1. Describe and define the multiplier effect.
2. State the relationships between the multiplier and the MPS and the MPC.
3. Define the net export schedule.
4. Explain the impact of positive (or negative) net exports on aggregate expenditures and the equilibrium level of real GDP.
5. Explain the effect of increases (or decreases) in exports on real GDP.
6. Explain the effect of increases (or decreases) in imports on real GDP.
7. Describe how government purchases affect equilibrium GDP.
8. Describe how personal taxes affect equilibrium GDP.
9. Explain what is meant by the balanced-budget multiplier and why it equals 1.
10. Identify a recessionary gap and explain its effect on real GDP.
11. Identify an inflationary gap and explain its effect.
12. Explain the relationship between the concept of recessionary gap and the Great Depression.
13. Explain the relationship between the Vietnam era inflation and the inflationary gap concept.
14. List four deficiencies of the aggregate expenditures model.
15. Define and identify terms and concepts listed at the end of the chapter.

1. As stated earlier, some instructors may choose to skip this chapter as well as Chapter 9 which develop the aggregate expenditures model. Time limitations may force the macro theory focus to begin with Chapter 11, on the aggregate demand-aggregate supply model. The text is organized for this possibility. However, as suggested in Chapter 9, students could still benefit from the Last Word sections for both Chapters 9 and 10, and the multiplier concept can still be successfully presented, as suggested in #2 below.
2. The multiplier concept can be demonstrated effectively by a role-playing exercise in which you have students pretend that one row (group) of students are construction workers who benefit from a $1 million increase in investment spending. (Some instructors use an oversized paper $1-million bill.) If their MPC is .9, then they will spend $900,000 of this at stores "owned" by a second row (group) of students, who will in turn spend $810,000 or .9 x $900,000. At the end of the exercise, each row can add up its new income and it will be well in excess of the initial $1 million. In fact, if played out to its conclusion, the final change in GDP should approximate $10 million, given the MPS is .1 in this example.

   If you decide to use an oversized paper $1-million bill, then students will have to clip off one-tenth of it at every stage to represent saving. By the end of the process, each row (group) of students has seen its income increase by nine-tenths of what the previous group received. Adding up all of these increases illustrates the idea that the original $1 million increase in spending has resulted in many times that amount in terms of the students' increased incomes. Obviously, you won't be able to illustrate the final multiplier, but it should give them a good idea of why the end multiplier would be equal to 10 in this example. In other words, if the process were carried to its conclusion, the original $1 million of new investment would result in a $10 million increase in student incomes and $10 million of new saving.

   If you don't want to use the prop, students are good at imagining that this could happen if you'll simply ask them to imagine that a new $1 million injection of investment spending (or government or export sales) occurs, and then go through the chain of events described above.

3. Note that the multiplier effect can work in reverse as well as the forward direction. The closing of a military base or a factory shutting down has a multiplied impact on the local community, reducing retail sales and placing a hardship on other businesses. Ask students to offer examples of the multiplier effect that they have witnessed.

   Government spending has frequently been targeted geographically to boost a local economy. The special-interest effect can often be seen in the choices that are made. Powerful congressmen have a vested interest in directing funds to their districts. The balanced-budget multiplier analysis can be viewed as a justification for shifting resources from the private sector to the government sector. Politicians can cheerfully spend more money and demonstrate with the balanced budget multiplier that we are better off with a higher level of GDP than would be the case if the money were left in private hands. Government spends all of its money, and consumers have this habit of saving a bit. It is this bit of saving that creates the balanced budget multiplier.

4. Note that net exports are kept as independent of the level of GDP to keep the analysis simple. You may want to note in passing that, in fact, there tends to be a direct relationship between import spending and the level of GDP.
5. The Last Word for this chapter is a humorous look at the multiplier. demonstration of the concept. Not only is it funny, but it provides a good
6. The "Economics USA" video series has a good segment on Keynes and the Great Depression. Call 1-800- LEARNER for information, or ask your McGraw-Hill representative about the availability of these tapes.

