Eastlake High School Income and Expenditure Equilibrium Discussions

Question Description

I’m working on a Economics exercise and need support.

Instructions: Post one significant sentence from any chapter 10-12 and one from any chapter 13-14. And please explain why it is a powerful sentence. 
Please find the chapters 10-14 attached as a pdf.

1 attachmentsSlide 1 of 1attachment_1attachment_1.slider-slide > img { width: 100%; display: block; }
.slider-slide > img:focus { margin: auto; }

Unformatted Attachment Preview

CHA PT E R 1 0
Income and Expenditures
Equilibrium
FUNDAMENTAL QUESTIONS
1. What does equilibrium mean
in macroeconomics?
2. How do aggregate
expenditures affect income,
or real GDP?
ª Antb/Shutterstock.com
3. What are the leakages from
and injections into spending?
4. Why does equilibrium real
GDP change by a multiple of a
change in autonomous
expenditures?
Preview
top: ª Carsten Reisinger/Shutterstock
What determines the level of income and expenditures, or real GDP? In the chapter titled
“Macroeconomic Equilibrium: Aggregate Demand and Supply,” we used aggregate
demand and aggregate supply to answer this question. Then, in the chapter titled
“Aggregate Expenditures,” we developed the components of aggregate expenditures in
more detail to provide the foundation for an additional approach to answering the question,
“What determines the level of real GDP?” If you know the answer to this question, you are
well on your way to understanding business cycles. Sometimes real GDP is growing and
jobs are relatively easy to find; at other times real GDP is falling and large numbers of people are out of work. Macroeconomists use several models to analyze the causes of busi-
5. What is the spending
multiplier?
6. What is the relationship
between the GDP gap and
the recessionary gap?
7. How does international
trade affect the size of the
spending multiplier?
8. Why does the aggregate
expenditures curve shift with
changes in the price level?
ness cycles. Underlying all of these models is the concept of macroeconomic equilibrium.
203
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
204
Chapter 10 Income and Expenditures Equilibrium
Equilibrium here means what it did when we talked about supply and demand: a point
of balance, a point from which there is no tendency to move. In macroeconomics, equilibrium is the level of income and expenditures that the economy tends to move toward
and remain at until autonomous spending changes.
Economists have not always agreed on how an economy reaches equilibrium or on
the forces that move an economy from one equilibrium to another. This last issue
formed the basis of economic debate during the Great Depression of the 1930s. Before
the 1930s, economists generally believed that the economy was always at or moving toward an equilibrium consistent with a high level of employed resources. The British
economist John Maynard Keynes did not agree. He believed that an economy can come
to rest at a level of real GDP that is too low to provide employment for all those who
desire it. He also believed that certain actions are necessary to ensure that the economy
rises to a level of real GDP consistent with a high level of employment. In particular,
Keynes argued that government must intervene in the economy in a big way (see the
Economic Insight “John Maynard Keynes”).
To understand the debate that began during the 1930s and continues on various
fronts today, it is necessary to understand the Keynesian view of how equilibrium real
GDP is determined. This is our focus here. We have seen in the chapter titled
“Macroeconomic Equilibrium: Aggregate Demand and Supply” that the aggregate
demand and supply model of macroeconomic equilibrium allows the price level to fluctuate as the equilibrium level of real GDP changes. The Keynesian income-expenditures
model assumes that the price level is fixed. It emphasizes aggregate expenditures without explicitly considering the supply side of the economy. This is why we considered the
components of spending in detail in the chapter titled “Aggregate Expenditures”—to
provide a foundation for the analysis in this chapter. The Keynesian model may be
viewed as a special fixed-price case of the aggregate demand and aggregate supply
model. In later chapters, we examine the relationship between equilibrium and the level
of employed resources and the effect of government policy on both of these elements.
10-1 Equilibrium Income and Expenditures
1. What does equilibrium
mean in macroeconomics?
Equilibrium is a point from which there is no tendency to move. People do not change their
behavior when everything is consistent with what they expect. However, when plans and
reality do not match, people adjust their behavior to make them match. Determining a
nation’s equilibrium level of income and expenditures is the process of defining the level of
income and expenditures at which plans and reality are the same.
10-1a Expenditures and Income
2. How do aggregate
expenditures affect income,
or real GDP?
