Chapter 11
Econ104 Parks
The 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.
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 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
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.
Example: University builds a new residence
hall worth $100 million. MPC=0.8
• 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?
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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:
•
•
•
•
•
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))
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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:
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.
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.
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.
The Multiplier Effect and a Temporary
Change in Aggregate Demand
•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.
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.