• This chapter examines why and how a particular level of real GDP might change.
• The revised model adds realism by including the foreign sector and government in the aggregate expenditures model. C.The new model is then applied to two historical periods and some of its deficiencies are considered. The focus remains on real GDP.

• Equilibrium GDP changes in response to changes in the investment schedule or to changes in the saving- consumption schedules. Because investment spending is less stable than the saving-consumption schedule, this chapter's focus will be on investment changes.
• Figure 10-1 shows the impact of changes in investment. Suppose investment spending rises (due to a rise in profit expectations or to a decline in interest rates).

• In both cases, the $5 billion increase in investment leads to a $20 billion increase in equilibrium GDP.
• Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20 billion.
• The multiplier effect:

• The multiplier is based on two facts.

• The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP.
• The simple multiplier given above can be generalized to include other "leakages" from the spending flow besides savings. For example, the realistic multiplier is derived by including taxes and imports as well as savings in the equation. (Key Question 2)

• Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending.

• The net export schedule (Table 10-2):

• The impact of net exports on equilibrium GDP is illustrated in Figure 10-4.

• International economic linkages:

• Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. (Many of these simplifications are dropped in Chapter 12, where there is further analysis on the government sector.)

• Table 10-3 gives a tabular example and Figure 10-5 gives the graphical illustration.

• Table 10-4 and Figure 10-6 show the impact of taxes. (Key Question 8)

• Balanced-budget multiplier is a curious result of this effect.

• When equilibrium GDP is below full-employment GDP, a recessionary gap exists.

• When aggregate expenditures exceed full-employment GDP, an inflationary gap exists.

• The Great Depression of the 1930s provides a significant case study. A major factor was the decline in investment spending, which fell by 82 percent between 1929 and 1933.

• The Vietnam War era inflation provides a historical example of an inflationary gap period.

• The aggregate expenditures model has four limitations.

• In Chapter 11, these deficiencies are remedied with a related aggregate demand-aggregate supply model.

• Humorist Art Buchwald illustrates the concept of the multiplier with this funny essay.
• Hofberger, a Chevy salesman in Tomcat, Va., called up Littleton of Littleton Menswear & Haberdashery, and told him that a new Nova had been set aside for Littleton and his wife.
• Littleton said he was sorry, but he couldn't buy a car because he and Mrs. Littleton were getting a divorce.
• Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the Hofbergers' home.
• Hofberger said he couldn't, because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger could not afford to paint his house.
• When Bedcheck went home that evening, he told his wife to return their new television set to Gladstone's TV store.When she returned it the next day, Gladstone immediately called his travel agent and canceled his trip. He said he couldn't go because Bedcheck returned the TV set because Hofberger didn't sell a car to Littleton because Littletons are divorcing.
• Sandstorm, the travel agent, tore up Gladstone's plane tickets, and immediately called his banker, Gripsholm, to tell him that he couldn't pay back his loan that month.
• When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the banker told him that he had no money to lend because Sandstorm had not repaid his loan yet.
• Rudemaker called his contractor, Eagleton, who had to lay off eight men.
• Meanwhile, General Motors announced it would give a rebate on its new models. Hofberger called Littleton to tell him that he could probably afford a car even with the divorce. Littleton said that he and his wife had made up and were not divorcing. However, his business was so lousy that he couldn't afford a car now. His regular customers, Bedcheck, Gladstone, Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month!

• If this means people have become less wealthy, then their consumption schedule will shift down and GDP will decrease by a multiple of the decrease in consumption. However, if the decline in government bond holding means households have been cashing them in to increase their consumption, then the effect will be the opposite.
• The increased consumption--and the possible increased investment in addition--will increase GDP.
• This will increase interest-sensitive consumer purchases and investment, causing GDP to increase.
• By reducing consumption (because households will feel--or be--less wealthy, or because they fear a recession) and by decreasing investment, the AE schedule will shift downward, causing the GDP to decline.
• This will increase AE, causing GDP to increase.
• Investment will increase both because of increased profitability and because of increased innovations, causing GDP to increase.
• The announcement will lead to an upward shift of the saving schedule (downward shift of the consumption schedule), causing GDP to decline.
• To the extent that this leads to increased buying for, say, a year, the AE schedule will shift upward for a year, leading to a temporary increase in GDP.
• An increase in the personal income tax will decrease the level of disposable income, decrease consumer spending, which could mean a decline in aggregate expenditures. But if the government increases its purchases to the extent of the tax increase, then aggregate expenditures will actually increase, since consumer expenditures fall only by a fraction of the decline in income and government spending is more than offsetting this decline. If this happens, the equilibrium level of GDP should rise. On the other hand, if government spending does not rise, then the equilibrium level of GDP may fall as private spending falls.

