllable G can be controlled by the governmentKeynes suggests to increase G thus AE to create more demand

• Closing the Recessionary Gap0YY*AEAE=Y\$YpRecessionary gapAEG

• How much should G increase to close the gap A smaller increase in G leads to larger increase in Y*Graphically illustration

• Closing the Recessionary Gap0YY*AEAE=Y\$YpLarger increase in Y*AEInitial increase in G

• Numerical illustrationThe model economyC = 100 + 0.9 DIT = 0I = 150G = 200X - IM = -50Solved: Y* = 4000Suppose: Yp = 5000

• Numerical illustrationAE = 400 + 0.9 Y Equilibrium Y:Y* = 1/(1-0.9) X 400 = 10 X 400 = 4000Potential GDP: Yp = 5000The recessionary gapYp - Y* = 5000 - 4000 = 1000

• Numerical illustrationSuppose G rises by 100, from 200 to 300, what happens to Y*? AE = C + I + G + (X - IM) = 500 + 0.9 YThe new equilibrium Y*Y** = 1/(1-0.9) X 500 = 10 X 500 = 5000

• Numerical illustrationIncrease in Y*Y* = 5000 - 4000 = \$1000 G = \$100 Y* = \$1000 An increase in G by 100 leads to an increase in Y* by 1000. Ten times large.

• Expenditure MultiplierExpenditure multiplierAlso called income multiplier

Increase in Y*Expenditure Multiplier = ------------------ Increase in G

Y*E = ---------- G

• Expenditure Multiplier Y* 1000E = ---------- = -------- = 10 G 100

• Expenditure Multiplier Y* Y* Y* Y*E = ----- = ---- = ---- = ----- G C I X-IM

• Economic insight of the multiplier The trickling down effectThe multiplier is greater than 1 because one persons spending is another persons income. spending incomeA portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on

• Insight of multiplierSuppose the government increases G by 100 (b\$)1st round, government spending: G = AE = 1002nd round, contracted firms: C = AE = DI X 0.9 = 100 X MPC = 100 X 0.9 = 903rd round, the shopkeepers,C = AE = DI X 0.9 = 90 X MPC = 90 X 0.9 = 81

• How the Multiplier BuildsCopyright 2003 South-Western/Thomson Learning. All rights reserved.Spending Round 20 15 10 8 6 4 2 Cumulative Spending Total \$4.0 2.0 3.0 1.0 0

• Insight of Multiplier

Round NumberIncrease in Spending in this round (b\$)Cumulative total(b\$) 1 100 100 2 90 190 3 81 271 4 72.9 343.9 5 65.61 409.51 ... ... ... ... ... ... Infinity 0 1,000

• Insight of multiplierCumulative increase in Y*: 100 + 90 + 81 + 72.9 + 65.61 + ...= 100 + 100 X 0.9 + 100 X (0.9)2 + 100 X (0.9)3 + 100 X (0.9)4 +...

= 100 X ( 1+0.9+0.92+ 0.93 + 0.94 + ... ) 1= 100 X --------- 1 - 0.9= 100 X 10= 1000

• Geometric Progression and solution1 + x + x2 + x3 + x4 + ... 1 = ---------- ( x < 1 ) 1 - x

• Expenditure multiplier 1 E = ---------- 1 MPC

"oversimplified multiplier" formulaLarger MPC, larger E

• Autonomous changes in AEAutonomous increase in C, I, or X-IMrefers to an increase in C, I, or X - IM, which is independent of income Y. In graph, an autonomous increase shifts the AE schedule up.Any autonomous increase generates a multiplier effect on Y*

• Induced changes in AEInduced increase in C, I, or X IMrefers to an increase in C, I or X - IM due to an increase in income Y. In graph, an induced increase produces a movement along the AE schedule.

• Autonomous and induced changes0YY*AEAE=Y\$YpAutonomous changeAEInduced change

• The Paradox of ThriftIf everyone tries to save more in recessionThen C fallsThen causes a multiple decrease in Y* Then each individual ends up with less saving in absolute term.

• The Paradox of ThriftSavingGDP before recessionGDP in recession