chapter+8+_14_+11-16-09

# chapter+8+_14_+11-16-09 - 1 Macroeconomics as a Second...

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1 Macroeconomics as a Second Language Chapter 8 (14): The Spending Multiplier Martha L. Olney [email protected] November 2009 Output or real GDP equals aggregate demand in short-run macroeconomic equilibrium (that was Chapter 6's message). Aggregate demand or aggregate spending equals the sum of consumption, investment, government, and net export spending (that was Chapter 7's message). What happens to output when there is an initial change in spending? The answer – that output changes by more than the initial change in spending – is the message of this chapter. One person’s spending is another person’s income. When someone’s income changes, they tend to change how much they spend. So an initial burst of spending generates income for someone, who spends part or all of that income, generating income for someone else. The cycle continues. This chain of events is called the multiplier process. The multiplier is a number that tells the total change in spending that results from an initial change in spending. The size or value of 8 - 1

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the multiplier depends on how much we change our spending on domestically produced goods when our income changes. Key terms and concepts \$ multiplier process \$ multiplier effect \$ Keynesian Cross diagram \$ multiplier \$ size of the multiplier \$ marginal propensity to consume \$ lump-sum taxes \$ proportional taxes \$ proportional tax rate \$ leakage \$ automatic stabilizer \$ marginal propensity to import \$ open economy multiplier \$ closed economy multiplier Key equations 8 - 2
\$ Definition of multiplier = spending initial Y total \$ Simplest spending multiplier = mpc - 1 1 \$ Proportional tax multiplier = mpc t - - ) 1 ( 1 1 \$ Open economy multiplier = mpm mpc + - 1 1 The Multiplier Process An initial change in spending causes output to change. The total change in output is greater than the initial change in spending. Because the change in output is some multiple greater than 1 of the initial change in spending, economists say a multiplier process kicks in when there is an initial change in spending. The multiplier process is really very intuitive. There are just two ideas that form its basis. One person’s spending is another person’s income. When income changes, spending changes. Spending changes income which changes spending which changes income which changes spending which . . . Round and round and round we go. That’s the essence of the multiplier process. 8 - 3

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The multiplier process works in either direction: with spending going up or going down. When spending increases, income rises. Those who have received more income will spend more. Someone else’s income rises, and their spending rises. That spending generates more income for someone else, who spends more. The total change in income for the aggregate economy is the sum of the increases in income in each of these rounds. An initial burst of spending generates a much larger total increase in income.
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