Basic Macroeconomic Relationships

&
The Aggregate Expenditure Model

Course Instructor:
Dr. Abhisek Sur

Email: [email protected]
Mob.: +91 8017 646257
Motivation
The Great Depression caused arethinking of the
Classical Theory of the macroeconomy.
It could not explain:
• Drop in output by 30% from 1929 to 1933
• Rise in unemployment to 25%
In 1936, J.M. Keynes developed a theoryto explain
this phenomenon

We will learn a version of this theory.

We shall start with the basic model:
“Keynesian Cross” model.
Also known as the Simple Keynesian model.
 The Great Depression

The Great Depression precipitated a thorough rethinking ofmacroeconomics

which gave rise to modern macroeconomics.
 The Business Cycle
• The business cycle is the cycle of short-term ups and downs in the
economy.

• Every business cycle has two phases:

• A recession
• An expansion
• And two turning points:
• A peak
• A trough

• The main measure of how an economy is doing is aggregate

output:
• Aggregate output is the total quantity of goods and
services produced in an economy in a given period.
• An expansion, or boom, is the period in the business cycle from
a trough up to a peak, during which output and employment rise.

• A contraction, recession, or slump is the period in the business

cycle from a peak down to a trough, during which output and
employment fall.
Aggregate Expenditure and Output
in the Short Run
 Aggregate Planned Expenditures and Real GDP

 Consumption/Savings Functions

 Equilibrium Expenditure

 Multiplier & Crowding out

 Relationship between AE and Aggregate Demand

Aggregate expenditure model: A macroeconomic model that focuses on the short-run

relationship between total spending and real GDP, assuming that the price level is
constant.
 Aggregate Expenditure
• The four components of aggregate expenditure (AE) -
consumption expenditure, investment, government purchases of
goods and services, and net exports - sum to real GDP

• AE = C +I + G+ (X- M) = Y
• A two-way link exists between aggregate expenditure and real
GDP:
• An increase in real GDP increases aggregate expenditure
• An increase in aggregate expenditure increases real GDP
 Elements of the Keynesian Cross
Consumption function: C = C (Y −T )
Govt. policy variables: G = G , T =T
Planned investment
(exogenous for now): I =I
Planned expenditure: E = C (Y − T ) + I + G

Equilibrium condition:
Actual expenditure = Planned expenditure
Y = E
CHAPTER 10 Aggregate Demand I
 Aggregate Expenditure

• Aggregate expenditure = Consumption + Planned investment +

Government purchases + Net exports
• AE = C + I + G + NX

• The Difference between Planned Investment and Actual Investment

Inventories: Goods that have been produced but not yet sold.

• Macroeconomic Equilibrium
Aggregate expenditure = GDP
 The Aggregate Expenditure Model
Adjustments to Macroeconomic Equilibrium

The Relationship between

Aggregate Expenditure and GDP

IF … THEN … AND …
Aggregate expenditure is inventories are the economy is in
equal to GDP unchanged macroeconomic equilibrium.

Aggregate expenditure is GDP and employment

less than GDP inventories rise decrease.

Aggregate expenditure is GDP and employment

greater than GDP inventories fall increase.
Table: Expenditure Approach to Measuring
GDP, 2011
 Determining the Level of Aggregate
Expenditure in the Economy
Consumption
Real Consumption
Consumption follows
a smooth, upward
trend, interrupted only
infrequently by brief
recessions.

• Consumption is
defined as all
spending done by the
household sector on
durables, non-
durables, and
services.

• Consumption is
assumed to be
determined primarily
by disposable income
(Yd), but it also may
be affected by taxes,
changes in the price
level, and real wealth.
 Determining the Level of Aggregate
Expenditure in the Economy

Consumption

Current Disposable Income

The most important determinant of consumption

is the current disposable income of households.

Household Wealth

Consumption depends in part on the wealth of households.

A household’s wealth is the value of its assets minus the

value of its liabilities.
Determining the Level of Aggregate
Expenditure in the Economy
Consumption
Expected Future Income
Consumption depends in part on expected future income.
Most people prefer to keep their consumption fairly stable
from year to year, even if their income fluctuates
significantly.

The Price Level

The price level measures the average prices of goods and

services in the economy. Consumption is affected by changes
in the price level.

The Interest Rate

When the interest rate is high, the reward for saving is

increased, and households are likely to save more and spend
less.
The Consumption Function

 C = a0 + bYd is the consumption function.