We use the aggregate expenditures function described at the end of the chapter titled
“Aggregate Expenditures” to demonstrate how equilibrium is determined. Keep in mind that
the aggregate expenditures function represents planned expenditures at different levels of
income, or real GDP. We focus on planned expenditures because they represent the amount
that households, firms, government, and the foreign sector expect to spend.
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 10 Income and Expenditures Equilibrium
205
ECONOMIC INSIGHT
John Maynard Keynes
John Maynard Keynes (pronounced “canes”) is considered
by many to be the greatest economist of the twentieth
century. His major work, The General Theory of Employment,
Interest, and Money, had a profound impact on macroeconomics, both in thought and policy. Keynes was born in
Cambridge, England, on June 5, 1883. He studied economics
at Cambridge University, where he became a lecturer in
economics in 1908. During World War I, Keynes worked for
the British treasury. At the end of the war, he was the treasury’s representative at the Versailles Peace Conference. He
resigned from the British delegation at the conference to protest the harsh terms being imposed on the defeated countries. His resignation and the publication of Economic
Consequences of the Peace (1919) made him an international
celebrity.
In 1936, Keynes published The General Theory. It was a
time of world recession (it has been estimated that around
one-quarter of the U.S. labor force was unemployed at the
height of the Depression), and policymakers were searching
for ways to explain the persistent unemployment. In the book,
Keynes suggested that an economy could be at equilibrium at
less than potential GDP. More important, he argued that government policy could be altered to end recession. His analysis
emphasized aggregate expenditures. If private expenditures
were not sufficient to create equilibrium at potential GDP, government expenditures could be increased to stimulate income
and output. This was a startling concept. Most economists of
the time believed that government should not take an active
role in the economy. With his General Theory, Keynes started
a “revolution” in macroeconomics.
Andre Seale/Alamy
Actual expenditures always
equal income and output because
they reflect changes in inventories.
That is, inventories automatically
raise or lower investment expenditures so that actual spending equals
income, which equals output,
which equals real GDP. However,
aggregate expenditures (which are
planned spending) may not equal
real GDP. What happens when
planned spending and real GDP
are not equal?
When planned spending on
goods and services exceeds the current value of output, the production
of goods and services increases.
Because output equals income, the
level of real GDP also increases.
This is the situation for all income
levels below $500 in Figure 1. At Net exports equal exports minus imports. Agricultural products are important exports for many
these levels, total spending is greater countries, like these papayas being shipped from the port of Manaus Amazonas Brazil. If sold to
than real GDP, which means that a U.S. importer, the papayas will represent Brazilian exports and contribute to increased GDP in
Brazil by means of higher net exports.
more goods and services are being
purchased than are being produced. The only way this can happen is for goods produced in
the past to be sold. When planned spending is greater than real GDP, business inventories fall.
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
206
Chapter 10 Income and Expenditures Equilibrium
FIGURE 1 The Equilibrium Level of Real GDP
(1)
Real GDP
(Y )
$0
(2)
Consumption
(C )
(3)
Investment
(I )
(4)
Government
Spending
(G)
$30
$50
$70
(5)
Net
Exports
(X )
(6)
Aggregate
Expenditures
(AE )
(7)
Unplanned
Change in
Inventories
$200
$200
$50
(8)
Change in
Real GDP
Increase
$100
$100
$50
$70
$40
$260
$160
Increase
$200
$170
$50
$70
$30
$320
$120
Increase
$300
$240
$50
$70
$20
$380
$80
Increase
$400
$310
$50
$70
$10
$440
$40
$500
$380
$50
$70
$0
$500
$0
$600
$450
$50
$70
$10
$560
$40
Decrease
$700
$520
$50
$70
$20
$620
$80
Decrease
Increase
No change
AE < Y Income Falls 700 Expenditures (AE ) (dollars) 600 Equilibrium 500 AE > Y
Income Rises
400
AE
300
200
100
45
0
100
200
300
400
500
600
700
Real GDP (Y ) (dollars)
Macroeconomic equilibrium occurs where aggregate expenditures (AE) equal real GDP (Y). In the graph it is the point where the AE line
crosses the 45-degree line, where expenditures and real GDP both equal $500. When aggregate expenditures exceed real GDP (as they do
at a real GDP level of $400, for example), real GDP rises to the equilibrium level. When aggregate expenditures are less than real GDP (as
they are at a real GDP level of $600, for example), real GDP falls back to the equilibrium level.
