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Solution

The following table illustrates the completed table. The equilibrium is level is italicized.

National Income After-tax Income Consumption I + G + X Minus Imports Aggregate Expenditures
$8,000 $4,800 $4,340 $5,000 $240 $9,100
$9,000 $5,400 $4,820 $5,000 $270 $9,550
$10,000 $6,000 $5,300 $5,000 $300 $10,000
$11,000 $6,600 $5,780 $5,000 $330 $10,450
$12,000 $7,200 $6,260 $5,000 $360 $10,900
$13,000 $7,800 $46,740 $5,000 $4,390 $11,350

The alternative way of determining equilibrium is to solve for Y, where Y = national income, using: Y = AE = C + I + G + X – M

Y = $500 + 0.8(Y – T) + $2,000 + $1,000 + $2,000 – 0.05(Y – T)

Solving for Y, we see that the equilibrium level of output is Y = $10,000.

Explain how the multiplier works. Use an MPC of 80% in an example.

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Solution

The multiplier refers to how many times a dollar will turnover in the economy. It is based on the Marginal Propensity to Consume (MPC) which tells how much of every dollar received will be spent. If the MPC is 80% then this means that out of every one dollar received by a consumer, $0.80 will be spent. This $0.80 is received by another person. In turn, 80% of the $0.80 received, or $0.64, will be spent, and so on. The impact of the multiplier is diluted when the effect of taxes and expenditure on imports is considered. To derive the multiplier, take the 1/1 – F; where F is equal to percent of savings, taxes, and expenditures on imports.

Review questions

What is on the axes of an expenditure-output diagram?

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What does the 45-degree line show?

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What determines the slope of a consumption function?

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What is the marginal propensity to consume, and how is it related to the marginal propensity to import?

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Why are the investment function, the government spending function, and the export function all drawn as flat lines?

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Why does the import function slope down? What is the marginal propensity to import?

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What are the components on which the aggregate expenditure function is based?

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Is the equilibrium in a Keynesian cross diagram usually expected to be at or near potential GDP?

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What is an inflationary gap? A recessionary gap?

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What is the multiplier effect?

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Why are savings, taxes, and imports referred to as “leakages” in calculating the multiplier effect?

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Will an economy with a high multiplier be more stable or less stable than an economy with a low multiplier in response to changes in the economy or in government policy?

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How do economists use the multiplier?

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Critical thinking questions

What does it mean when the aggregate expenditure line crosses the 45-degree line? In other words, how would you explain the intersection in words?

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Which model, the AD/AS or the AE model better explains the relationship between rising price levels and GDP? Why?

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What are some reasons that the economy might be in a recession, and what is the appropriate government action to alleviate the recession?

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What should the government do to relieve inflationary pressures if the aggregate expenditure is greater than potential GDP?

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Two countries are in a recession. Country A has an MPC of 0.8 and Country B has an MPC of 0.6. In which country will government spending have the greatest impact?

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Compare two policies: a tax cut on income or an increase in government spending on roads and bridges. What are both the short-term and long-term impacts of such policies on the economy?

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What role does government play in stabilizing the economy and what are the tradeoffs that must be considered?

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If there is a recessionary gap of $100 billion, should the government increase spending by $100 billion to close the gap? Why? Why not?

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What other changes in the economy can be evaluated by using the multiplier?

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References

Joyner, James. Outside the Beltway. “Public Financing of Private Sports Stadiums.” Last modified May 23, 2012. http://www.outsidethebeltway.com/public-financing-of-private-sports-stadiums/.

Siegfried, John J., and Andrew Zimbalist. “The Economics of Sports Facilities and Their Communities.” Journal of Economic Perspectives . no. 3 (2000): 95-114. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.14.3.95.

Questions & Answers

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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