 The intercept of the consumption function, a0, represents

subsistence consumption.

 The slope of the consumption function, ∆C/ ∆ Y, is called

the marginal propensity to consume, MPC.

 The MPC shows by how much consumption changes as income

changes.
Determining the Level of Aggregate Expenditure in the
Economy
Consumption
The Consumption Function

The Relationship between Consumption and Income, 1960– 2008

Panel (a) shows the relationship between consumption In panel (b), we draw a straight line through the points
and income. The points represent combinations of real from panel (a). The line, which represents the relationship
consumption spending and real disposable income for the between consumption and disposable income, is called
years between 1960 and 2008. the consumption function. The slope of the consumption
function is the marginal propensity to consume.
AGGREGATEOUTPUT AND
AGGREGATEINCOME (Y)

An Aggregate Consumption Function

15 of 38
 Consumption and Saving
C AS
C C=a + bYd The savings function can be derived
from the consumption function.
D
E At point E, C = Yd, so S = 0.
A
At point A, C>Yd by the amount AB,
a B so S <0 by the amount A’B’.

At point C, C<Yd by the amount CD,

0 Y1 Y2 Y3 Y so S >0 by the amount C’D’.
S
Note that the intercept of the savings
S=-a + (1-b)Yd function is –a, reflecting the fact that
C’ when Yd is 0, savings are drawn down.
B’ D’
0 E Y
-a A’
 Determining the Level of Aggregate
Expenditure in the Economy
The Relationship between Consumption
and National Income

Disposable income = National income − Net taxes

We can rearrange the equation like this:

National income = GDP = Disposable income + Net taxes

 Determining the Level of Aggregate
Expenditure in the Economy
The Relationship between Consumption
and National Income

The Relationship between

Consumption and National
Income
Because national income differs
from disposable income only by
net taxes—which, for simplicity,
we assume are constant—we can
graph the consumption function
using national income rather than
disposable income.
We can also calculate the MPC,
which is the slope of the
consumption function, using either
the change in national income or
the change in disposable income
and always get the same value.
The slope of the consumption
function between point A and
point B is equal to the change in
consumption—$1,500 billion—
divided by the change in national
income—$2,000 billion—or 0.75.
 Determining the Level of Aggregate
Expenditure in the Economy
Income, Consumption, and Saving

National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving +

Change in taxes

Y=C+S+ T

and

Y = C + S + T
To simplify, we can assume that taxes are always a constant
amount, in which case ΔT= 0, so the following is also true:

ΔY= ΔC+ ΔS
 Determining the Level of Aggregate
Expenditure in the Economy

Income, Consumption, and Saving

Marginal propensity to save (MPS)

The change in saving divided by the
change in disposable income.

Y C S
= +
Y Y Y
or,

1 = MPC + MPS
Calculating the Marginal Propensity to
Consume and the Marginal Propensity to Save

C
MPC =
Y

S
MPS =
Y
NATIONAL INCOME CONSUMPTION SAVING MARGINAL PROPENSITY TO MARGINAL PROPENSITY
AND REAL GDP (Y) (C) (S) CONSUME (MPC) TO SAVE (MPS)
$9,000 $8,000 $1,000 — —
10,000 8,600 1,400 0.6 0.4
11,000 9,200 1,800 0.6 0.4
12,000 9,800 2,200 0.6 0.4
13,000 10,400 2,600 0.6 0.4
AGGREGATEOUTPUT AND
AGGREGATEINCOME (Y)

Y - C = S
AGGREGATE AGGREGATE AGGREGATE
INCOME CONSUMPTION SAVING
(Billions of (Billions of (Billions of
Dollars) Dollars) Dollars)

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150

Deriving a Saving Function from a Consumption Function

22 of 38
AGGREGATEOUTPUT AND
AGGREGATEINCOME (Y)
• Where the consumption function is above the 45° line,
consumption exceeds income, and saving is negative.

• Where the consumption function crosses the 45° line,

consumption is equal to income, and saving is zero.

• Where the consumption function is below the 45° line,

consumption is less than income, and saving is positive.

Note that the slope of the saving function is ΔS/ΔY, which

is equal to the marginal propensity to save (MPS).

The consumption function and the saving function are mirror images of one another. No information
appears in one that does not also appear in the other. These functions tell us how households in the
aggregate will divide income between consumption spending and saving at every possible income
level. In other words, they embody aggregate householdbehavior.
 Determining the Level of Aggregate
Expenditure in the Economy

Planned Investment
Real Investment
Investment is subject
to larger changes
than is consumption.
Investment declined
significantly during
the recessions of
1980, 1981–1982,
1990–1991, 2001,
and 2007–2009.
 Investment Expenditure
 Investment is defined as all spending done by the business sector on plant,
equipment, and inventories.