When aggregate expenditures
exceed real GDP, real GDP
rises.
This change in inventories offsets the excess of planned expenditures over real GDP, so actual
expenditures (including the unplanned change in inventories) equal real GDP. You can see
this in column 7 of the table in Figure 1, where the change in inventories offsets the excess of
aggregate expenditures over real GDP (the difference between columns 6 and 1).
What happens when inventories fall? As inventories fall, manufacturers increase production to meet the demand for products. The increased production raises the level of real
GDP. When aggregate expenditures exceed real GDP, real GDP rises.
At real GDP levels above $500 in the table, aggregate expenditures are less than income.
As a result, inventories are accumulating above planned levels—more goods and services are
being produced than are being purchased. As inventories rise, businesses begin to reduce the
quantity of output they produce. The unplanned increase in inventories is counted as a form
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
207
Chapter 10 Income and Expenditures Equilibrium
of investment spending so that actual expenditures equal real GDP. For example, when real
GDP is $600, aggregate expenditures are only $560. The $40 of goods that are produced but
not sold are measured as inventory investment. The $560 of aggregate expenditures plus the
$40 of unplanned inventories equal $600, the level of real GDP. As inventories increase,
firms cut production; this causes real GDP to fall. When aggregate expenditures are less than
real GDP, real GDP falls.
There is only one level of real GDP in the table in Figure 1 at which real GDP does not
change. When real GDP is $500, aggregate expenditures equal $500. The equilibrium level of
real GDP (or output) is that point at which aggregate expenditures equal real GDP (or output).
When aggregate expenditures equal real GDP, planned spending equals the output produced and the income generated from producing that output. As long as planned spending
is consistent with real GDP, real GDP does not change. But if planned spending is higher or
lower than real GDP, real GDP does change. Equilibrium is that point at which planned
spending and real GDP are equal.
The graph in Figure 1 illustrates equilibrium. The 45-degree line shows all possible
points where aggregate expenditures (measured on the vertical axis) equal real GDP (measured on the horizontal axis). The equilibrium level of real GDP, then, is simply the point
where the aggregate expenditures line (AE) crosses the 45-degree line. In the figure, equilibrium occurs where real GDP and expenditures are $500.
When the AE curve lies above the 45-degree line—for example, at a real GDP level of
$400—aggregate expenditures are greater than real GDP. What happens? Real GDP rises to
the equilibrium level, where it tends to stay. When the AE curve lies below the 45-degree
line—at a real GDP level of $600, for example—aggregate expenditures are less than real
GDP; this pushes real GDP down. Once real GDP falls to the equilibrium level ($500 in our
example), it tends to stay there.
When aggregate expenditures
are less than real GDP, real
GDP falls.
The equilibrium level of real
GDP is where aggregate
expenditures equal real GDP.
10-1b Leakages and Injections
Equilibrium can be determined by using aggregate expenditures and real GDP, which represents income. Another way to determine equilibrium involves leakages from and injections
into the income stream, the circular flow of income and expenditures.
Leakages reduce autonomous aggregate expenditures. There are three leakages in j the
stream from domestic income to spending: saving, taxes, and imports.
•
•
•
The more households save, the less they spend. An increase in autonomous saving
means a decrease in autonomous consumption, which could cause the equilibrium level
of real GDP to fall (see the Economic Insight “The Paradox of Thrift”).
Taxes are an involuntary reduction in consumption. The government transfers income
away from households. Higher taxes lower autonomous consumption, in the process
lowering autonomous aggregate expenditures and the equilibrium level of real GDP.
Imports are expenditures for foreign goods and services. They reduce expenditures on
domestic goods and services. An autonomous increase in imports reduces net exports,
causing autonomous aggregate expenditures and the equilibrium level of real GDP to fall.
For equilibrium to occur, these leakages must be offset by corresponding injections of
spending into the domestic economy through investment, government spending, and
exports.
•
•
•
3. What are the leakages from
and injections into spending?
Saving, taxes, and imports are
leakages that reduce
autonomous aggregate
expenditures.
Investment, government
spending, and exports are
injections that increase
autonomous aggregate
expenditures.
Household saving generates funds that businesses can borrow and spend for investment
purposes.
The taxes collected by government are used to finance government purchases of goods
and services.
