LEAKAGES VS INJECTIONS THE MULTIPLIER IN ACTION Ch

LEAKAGES VS. INJECTIONS &THE MULTIPLIER IN ACTION Ch. 10 Instability or Self Adjustment

PREDICTIONS OF MACRO FAILURE (UNEMPLOYMENT, OUTPUT AND PRICES DON’T MEET GOALS) Keynes Classical Economists In short run—they WILL occur In short run—they MAY occur In long run—they WILL persist In long run—they WON’T persist

IDEAL WORLD: AT FULL EMPLOYMENT GDP, SUFFICIENT INCOME TO BUY ALL GOODS PRODUCED Leakages: Output that is lost to the circular flow Injections: Additions of spending to the circular flow Leakages and injections balance each other out. PROBLEM! • Imbalances between income and output • Instability where economic goals are met briefly

THE ROOT OF FAILURES: IMBALANCES & INSTABILITY Leakages Output that is lost to the circular flow Consumer / Business Saving � Personal / Business Taxes � Imports � Injections Additions of spending to the circular flow � Investment � Government � Exports Spending

THE CIRCULAR FLOW The focus of macro concern is whether desired injections will offset desired leakage at full employment. � Full employment GDP is the value of total output (real GDP) produced at full employment. LO 1

LEAKAGES AND INJECTIONS Government spending Exports Investment Product market Households (disposable income) Business Firms Factor market Saving Imports Household taxes LO 1 LEAKAGES Business Gross Business Saving taxes (Dep. & Ret Earnings)

CONSUMER SAVING Saving is a primary leakage from the circular flow. Saving represents income not directly returned to the product markets. Paradox of Thrift: Impossible to save your way out of recession—dollars saved represent further consumption forgone, recession worsens LO 1

SELF ADJUSTMENT OR INSTABILITY Self Adjustment (Classical) Injections =Leakages � Suppliers can lower prices to encourage spending again Injections = Leakages � Savings won’t sit around long Flexible Price Levels � Full Employment GDP Flexible Interest Rates � Instability (Keynes) DESPITE Flexible Rates � No Full Employment GDP Lower Consumption hurts business expectations (why invest if no one is buying) DESPITE New Price Levels � Expectations still stall investment

THE MULTIPLIER EFFECT “No holiday season”

“NO HOLIDAY SEASON” Divide into 7 groups Each group assigned a short skit (1 -3 minutes) � 10 minutes to prepare Perform skits in sequence � Describe each step in sequence on organizer Complete debriefing questions with group � 5 minutes to complete � 5 minutes for class discussion

DISCUSSION QUESTIONS Define the multiplier effect in your own words. What does the multiplier effect tell us about the chances for self-adjustment? Where do we see the multiplier effect today?

THE MULTIPLIER Multiple by which an initial change in spending will alter total spending as it moves through the circular flow of economic activity ad infinitum Multiplier=___1___ 1—MPC A “snowball effect”

THE MULTIPLIER LO 2

THE MULTIPLIER PROCESS 3. Income reduced by $100 billion 7. Income reduced by $75 billion more 4. Consumption reduced by $75 billion Househol ds Factor markets 8. Consumption reduced by $56. 25 billion more Product markets 9. And so on 6. Further cutbacks in employment or wages Cutbacks in employment or wages LO 2 Business firms 5. Sales fall $75 billion 1. $100 billion in unsold goods appear

THE MULTIPLIER CYCLES LO 2

MULTIPLIER CAVEATS… 1/1 -MPC is OVERSIMPLIFIED � U. S. MPC estimated at around 0. 9 Should mean a multiplier of 10! REALITY: Multiplier is less than 2 What reduces the multiplier? � Imports (as GDP grows, so do imports—a leakage) � Inflation (change price levels) � Income taxes(higher taxes lower multiplier)

KEYNESIAN ADJUSTMENT IN ACTION • If leakages > injections 1 st Action • Then producers reduce output & lay off workers LO 2 2 nd Step • If Income falls • Then consumer spending falls 3 rd Step • If consumer spending falls • Then producers will further reduce output & lay off more workers Why? The multiplier effect!

Price Level (average price) MULTIPLIER EFFECTS AS C = $300 billion I = $100 billion P 0 m d a b AD 0 c AD 1 AD 2 2600 2900 QF = 3000 Real Output (in billions of dollars per year) LO 2

CHECK FOR UNDERSTANDING If the MPC is 0. 8 and investors have reduced planned investment by $100, by how much will the AD shift? � How much of the shift is induced by the multiplier (not the original) � Graph the recessionary gap

PRICE AND OUTPUT EFFECTS LO 3 The impact of a shift in aggregate demand is reflected in both output and price changes.

RECESSIONARY GDP GAP LO 3 The Multiplier’s overall scope is REDUCED by changes in price level As long as the aggregate supply curve is upwardsloping, the shock of any AD shift will be spread across output and prices.

RECESSIONARY GDP GAP The recessionary GDP gap is the amount by which equilibrium GDP falls short of fullemployment GDP. The recessionary GDP gap equals the difference between equilibrium real GDP (QE) and full-employment real GDP (QF). Result=Cyclical Unemployment LO 3

RECESSIONARY GDP GAP PRICE LEVEL (average price) AS AD 2 P 0 PE m a c AD 0 Recessionary GDP gap QE QF REAL OUTPUT (in billions of dollars per year) LO 3

CLOSING THE GAP Trade-off unemployment reductions for inflation increases Explains why full employment is not the same as zero unemployment

CHECK FOR UNDERSTANDING Describe how the multiplier would work for an INCREASE in autonomous spending? � MPC =0. 75 � Increase=Stimulus check of $250 � What is the full shift of AD? � What is induced? � Graph the Inflationary Gap

NEXT STEPS… Complete Unit 3 Study Guide Take Quia Quizzes on Chapters 8 -10 � Chapter 8 http: //www. quia. com/quiz/2661735. html � Chapters 9 & 10 http: //www. quia. com/quiz/2681803. html I will use the best of the two scores TOMORROW: Test!