 The four most important variables that determine the level of investment
are:
 Expectations of future profitability
 Interest rate
 Taxes
 Cash flow

 An important determinant of investment spending is the rate of interest.

 There is a negative relationship between investment and the rate of interest.
 As interest rates rise, investment falls.
 As interest rates fall, investment rises.

 The negative relationship between interest rates and investment exists

because firms must either borrow or generate their own funds to invest.
 As a result, firms are willing to invest in only those projects that pay a return in excess of
the
borrowing cost or rate of interest paid.
 When rates are high, few projects are sufficiently profitable, but as rates fall, more and
more projects become profitable.
Determining the Level of Aggregate
Expenditure in the Economy
Planned Investment

Expectations of Future Profitability

The optimism or pessimism of firms is an important

determinant of investment spending.

Interest Rate

A higher real interest rate results in less investment

spending, and a lower real interest rate results in more
investment spending.
Determining the Level of Aggregate
Expenditure in the Economy
Planned Investment

Taxes
Firms focus on the profits that remain after
they have paid taxes.

Cash Flow

Cash flow : The difference between

the cash revenues received by a firm
and the cash spending by the firm.
Investment and the Rate of Interest

r
At i2, the higher rate of interest,
investment equals I1. Only a few projects
are profitable at this high level.
i2
At i1, the lower rate of interest,
investment equals I2. As the rate of interest
i1 falls, more projects become profitable.

I
0 I1 I2 Investment
AGGREGATEOUTPUT AND
AGGREGATEINCOME (Y)

The Planned Investment Function

29 of 38
 Investment in the AE Model
C AS C + I2 = AE2 Investment enters the model as a
+ lump sum.
I B C + I1 =AE1 An increase in investment
spending from I1 to I2 shifts
aggregate expenditures from AE1
to AE2.

A decrease in investment spending

from I2 to I1 shifts aggregate
A
expenditures from AE2 to AE1.

Note that as investment changes

so does equilibrium income, Y.
0 Y1 Y2 Y
 Saving and Investment
C,I AS C+I
C C Investment enters the AE/AS model as a
lump-sum equal to the amount CD, and is
D
E shown by a parallel line drawn above C by
the amount CD. Equilibrium occurs at point C.

a Investment enters the S/I model as a

horizontal line that intercepts the vertical
0 Y1 Y2 Y3 Y axis at the amount CD. Equilibrium occurs
S,I at the point C’.

C’ S
I
0 E Y
-a
 Making Intel Tries to Jump Off the
the Roller Coaster of Information
Connection Technology Spending

Purchases of information
processing equipment
and software declined 8
percent during the 2001
recession and 12 percent
during the 2007–2009
recession.
Government Spending

 Government spending is defined as a

spending done by all levels of
government on goods and services
 Government spending enters the model as a
lump-sum.
 We invoke this simplifying assumption because there
is no consistent relationship between government
spending and the level of national income.
Determining the Level of Aggregate
Expenditure in the Economy
Government Purchases

Real Government
Purchases
Government purchases
grew steadily for most
of the 1979–2009
period, with the
exception of the early
1990s, when concern
about the federal budget
deficit caused real
government purchases
to fall for three years,
beginning in 1992.
 Government in the AE Model
Government spending is drawn as a
C AS C+I+G parallel line above C+I, reflecting the
+ assumption that government spending
C+I enters the model as a lump-sum.
I
E
+ C The distance between C+I and C+I+G
G A
represents lump-sum government
B expenditures.

At Y1, consumption equals the line

segments Y1B, consumption plus
investment is Y1A, consumption
plus investment plus government
spending is Y1E, investment is
AB, and government spending is AE.
0 Y1 Y
 Saving, Investment and
Government
AE AS C+I+G
F C+I
G Government enters the AE/AS model as a
lump-sum equal to the amount FG, and is
E
shown by a parallel line drawn above C+I by
the amount FG. Equilibrium occurs at point F.
a+I0
Government enters the S/I model as a
0 Y2 Y3 Y
horizontal line that intercepts the vertical
S,I axis at the amount 0F. Equilibrium occurs
G at the point F’.
S
F F’ G
G E
I
0 Y
-a
Determining the Level of Aggregate
Expenditure in the Economy
Net Exports

