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The Multiplier and Changes in Aggregate Demand

25 April, 2016 - 09:12

In the aggregate expenditures model, a change in autonomous aggregate expenditures changes equilibrium real GDP by the multiplier times the change in autonomous aggregate expenditures. That model,however, assumes a constant price level. How can we incorporate the concept of the multiplier into the model of aggregate demand and aggregate supply?

Consider the aggregate expenditures curves given in Panel (a) of Figure 28.14, each of which corresponds to a particular price level. Suppose net exports rise by $1,000 billion. Such a change increases aggregate expenditures at each price level by $1,000 billion.

A $1,000-billion increase in net exports shifts each of the aggregate expenditures curves up by $1,000 billion, to AE’ P=1.0 and AE’ P=1.5. That changes the equilibrium real GDP associated with each price level; it thus shifts the aggregate demand curve to AD2 in Panel (b). In the aggregate expenditures model, equilibrium real GDP changes by an amount equal to the initial change in autonomous aggregate xpenditures times the multiplier, so the aggregate demand curve shifts by the same amount. In this example, we assume the multiplier is 2. The aggregate demand curve thus shifts to the right by $2,000 billion, two times the $1,000-billion change in autonomous aggregate expenditures.

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Figure 28.14 Changes in Aggregate Demand

The aggregate expenditures curves for price levels of 1.0 and 1.5 are the same as in Figure 28.13, as is the aggregate demand curve. Now suppose a $1,000-billion increase in net exports shifts each of the aggregate expenditures curves up; AEP=1.0, for example, rises to AE′ P=1.0. The aggregate demand curve thus shifts to the right by $2,000 billion, the change in aggregate expenditures times the multiplier, assumed to be 2 in this example.

In general, any change in autonomous aggregate expenditures shifts the aggregate demand curve. The amount of the shift is always equal to the change in autonomous aggregate expenditures times the multiplier. An increase in autonomous aggregate expenditures shifts the aggregate demand curve to the right; a reduction shifts it to the left.

KEY TAKEAWAYS

  • There will be a different aggregate expenditures curve for each price level.
  • Aggregate expenditures will vary with the price level because of the wealth effect, the interest rate effect, and the international trade effect. The higher the price level, the lower the aggregate expenditures curve and the lower the equilibrium level of real GDP. The lower the price level, the higher the aggregate expenditures curve and the higher the equilibrium level of real GDP.
  • A change in autonomous aggregate expenditures shifts the aggregate expenditures curve for each price level. That shifts the aggregate demand curve by an amount equal to the change in autonomous aggregate expenditures times the multiplier.

TRY IT!

Sketch three aggregate expenditures curves for price levels of P1, P2, and P3, where P1 is the lowest price level and P3 the highest (you do not have numbers for this exercise; simply sketch curves of the appropriate shape). Label the equilibrium levels of real GDP Y1, Y2, and Y3. Now draw the aggregate demand curve implied by your analysis, labeling points that correspond to P1, P2, and P3 and Y1, Y2, and Y3. You can use Figure 28.13 as a model for your work.

Case in Point: Predicting the Impact of Alternative Fiscal Policies in 2008

Economists are often asked to simulate the effects of policy changes on the economy. In 2008, as the economy weakened and Congress and the president debated a stimulus package, Mark M. Zandi, an economist at Moody’s Economy.com, produced a paper assessing the impact of various possible stimulus packages. His research produced the following table.

Economists are often asked to simulate the effects of policy changes on the economy. In 2008, as the economy weakened and Congress and the president debated a stimulus package, Mark M. Zandi, an economist at Moody’s Economy.com, produced a paper assessing the impact of various possible stimulus packages. His research produced the following table.

Fiscal Economic Bang for the Buck

One year $ change in real GDP for a given $ reduction in federal tax revenue or increase in spending

Tax cuts

Nonrefundable lump-sum tax rebate

1.02

Refundable lump-sum tax rebate

1.26

Temporary tax cuts

Payroll tax holiday

1.29

Across-the-board tax cu

1.03

Accelerated depreciation

0.27

Permanent tax cuts

Extend alternative minimum tax patch

0.48

Make Bush income tax cuts permanent

0.29

Make dividend and capital gains tax cuts permanent

0.37

Spending increases

Extending UI benefits

1.64

Temporary increase in food stamps

1.73

General aid to state governments

1.36

Increased infrastructure spending

1.59

 


The $100-billion tax rebate for households that was actually passed was of the nonrefundable lump-sum type. “Nonrefundable” refers to the fact those not earning enough to pay income taxes would not receive a rebate, meaning that many households received zero or partial refunds. As shown, he estimated that a $100-billion tax rebate would shift the aggregate demand curve by $102 billion, assuming a constant price level. As part of the analysis, in the article he mentioned that he assumed an MPC of about two-thirds, since many households at the time were living paycheck-to-paycheck. So, consumption would increase by about $67 billion. The implied multiplier is thus 1.54 (= 102/67).

The table shows that other stimuli would have smaller or larger effects. He reasoned that making various tax cuts permanent would have little impact on consumption now, since households in 2008 were cash-strapped. The table shows an estimated bigger bang for the buck from various kinds of government spending increases. That follows, since the change in aggregate expenditure is the full amount of the spending increase instead of the portion of a tax rebate of the same magnitude that consumers decide to spend.

Source: Mark M. Zandi, “Assessing the Macro Economic Impact of Fiscal Stimulus 2008,” Moody’s Economy.com, January 2008.

ANSWER TO TRY IT! PROBLEM

The lowest price level, P1, corresponds to the highest AE curve, AEP = P1, as shown. This suggests a downward sloping aggregate demand curve. Points A, B, and C on the AE curve correspond to points A ′, B′, and C′ on the AD curve, respectively.

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