Economics 1B
COECB1-11
Multiplier
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Eduvos and the Flipped Classroom
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Keynesian model Quiz
1. What is the relationship between aggregate planned expenditure and the real GDP at
equilibrium expenditure?
2. How does equilibrium expenditure come about? What adjusts to achieve equilibrium?
3. If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to
firms’ inventory? How do firms change their production? And what happens to real GDP?
4. If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens
to firms’ inventory? How do firms change their production? And what happens to real GDP?
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Keynesian model Quiz
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What will be covered in the rest of today’s session?
What will be covered in the lecture-led session:
Define, explain and calculate the expenditure multiplier given
fixed price levels.
Discuss the relationship between aggregate expenditure and
aggregate demand and explain the effect of the multiplier on
expenditure and income.
The Multiplier
The Multiplier: The amount by which a change in autonomous expenditure is magnified
or multiplied to determine the change in equilibrium expenditure and real GDP.
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The Multiplier
Production Income
Definition: The Keynesian
Multiplier is an economic concept
that shows how an initial increase
in spending leads to a larger
overall increase in national
income.
Expenditure •Key Idea: Spending by one
person becomes income for
another, creating a ripple effect in
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the economy.
The Multiplier
•
The Multiplier Effect • The
change in autonomous
expenditure leads to an
amplified change in
equilibrium expenditure
Equilibrium expenditure
increases by more than the
increase in autonomous
expenditure
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The Multiplier Formula
Multiplier=
• MPC = Marginal Propensity to Consume (the
fraction of additional income that is spent).
• (1-mpc): marginal propensity to save
Example: If MPC=0.8 then:
• Multiplier=
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The Multiplier
•
The Multiplier and the Slope of the AE Curve
• The magnitude of the multiplier depends on the
slope of the AE curve Imports and Income Taxes
• Make the multiplier smaller than it Otherwise would
be
• Imports – the increase in investment increases real
GDP, which in turn increases consumption
expenditure but part of the increase in expenditure
is on imported goods and services.
• Only expenditure on South African produced
goods and services increases South Africa’s real
GDP.
The larger the marginal propensity to import, the
smaller is the change in South Africa’s real GDP
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The Multiplier Formula
Multiplier (with proportional tax =
• t: proportional tax rate
• (1-t) shows the after tax income
• mpc×(1-t): the proportion of disposable income is use in consumption
• 1-mpc ×(1-t): the proportion of disposable income is saved
Example: If MPC=0.8; t=0.25 then:
• Multiplier=
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The Multiplier Formula
Multiplier (with tax and import) =
• mpi: marginal propensity to import
• [1-mpc*(1-t)+mpi]: the proportion of income after paying tax, after
payment for imported good that is saved
Example: If MPC=0.8; t=0.25; MPI=0.2 then:
• Multiplier=
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The Multiplier
What determined the size of the multiplier
The saving, tax and import will reduced the size of the multiplier
(leakage in expenditure)
The greater save rate or smaller the MPC
Greater tax rate
Greater portion of income spend on imported good
All of above leak the income from spending and for every
expenditure round the income become smaller
Base on example above with more and more leakage introduced,
the multiplier size decreased from 5 to 2.5 to 1.67.
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The Multiplier
•
Income taxes – The increase in
investment increases real GDP.
Income tax payments increase so
disposable income increases by
less than the increase in real GDP
and consumption expenditure
increases by less than it would if
taxes had not changed. The larger
the income tax rate, the smaller is
the change in real GDP
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Mathematical note: The algebra of the
Keynesian model
We begin by defining the symbols we
need:
AE – aggregate planned expenditure
Y – real GDP
C – consumption expenditure
I – investment
G – Government expenditure
X – Exports
M - Imports
T – Taxes
a or – Autonomous consumption
spending
Tₐ - Autonomous taxes
b or mpc – Marginal propensity to
consume
m or mpi – Marginal propensity to
import
t – marginal tax rate
A or – autonomous expenditure
Y=AE
AE=C+I+G+X-M
I=
G=
X=
All the bar above C, I, G, X and M
indicate autonomous expenditures
The national income is calculate by
Aggregate expenditure
AE = C + I + G + X – M
Consumption function – C depends on disposable income (YD)
C = a + bYD or C=
YD = real GDP minus net taxes (Y – T)
So if we replace YD with (Y-T) the consumption functions is:
C = a + b(Y-T) or
C= + mpc(Y-T)
Net taxes (T) equal autonomous taxes (independent of
income) Tₐ, plus induced taxes(vary with income), tY. So:
T = Tₐ + tY
Use this last equation to replace T in the consumption
function. So the consumption function is:
C = a - bTₐ + b(1-t)Y or C = -mpc×Tₐ + mpc×(1-t)Y
• bTₐ: autonomous tax
Import function: autonomous import and also Imports depend on
real GDP and the import function is:
M = +mpiY
Aggregate expenditure curve. Use the consumption function and
the import function to replace C and M in the AE equation. That is:
[b(1 – t) - mpi] or [mpc(1-t)-mpi]
AE = a - bTₐ + b(1-t)Y + I + G + X –+mpiY)
AE=
Collect the terms on the right side of the equation that involve Y
AE = (a - bTₐ + I + G + X-) + [b(1 – t) - mpi]Y
AE= (
Autonomous expenditure () is
(a - bTₐ + I + G + X-) or
and the slope of the AE curve is
[b(1 – t) - m] or
[mpc(1 – t) - mpi]
So the equation for the AE curve is:
AE = A + [b(1 – t) - m]Y or
AE = + [mpc×(1 – t) - mpi]Y
Autonomous expenditure equals
a - bTₐ + I + G + X- or
Aggregate planned expenditure
15 AE
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Slope equals
5 b(1 – t) – m or
[mpc(1 – t) - mpi]
5 10 15
Real GDP
Equilibrium expenditure
Equilibrium expenditure occurs when aggregate
planned expenditure(AE) equals real GDP(Y)
That is:
×
Or
Beware that there are double brackets in 2nd
equation hence – and - becomes +
• The scale on the x-axis and y-axis is identical, so the 45⁰ line shows
the points at which aggregate planned expenditure equal real GDP
• The figure shows the point of equilibrium at the intersection of the
AE curve and the 45⁰ line
• To calculate equilibrium expenditure, solve the equation for the AE
curve an the 45⁰ line for the two unknown quantities AE and Y
starting with
AE = A + [b(1 – t) - m]Y or
AE
AE = Y
Replace AE with Y in the AE equation to obtain
Y = A + [b(1 – t) - m]
Y
The solution for Y is
× hence
×
The multiplier
The multiplier equals the change in equilibrium expenditure
and real GDP (Y) that results from a change in autonomous
expenditure(AE)divided by the change in autonomous
expenditure(A)
changes equilibrium expenditure and real GDP by:
AE or
Multiplier =
The size of the multiplier depends on the slope of the AE curve,
[b(1 – t) – m] or [mpc(1-t)-mpi].