Real Net Exports

Net exports were
negative in most years
between 1979 and
2009. Net exports have
usually increased when
the U.S. economy is in
recession and
decreased when the
U.S. economy is
expanding, although
they fell during most of
the 2001 recession.
Net Exports
 Net exports are the difference between
the goods and services we produce for the
rest of the world and the goods and
services they produce for us.
 Net exports equal exports minus imports
 NX = (X- M)
 Net exports enter the model as a lump sum.
Determining the Level of Aggregate
Expenditure in the Economy
Net Exports
The following are the three most important variables that determine
the level of net exports:
The Price Level in India Relative to the Price Levels in Other Countries

If inflation in India is lower than inflation in other countries, prices of

Indian products increase more slowly than the prices of products of
other countries.

The Growth Rate of GDP in India Relative to the Growth Rates of GDP in
Other Countries
When incomes in India rise more slowly than incomes in other
countries, net exports will rise.

The Exchange Rate Between the Rupee and Other Currencies

As the value of the Indian rupee rises, the foreign currency price of
Indian products sold in other countries rises, and the rupee price of
foreign products sold in India falls.
 Net Exports in the AE/AS Model
AS Net exports (NX) is drawn as a
parallel line above C+I+G, reflecting
C C+I+G+NX the assumption that net exports
+ E C+I+G enter the model as a lump-sum and
I that exports exceed imports. If imports
C C+I
exceed exports, net exports is drawn as
+ B C a parallel line below C+I+G.
G
A
+ The distance between C+I+G and
NX C+I+G+NX represents lump-sum
net export expenditures.

At Y1, consumption equals the line

segment Y1A, consumption plus
investment is Y1B, consumption
plus investment plus government
0 Y1 Y spending is Y1C, and consumption
plus investment plus government plus
net exports is Y1E.
Graphing the equilibrium condition
E
planned E =Y
expenditure

45º

income, output, Y

slide 42
 The equilibrium value of income
E
planned E =Y
expenditure
E =C +I +G

income, output, Y

Equilibrium
income
slide 43
Graphing Macroeconomic Equilibrium

Macroeconomic Equilibrium
on the 45°-Line Diagram
Macroeconomic equilibrium occurs
where the aggregate expenditure
(AE) line crosses the 45° line.
The lowest upward-sloping line, C,
represents the consumption
function.
The quantities of planned
investment, government
purchases, and net exports are
constant because we assumed
that the variables they depend on
are constant. So, the total of
planned aggregate expenditure at
any level of GDP is the amount of
consumption at that level of GDP
plus the sum of the constant
amounts of planned investment,
government purchases, and net
exports.
We successively add each
component of spending to the
consumption function line to arrive
at the line representing aggregate
expenditure.
Graphing Macroeconomic Equilibrium: Stability in
Equilibrium

Macroeconomic Equilibrium
Macroeconomic equilibrium occurs
where the AE line crosses the 45°
line. In this case, that occurs at
GDP of $10 trillion.
If GDP is less than $10 trillion, the
corresponding point on the AE line
is above the 45° line, planned
aggregate expenditure is greater
than total production, firms will
experience an unplanned decrease
in inventories, and GDP will
increase.
If GDP is greater than $10 trillion,
the corresponding point on the AE
line is below the 45° line, planned
aggregate expenditure is less than
total production, firms will
experience an unplanned increase
in inventories, and GDP will
decrease.
 Graphing Macroeconomic Equilibrium
Showing a Recession on the 45°-Line Diagram

Showing a Recession
on the 45°-Line Diagram
When the aggregate expenditure
line intersects the 45° line at a level
of GDP below potential real GDP,
the economy is in recession.
The figure shows that potential A
real GDP is $10 trillion, but
because planned aggregate
expenditure is too low, the C
equilibrium level of GDP is only B
$9.8 trillion, where the AE line
intersects the 45° line. As a result,
some firms will be operating below
their normal capacity, and
unemployment will be above the
natural rate of unemployment.
We can measure the shortfall in
planned aggregate expenditure as
the vertical distance between the AE
line and the 45° line at the level of
potential real GDP.
Graphing Macroeconomic Equilibrium
The Important Role of Inventories

Whenever planned aggregate expenditure is

less than real GDP, some firms will experience
unplanned increases in inventories.
Graphing Macroeconomic Equilibrium
A Numerical Example of Macroeconomic Equilibrium