Exports bring foreign expenditures into the domestic economy.
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
208
Chapter 10 Income and Expenditures Equilibrium
ECONOMIC INSIGHT
The Paradox of Thrift
People generally believe that saving is good and more saving
is better. However, if every family increased its saving, the
result could be less income for the economy as a whole. In
fact, increased saving could actually lower savings for all
households.
An increase in saving may provide an example of the paradox of thrift. A paradox is a true proposition that seems to
contradict common beliefs. We believe that we will be better
off if we increase our saving, but in the aggregate, increased
saving could cause the economy to be worse off. The paradox of thrift is a fallacy of composition: the assumption that
what is true of a part is true of the whole. It often is unsafe to
generalize from what is true at the micro level to what is true
at the macro level.
The graph illustrates the effect of higher saving. Initial
equilibrium occurs where the S1 þ T þ IM curve intersects
the I þ G þ EX curve, at an income of $500. Suppose saving
Saving
Increases
100
Leakages (S + T + I M ),
Injections (I + G + EX) (dollars)
increases by $20 at every level of income. The S1 þ T þ IM
curve shifts up to the S2 þ T þ IM curve. A new equilibrium
is established at an income level of $400. The higher rate of
saving causes equilibrium income to fall by $100.
Notice that the graph is drawn with a constant I þ G þ
EX line, since these are autonomous spending items that do
not depend upon income. If investment increases along with
saving, equilibrium income will not necessarily fall. In fact,
because saving is necessary before there can be any investment, we would expect a greater demand for investment
funds to induce higher saving. If increased saving is used to
fund investment expenditures, the economy should grow
over time to higher and higher levels of income. Only if the
increased saving is not injected back into the economy is
there a paradox of thrift. The fact that governments do not
discourage saving suggests that the paradox of thrift generally is not a real-world problem,
80
S2
S1
e2
e1
60
20
–20
T
G
IM
IM
EX
Income
Falls
40
0
I
T
100
200
300
400
500
600
Real GDP (Y ) (dollars)
–40
–60
The equilibrium level of real
GDP occurs where leakages
equal injections.
There is no reason to expect that each injection will match its corresponding leakage—
that investment will equal saving, that government spending will equal taxes, or that exports
will equal imports. But for equilibrium to occur, total injections must equal total leakages.
Figure 2 shows how leakages and injections determine the equilibrium level of real
GDP. Column 5 of the table lists the total leakages from aggregate expenditures: saving (S)
plus taxes (T) plus imports (IM). Saving and imports both increase when real GDP
increases. We assume that there are no taxes, so the total amount of leakages (S þ T þ IM)
increases as real GDP increases.
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
209
Chapter 10 Income and Expenditures Equilibrium
FIGURE 2 Leakages, Injections, and Equilibrium Income
(1)
Real
GDP
(Y )
(2)
Saving
(S )
(3)
(4)
(5)
Taxes Imports
Leakages
(T )
(IM)
(S T IM)
(7)
(6)
Government
(8)
(9)
Investment
Spending
Exports
Injections
(I )
(G)
(EX )
(I G EX )
(10)
Change in
Real GDP
$0
$30
$0
$0
$30
$50
$70
$50
$170
Increase
$100
$0
$0
$10
$10
$50
$70
$50
$170
Increase
$200
$30
$0
$20
$50
$50
$70
$50
$170
Increase
$300
$60
$0
$30
$90
$50
$70
$50
$170
Increase
$400
$90
$0
$40
$130
$50
$70
$50
$170
Increase
$500
$120
$0
$50
$170
$50
$70
$50
$170
No change
$600
$150
$0
$60
$210
$50
$70
$50
$170
Decrease
$700
$180
$0
$70
$250
$50
$70
$50
$170
Decrease
Leakages (S + T + IM ),
Injections (I + G + EX) (dollars)
S
200
S T IM I G EX
(Leakages) (Injections)
Income Falls
Equilibrium
I
G
T IM
EX
150
S T IM I G EX
(Leakages) (Injections)
Income Rises
100
50
0
–50
100
200
300
400
500
600
700
Real GDP (Y ) (dollars)
Leakages equal saving (S ), taxes (T ), and imports (IM ). Injections equal investment (I ), government spending (G ), and exports (EX ).