The multiplier effect is the magnified increase in equilibrium GDP that occurs when any component of aggregate expenditures changes. The greater the MPC (the smaller the MPS), the greater the multiplier.

MPS = 0, multiplier = infinity; MPS = .4, multiplier = 2.5; MPS = .6, multiplier = 1.67; MPS = 1, multiplier = 1.

MPC = 1; multiplier = infinity; MPC = .9, multiplier = 10; MPC = .67; multiplier = 3; MPC = .5, multiplier = 2; MPC = 0, multiplier = 1.

MPC = .8: Change in GDP = $40 billion (= $8 billion [!]multiplier of 5); MPC = .67: Change in GDP = $24 billion ($8 billion [!]multiplier of 3). The simple multiplier takes account of only the leakage of saving. The complex multiplier also takes account of leakages of taxes and imports, making the complex multiplier less than the simple multiplier.

If the slope of the aggregate expenditures schedule were .8, then the MPC = .8 and the MPS = .2. Therefore, the multiplier would be 1/(.2) = 5. The ratio of decline in real GDP to the initial drop of expenditures would be a ratio of 5:1. That is, if expenditures declined by $100 million, GDP should decline by $500 million. On the graph it can be seen that a one-unit decline in (C + I) leads to a five-unit decline in real GDP.

A planned increase in saving means a decline in consumer spending. This decrease in aggregate expenditures means a downward shift in the schedule, and the multiplier effect will cause the new real GDP to be lower than the initial level by a factor equal to the multiplier. If, as in #3, the multiplier were 5, then the real GDP would drop by 5 times the initial decline in consumption. It is possible that this new low level of income will not support higher saving, because there is a direct relationship between income and saving. While households intended to save more by increasing the fraction of their income saved, they now have less income and a smaller income "pie" to divide. The larger fraction of a smaller pie may not be any more than the previous smaller fraction of the bigger income pie. (This is known as the paradox of thrift.)

If investment rose to offset the increase in saving, real GDP would not be affected in terms of its level. However, the composition would change from consumer goods toward more capital goods production. This is desirable for a society's future growth in output and productivity potential.

• Graph this consumption schedule and note the size of the MPC.
• Assume now a lump-sum tax system is imposed such that the government collects $10 billion in taxes at all levels of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with that of the pretax consumption schedule.
  • The size of the MPC is 80/100 or .8 because consumption changes by 80 when GDP changes by 100.
  • The resulting consumption schedule will be exactly $10 billion below the original at all levels of GDP, because people now have to pay $10 billion in tax out of each level of income. The multiplier should be 5 because the MPS is .2 and 1/.2 is 5. We see on the graph that the equilibrium GDP has fallen to $150 billion. That is equilibrium GDP fell by $50 billion when expenditures fell by $10 billion, a multiple of 5 times the decline in expenditures.

Question 7 has been changed to add a lump-sum tax. The figure below shows both the changes in C and the change in T you could use this in the IM or use the 2 figures from the text on the next pages.

Before G is added, private sector equilibrium will be at 470. The addition of government expenditures of G to our analysis raises the aggregate expenditures (C + I_g+X_n+ G) schedule and increases the equilibrium level of GDP as would an increase in C, 1_g, or X_n. Note that changes in government spending are subject to the multiplier effect. In terms of the leakages-injections approach, government spending supplements private investment and export spending (I_g+ X + G), increasing the equilibrium GDP to 550.

