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Econ_2025finrev

Econ_2025finrev - 1 Describe the multiplier process The...

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1. Describe the multiplier process. The multiplier process begins with an event that changes any component of aggregate demand, C, I, G or (X-M). Because Aggregate Demand equals C+I+G+(X-M), any change in a variable on the right hand side of the equality immediately leads to an equal change on the left hand side of the equality. The multiplier process works as follows. Keynes argued that consumers seek to maximize satisfaction and that they do so through increased consumption. Therefore, when income increases consumption will increase, and when income decreases, consumption will decrease. As individuals earn more income they will consume more of that income, however not all of it as some of that increase in income will be saved. The proportion of income that is consumed he called the marginal propensity to consume (mpc) and the proportion of income that is saved he called the marginal propensity to save (mps). Together they must equal 100% (mpc + mps = 1.0 = 100%). 2. What role does the mpc play in the multiplier process? Therefore, when income increases consumption will increase, and when income decreases, consumption will decrease. As individuals earn more income they will consume more of that income, however not all of it as some of that increase in income will be saved. The proportion of income that is consumed he called the marginal propensity to consume (mpc) and the proportion of income that is saved he called the marginal propensity to save (mps). Together they must equal 100% (mpc + mps = 1.0 = 100%). Therefore, if we assume that the mpc = 0.8 and the mps = 0.2. Then for every \$1 increase in income consumption will increase by \$0.80 and savings will increase by \$0.20. If, on the other hand the mpc = 0.9, then for every \$1 increase in income consumption would increase by \$0.90 and savings would increase by \$0.10. As the mpc increases then we spend more of our income and as it decreases we spend less of our income. Understanding that a change in any of the determinants of GDP leads to an initial impact on GDP and then a series of subsequent impacts through the income – consumption process, we can calculate the total impact as follows. Assume that Government spending on final goods and services increases by \$100 and that the mpc = 0.8. The increase in G of \$100 immediately causes GDP to increase by \$100. However, this increase in G of \$100 becomes income for someone of \$100. This \$100 increase in income will in turn result in an increase in Consumption in the second round of \$80 (the mpc = 0.8), which causes GDP to increase by an additional \$80. Furthermore, the increase in Consumption of \$80 becomes income for someone else of \$80 and assuming that they have the same mpc then as their income rises by \$80 there will be a third round increase in Consumption of \$64, which becomes income for someone else which leads to a fourth round increase in Consumption and GDP and so on.

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3. Explain under what conditions AS is flat, vertical and upward sloping, in the AD/AS model.

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4. Explain why the AD curve has a downward slope.
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