Macroeconomic Equilibrium
PLANNED
REAL PLANNED GOVERNMENT NET AGGREGATE UNPLANNED REAL
GDP CONSUMPTION INVESTMENT PURCHASES EXPORTS EXPENDITURE CHANGE IN GDP
(Y) (C) (I) (G) (NX) (AE) INVENTORIES WILL …
$8,000 $6,200 $1,500 $1,500 – $500 $8,700 –$700 increase

9,000 6,850 1,500 1,500 –500 9,350 –350 increase

be in
10,000 7,500 1,500 1,500 –500 10,000 0 equilibrium

11,000 8,150 1,500 1,500 –500 10,650 +350 decrease

12,000 8,800 1,500 1,500 –500 11,300 +700 decrease

Determining Macroeconomic Equilibrium

Planned aggregate expenditure (AE) = Consumption (C) + Planned

investment (I) + Government purchases (G) + Net exports (NX)

Unplanned change in inventories = Real GDP (Y) −

Planned aggregate expenditure (AE)

Planned
Real Planned Government Net Aggregate Unplanned
GDP Consumption Investment Purchases Exports Expenditure Change in
(Y) (C) (I) (G) (NX) (AE) Inventories

$8,000 $6,200 $1,675 $1,675 $–500 $9,050 $–1,050

9,000 6,850 1,675 1,675 –500 9,700 –700

10,000 7,500 1,675 1,675 –500 10,350 –350

11,000 8,150 1,675 1,675 –500 11,000 0

12,000 8,800 1,675 1,675 –500 11,650 350

 Equilibrium Income: Summary

 Equilibrium is a state in which there is no internal tendency to change.

 It happens when
◦ firms and households are just willing to purchase everything
produced, i.e.
Y = E (vs. Micro: Qs = Qd)
 This is the Income-Expenditure Approach

◦ planned saving is equal to planned investment, i.e.,

S=I
 This is the Injection-Withdrawal Approach
Equilibrium Income: Summary

• When there is excess supply, i.e.,

planned output > planned expenditure

firms will reduce output to restore equilibrium

• When there is excess demand, i.e.,

planned expenditure > planned output

firms will increase output to restore equilibrium

 The Multiplier Effect

Autonomous expenditure: An
expenditure that does not depend on the
level of GDP.

Multiplier: The increase in equilibrium

real GDP divided by the increase in
autonomous expenditure.

Multiplier effect: The process by which

an increase in autonomous expenditure
leads to a larger increase in real GDP.
The Multiplier Effect

The Multiplier Effect

The economy begins at point
A, at which equilibrium real
GDP is $9.6 trillion.
A $100 billion increase in
planned investment shifts up
aggregate expenditure from
AE1 to AE2.
The new equilibrium is at
point B, where real GDP is
$10.0 trillion, which is
potential real GDP.
Because of the multiplier
effect, a $100 billion increase
in investment results in a
$400 billion increase in
equilibrium real GDP.
 Multiplier Process
The multiplier process begins at an
AS initial equilibrium level of Y such as Y 1,
AE AE2 where AE=AS.
E2
G AE1 It is initiated by an autonomous change
D
F in spending that causes AE to exceed AS.
B We show that change as a shift in AE from
C
AE1 to AE2. Now at Y1, AE is greater than
AS by the amount BE1.
E1
At this point, inventories fall and are
replaced with new production that causes
an increase in employment. As employment
increases, income increases, and as income
increases, consumption rises.

0 Y1 Y2 Y We are now at D. We repeat the process

until we reach E2.
Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in

Y: ΔY = ΔG.
But #Y g #C
g further #Y
g further #C
g further #Y
So the final impact on income is much bigger than the
initial ΔG.
 Consider an
increase in
government
spending G

 What
happens tothe
planned
expenditure line?

 What is the new

equilibrium point?
Explain the
mechanisms
involved that make
the economy move
towards this new
equilibrium point.
 Multiplier: Government Expenditure Multiplier
Solving for ΔY
Y = C + I + G equilibrium condition

Y = C + I + G in changes

= C + G because I exogenous

= MPC  Y + G because ΔC = MPC

ΔY
Collect terms with ΔY Solve for ΔY :
on the left side of the
equals sign:  1 
Y =    G
(1 − MPC)Y = G  1 − MPC 
The government purchases multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt
purchases multiplier equals Y 1
=
G 1 − MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
= = 5 causes income to
G 1 − 0.8 increase 5 times
as much!
 Multiplier: Example
• Let ∆I = 100 and the MPC = 0.8
• ∆I ∆Y ∆C ∆S
100 100 80 20
80 64 16
64 51.2 12.8
51.2 40.96 10.2
40.96 32.76 8.2