The addition of $20 billion of government expenditures and $20 billion of personal taxes increases equilibrium GDP from $350 to $370 billion. The $20 billion increase in G raisesequilibrium GDP by $100 billion (= $20 billion [!] the multiplier of 5); the $20 billion increase in T reducesconsumption by $16 billion (= $20 billion [!]the MPC of .8). This $16 billion decline in turn reduces equilibrium GDP by $80 billion (= $16 billion [!]multiplier of 5). The net change from adding government is $20 billion (= $100 billion - $80 billion).

The balanced-budget multiplier stems from the fact that increases in government spending go directly into the flow of aggregate expenditures. Whereas the tax increase reduces incomes by the amount of the tax, but spending will be reduced by a fraction of the income reduction (the fraction will be equal to the MPC), and the multiplier effect will work in opposite directions on the increase and the reduction in spending. But the reduction will be less than the increase due to the initial government spending influx, which was not affected by the MPC. Since this initial "shot" of government spending was not offset by an equal and opposite effect on the downside from the tax increase, it is an addition to the aggregate expenditures flow which just equals the change in the budget. Thus, we say the balanced budget multiplier is equal to 1.

In question 8, the added government spending alone would increase GDP by 5 [!]$20 billion, and the tax increase would reduce GDP by 5 [!]$16 billion, for a net change of ($ 100 - $80) billion or $20 billion. This is equal to 1 [!] the change in G and T so the balanced budget multiplier is 1 in this example. (Note: The multiplier is 5 because MPS = .2 and 1/.2 = 5. The tax increase reduces consumer spending by $16 billion because the tax reduces incomes by $20, and this will reduce spending by a factor equal to the MPC, or 8 [!] $20 billion.)

The quote does hold true regardless of the size of the MPS. This is true because the only increase in expenditures that will occur is a result of the initial change in government spending. Beyond that, increases in spending from the "ripple" effect of the initial change in G will be exactly offset by decreases in spending which result from the "ripple" effect caused by the higher taxes. It doesn't matter whether the multiplier is 10 or 2, the offsetting effect will occur on all changes except the initial increase in government spending.

• If full employment in this economy is 130 million, will there be an inflationary or recessionary gap? What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
• Will there be an inflationary or recessionary gap if the full-employment level of output is $500 billion? Explain the consequences. By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
• Assuming that investment, net exports, and government expenditures do not change with changes in real GDP, what are the sizes of the MPC, the MPS, and the multiplier?
  • A recessionary gap. Equilibrium GDP is $600 billion, while full employment GDP is $700 billion. Employment will be 20 million less than at full employment. Aggregate expenditures would have to increase by $20 billion (= $700 billion -$680 billion) at each level of GDP to eliminate the recessionary gap.
  • An inflationary gap. Aggregate expenditures will be excessive, causing demand-pull inflation. Aggregate expenditures would have to fall by $20 billion (= $520 billion -$500 billion) at each level of GDP to eliminate the inflationary gap.
  • MPC = .8 (= $40 billion/$50 billion); MPS = .2 (= 1 -.8); multiplier = 5 (= 1/.2).

• Calculate the equilibrium level of income for this economy. Check your work by expressing the consumption, investment, and net export schedules in tabular form and determining the equilibrium GDP. What will happen to equilibrium Yif I_gchanges to 10? What does this tell you about the size of the multiplier?
• Y= C+ I_g+ X_n= $50 + 0.8Y + $30 +$10 = 0.8Y+ $90
• Therefore Y- 0.8Y= $90, and 0.2Y= $90, so Y= $450 at equilibrium.

• If I_gdecreases from $30 to $10, the new equilibrium GDP will be at GDP of $350, for with I_gnow $10 this is where AE also equals $350. This indicates that the multiplier equals 5, for a decline in AE of $20 has led to a decline in equilibrium GDP of $100. The size of the multiplier could also have been calculated directly from the MPC of 0.8 .

The central idea illustrated is the multiplier effect that exists in a market economic system. One independently determined change in spending has an effect on another's income, which then sets in motion a chain of events whereby spending changes directly with the income changes. A decline in spending begins a chain of declines, or, in other words, the initial decrease in spending is multiplied in terms of the final effect of this single decision. This occurs because of the observation that any change in income causes a change in spending that is directly proportional to it.