Equilibrium is that point where leakages equal injections. In the graph, equilibrium is the point at which the S þ T þ IM curve intersects the
I þ G þ EX curve, where real GDP (Y) equals $500. At lower levels of income, injections exceed leakages, so Y rises. At higher levels of
income, leakages exceed injections, so Y falls
Column 9 lists the injections at alternative income levels. Because investment (I), government spending (G), and exports (EX) are all autonomous, total injections (I þ G þ EX)
are constant at all levels of real GDP.
To determine the equilibrium level of real GDP, we compare leakages with injections.
When injections exceed leakages, planned spending is greater than current income or output, so real GDP rises. In the table in Figure 2, this occurs for levels of real GDP under
$500, so real GDP increases if it is under $500 (see the last column). When leakages exceed
injections, planned spending is less than current real GDP, so real GDP falls. In Figure 2, at
all levels of real GDP above $500, real GDP falls. Only when leakages equal injections is the
equilibrium level of real GDP established. When real GDP equals $500, both leakages and
injections equal $170, so there is no pressure for real GDP to change. The equilibrium level
of real GDP occurs where leakages (S þ T þ IM) equal injections (I þ G þ EX).
Figure 2 shows the interaction of leakages and injections graphically. The equilibrium
point is where the S þ T þ IM and I þ G þ EX curves intersect, at a real GDP level of $500.
At higher levels of real GDP, leakages are greater than injections (the S þ T þ IM curve lies
above the I þ G þ EX curve). When leakages are greater than injections, real GDP falls
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
210
Chapter 10 Income and Expenditures Equilibrium
to the equilibrium point. At lower levels of income, injections are greater than leakages
(the I þ G þ EX curve lies above the S þ T þ IM curve). Here real GDP rises until it
reaches $500. Only at $500 is there no pressure for real GDP to change.
If you compare Figure 1 and Figure 2, you can see that it does not matter whether we
use aggregate expenditures or leakages and injections—the equilibrium level of real GDP is
the same.
RECAP
1. Equilibrium is a point from which there is no
tendency to move.
2. When aggregate expenditures exceed real
GDP, real GDP rises.
3. When aggregate expenditures are less than
real GDP, real GDP falls.
5. Investment, government spending, and exports
are injections of planned spending into domestic aggregate expenditures.
6. Equilibrium occurs at the level of real GDP at
which aggregate expenditures equal real GDP,
and leakages equal injections.
4. Saving, taxes, and imports are leakages of
planned spending from domestic aggregate
expenditures.
10-2 Changes in Equilibrium Income
and Expenditures
4. Why does equilibrium real
GDP change by a multiple of a
change in autonomous
expenditures?
5. What is the spending
multiplier?
Any change in autonomous
expenditures is multiplied into
a larger change in equilibrium
real GDP.
Equilibrium is a point from which there is no tendency to move. But in fact, the equilibrium
level of real GDP does move. In the last section, we described how aggregate expenditures
push real GDP, representing the economy’s income and output, up or down toward their
level of equilibrium. Here we examine how changes in autonomous expenditures affect equilibrium. This becomes very important in understanding macroeconomic policy, the kinds of
things that government can do to control the business cycle.
10-2a The Spending Multiplier
Remember that equilibrium is that point where aggregate expenditures equal real GDP. If
we increase autonomous expenditures, then we raise the equilibrium level of real GDP—but
by how much? It seems logical to expect a one-to-one ratio: If autonomous spending
increases by a dollar, equilibrium real GDP should increase by a dollar. Actually, equilibrium
real GDP increases by more than a dollar. The change in autonomous expenditures is multiplied into a larger change in the equilibrium level of real GDP.
In the chapter titled “National Income Accounting,” we used a circular flow diagram to
show the relationship of expenditures to income. In that diagram, we saw how one sector’s
expenditures become another sector’s income. This concept helps explain the effect of a
change in autonomous expenditures on the equilibrium level of income or real GDP. If A’s
autonomous spending increases, then B’s income rises. Then B spends part of that income
in the domestic economy (the rest is saved or used to buy foreign goods), generating new
income for C. In turn, C spends part of that income in the domestic economy, generating
new income for D. And the rounds of increased spending and income continue. All of this
is the product of A’s initial autonomous increase in spending. And each round of increased
spending and income affects the equilibrium level of income, or real GDP.