• 500 400 100

 Consider the
affects of a
decrease in taxes
T < 0
 What does a tax
reduction do to
disposable income
and consumption?
 So what happens
to the planned
expenditure line?
 By how much does
the curve shift?
 Where is the new
equilibrium point
located?
Solving for ΔY
eq’m condition in
Y = C + I + G
changes
= C I and G exogenous

= MPC  ( Y − T )
Solving for ΔY : (1 − MPC)Y = − MPC  T

 − MPC 
Final result: Y =    T
 1 − MPC 
def: the change in income resulting from a
$1 increase in T :
Y −MPC
=
T 1 − MPC
If MPC = 0.8, then the tax multiplier equals
Y −0.8 −0.8 =
= = −4
T 1 − 0.8 0.2
The tax multiplier:
…is negative:
A tax increase reduces C,
which reduces income.

…is greater than one:

A change in taxes has a
multiplier effect on income.

…is smaller than the govt spending multiplier:

Consumers save the fraction (1 – MPC) of a tax cut.
Thus, the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
The Balanced Budget Multiplier

 In the balanced budget policy, T =G and G =T.

 The effect of the balanced budget policy on the national

income is measured through the balanced budget
theorem or balanced budget multiplier.

 The balanced budget theorem states that the balanced

budget multiplier is always equal to one.
The Balanced Budget Multiplier (Contd.)
The Balanced Budget Multiplier (Contd.)

 The balance budget multiplier (BBm)

 10 - 67

Real World Examples

Canada in 2000.
Japan in the 1990s.
The 1930s depression.

© 2003 McGraw-Hill Ryerson Limited.

 10 - 68

Canada in 2000
Consumer confidence rose substantially causing
autonomous consumption expenditures to increase
more than economists had predicted.
While economists had expected the economy to grow
slowly, it boomed.

© 2003 McGraw-Hill Ryerson Limited.

 10 - 69

Japan in the 1990s

A dramatic rise in the value of the yen
cut Japanese exports.
Suppliers could not sell all they had
produced.
Suppliers laid off workers and
decreased output.
Aggregate income (aggregate
expenditures) fell causing the multiplier
to work in reverse.
© 2003 McGraw-Hill Ryerson Limited.
 10 - 70

The 1930s Depression

The 1929 stock market crash, which continued into
1930, threw the financial markets into chaos.
This resulted in a downward shift of the AE curve.

© 2003 McGraw-Hill Ryerson Limited.

 10 - 71

The 1930s Depression

Frightened business people decreased investment
and laid off workers.
Frightened consumers decreased
autonomous consumption and
increased savings, thereby increasing
withdrawals from the system.
Governments cut spending to balance
their budgets, as tax revenue declined.
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The 1930s Depression

Businesspeople responded by decreasing output,
which decreased income, starting a downward cycle,
thereby confirming the fears of the businesspeople.

© 2003 McGraw-Hill Ryerson Limited.

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The 1930s Depression

The process continued until the economy settled at a
low-level equilibrium, far below the potential level of
income.

© 2003 McGraw-Hill Ryerson Limited.

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The 1930s Depression

The process caused the paradox of thrift, whereby
individuals attempting to save more, spent less, and
caused income to decrease.

They ended up saving not more, but

less.

© 2003 McGraw-Hill Ryerson Limited.

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Limitations of the Multiplier Model

On the surface, the multiplier model makes a lot of
intuitive sense.
Surface sense can often be misleading.

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The Multiplier Model Is Not a Complete

Model of the Economy
The multiplier model does not determine income from
scratch.
At best, it can estimate the directions and rough sizes
of autonomous demand or supply shifts.

© 2003 McGraw-Hill Ryerson Limited.

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Shifts Are Not as Great as Intuition

Suggests
The multiplier model leads people to overemphasize
the aggregate expenditure shifts that would occur in
response to a shift in autonomous expenditures.

© 2003 McGraw-Hill Ryerson Limited.

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The Price Level Will Often Change in

Response to Shifts in Demand

The multiplier model assumes that the

price level is fixed.
The price level can change in response
to changes in aggregate demand.
Price level changes will occur when the
SAS is upward sloping.

© 2003 McGraw-Hill Ryerson Limited.