The larger the slope, the larger is the multiplier.
So the multiplier is larger:
• The greater the marginal propensity to consume(b or mpc)
• The smaller the marginal tax rate(t)
• The smaller the marginal propensity to import(m or mpi)
Questions for Discussion
The multiplier.
Consider each scenario, discuss its impact on multiplier:
Behavior change of citizens: save large chunk of income
Citizens feel that foreign goods are superior to the local goods (local is no longer
lekker) and spend large chunk of income on foreign goods
To fund expensive 40 year independent day celebration and fund for free
educations and health services as the birthday gift for all its citizen, a 10% tax imposed
on citizens income.
Questions for Discussion
The multiplier : the Solution.
Consider each scenario, discuss its impact on multiplier:
Behavior change of citizens: save large chunk of income: a fall in mpc and the
size of multiplier decrease (smaller the induced expenditure)
Citizens feel that foreign goods are superior to local (local is no longer lekker) and
spend large chunk of income on foreign goods: an increase in the mpi and the size of
multiplier decrease
To fund expensive 40 year independent day celebration and fund for free
educations and health service as the birthday gift to its citizens, a 10% tax imposed on
citizens income: an increase in tax and the size of multiplier decrease (lower induced
expenditure)
Use the Macroeconomics Data for Queens Republic in the table and answer the following questions.
Calculate the following questions (give your answers in million where applicable). Round your answer off to three
decimals.
1. Calculate total autonomous expenditure. (3 Marks)
2. Calculate the value of the multiplier. (3 Marks)
3. Calculate the equilibrium level of income. Round your answer off to three decimals. (3 Marks)
4. How much additional real investment is required to bring the economy to full employment, i.e., to close the
gap between real GDP and the level of GDP at full employment (ceteris paribus)? Round your answer off to
three decimals. (4 Marks)
5. Calculate the equilibrium level of consumption. Round your answer off to three decimals. (4 Marks)
Answers
2.
3.
4. GDP gap = 1000-888.96= 111.04 million
5.
The Multiplier
Business Cycle Turning Points
At business cycle turning points, the economy moves from expansion to recession or
from recession to expansion Adjusting Quantities and Prices
When firms cannot keep up with sales and their inventories fall below target, they
increase production, but at some point, they raise their prices Similarly, when firms
find unwanted inventories piling up, they decrease production, but eventually they
cut their prices
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The Multiplier
Aggregate Expenditure and Aggregate Demand
The aggregate expenditure curve is the relationship between the aggregate planned expenditure
and real GDP
The aggregate demand curve is the relationship between the aggregate quantity of goods and
services demanded and the price level
Deriving the Aggregate Demand Curve
• When the price level changes, aggregate planned expenditure changes and the quantity of
real GDP demanded changes
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The Multiplier
The aggregate demand curve slopes
downward for two main reasons:
Wealth Effect
The higher the price level, the smaller is
the purchasing power of wealth
Substitution Effects
• For a given expected future price level,
a rise in the price level today makes
current goods and services more
expensive relative to future goods and
services and results in a delay in
purchases – an intertemporal
substitution
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The Multiplier
Changes in Aggregate Expenditure and Aggregate Demand
When any influence on aggregate planned expenditure other than the price level changes, both the aggrega
Activity
Think-pair-repair
Pose an open-ended question to your
class and ask students to come up with
their best answer. Next, pair learners
up and get them to agree on a
response. Get two pairs together, and
the group of four needs to do the same
thing. Continue until half the group
goes head to head with the other half. If
your students are online, breakout
rooms in your conferencing software let
you do the same thing virtually.
Source: Whenham, T. 2020. 15 Active Learning Activities to Energize your Next Class. [Online] Available at:
15 active learning activities to energize your next college class (nureva.com). [Accessed 16/12/2022].
The Multiplier
Equilibrium Real GDP and the Price Level An Increase in Aggregate Demand in the
Short Run and in the Long Run