Let us look at an example, using Table 1. Suppose government spending goes up $20 to
improve public parks. What happens to the equilibrium level of income? The autonomous
increase in government spending increases the income of park employees by $20. As the
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
211
Chapter 10 Income and Expenditures Equilibrium
income of the park employees increases, so does their consumption. For example, let us say
they spend more money on hamburgers. In the process, they are increasing the income of
the hamburger producers, who in turn increase their consumption.
Table 1 shows how a single change in spending generates further changes. Round 1 is
the initial increase in government spending to improve public parks. That $20 expenditure
increases the income of park employees by $20 (column 1). As income increases, those components of aggregate expenditures that depend on current income—consumption and net
exports—also increase by some fraction of the $20.
Consumption changes by the marginal propensity to consume multiplied by the change
in income; imports change by the marginal propensity to import multiplied by the change
in income. To find the total effect of the initial change in spending, we must know the fraction of any change in income that is spent in the domestic economy. In the hypothetical
economy we have been using, the MPC is .70 and the MPI is .10. This means that for each
$1 of new income, consumption rises by $.70 and imports rise by $.10. Spending on domestic goods and services, then, rises by $.60. Because consumption is spending on domestic
goods and services, and imports are spending on foreign goods and services, the percentage
of a change in income that is spent domestically is the difference between the MPC and the
MPI. If the MPC equals .70 and the MPI equals .10, then 60 percent of any change in
domestic income (MPC ” MPI ¼ .60) is spent on domestic goods and services.
In round 1 of Table 1, the initial increase in spending on domestic goods and services
of $12 (.60 $ $20). Out of the $20, $6 is saved, because the marginal propensity to save is
.30 (1 ” MPC). The other $2 is spent on imports (MPI ¼ .10). The park employees receive
$20 more income. They spend $12 on hamburgers at a local restaurant, they save $6, and
they spend $2 on imported coffee.
Only $12 of the workers’ new income is spent on goods produced in the domestic economy, hamburgers. That $12 becomes income to the restaurant’s employees and owner.
When their income increases by $12, they spend 60 percent of that income ($7.20) on
domestic goods (round 2, column 2). The rest of the income is saved or spent on imports.
The percentage of a change in
income that is spent
domestically is the difference
between the MPC and the
MPI.
TABLE 1 The Spending Multiplier Effect
(1)
Change in
Income
(2)
Change in
Domestic
Expenditures
(3)
Change in
Saving
(4)
Change in
Imports
Round 1
$20.00
$12.00
$ 6.00
$2.00
Round 2
12.00
7.20
3.60
1.20
Round 3
7.20
4.32
2.16
0.72
Round 4
4.32
2.59
1.30
0.43
$50.00
$30.00
$15.00
$5.00
Totals
Column 2 ¼ column 1 $ (MPC ” MPI )
Column 3 ¼ column 1 $ MPS
Column 4 ¼ column 1 $ MPI
1
Multiplier ¼
MPS þ MPI
1
¼
ð:30 þ :10Þ
1
¼
:40
¼ 2:50
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
212
Chapter 10 Income and Expenditures Equilibrium
spending multiplier
A measure of the change in
equilibrium income or real
GDP produced by a change in
autonomous expenditures.
NOW YOU TRY IT
The MPS equals .20 and the
MPI equals .10. If
expenditures increase by
$100, how much will the
equilibrium level of real GDP
increase?
Each time income increases, expenditures increase. But the increase is smaller and
smaller in each new round of spending. Why? Because 30 percent of each change in income
is saved and another 10 percent is spent on imports. These are leakages out of the income
stream. This means that just 60 percent of the change in income is spent and passed on to
others in the domestic economy as income in the next round.
To find the total effect of the initial change in spending of $20, we could keep on computing
the change in income and spending round after round, and then sum the total of all rounds.
The change in income and spending never reaches zero, but it becomes infinitely small.
Fortunately, we do not have to compute the increases in spending round by round to
find the total increase. If we know the percentage of additional income that “leaks” from
domestic consumption at each round, we can determine the total change in income, or real
GDP, by finding its reciprocal. This measure is called the spending multiplier. The leakages
are that portion of the change in income that is saved (the MPS) and that proportion of the
change in income that is spent on imports (the MPI).
1
leakages
1
¼
MPS þ MPI
Multiplier ¼
When the MPS is .30 and the MPI is .10, the multiplier equals 2.5 (1/.4). An initial
change in expen