Introduction to

Economics II
6th lecture
The structure of today’s class
 Exam information – the structure of the
exam

 The Keynesian multiplicator model

 Fiscal policy in the multiplier model (with

1 calculation)

 The state budget

The structure of the exam
50 points:

• 5 multiple choice questions – 15 points

• 1 essay question – 20 points

• 3 short calculations, or 1 complex calculation – 15 points

 for the final grading, your score in the exam will be doubled  max 100 points

(+ the potential extra points from the essay / podcast episode / video submission)
The Keynesian
multiplier model
What is the multiplier model?
• the simplest Keynesian example of a model of aggregate demand
• the mechanism by which changes in spending get translated into
changes in output (and employment)
• a macroeconomic theory to explain how output is determined in
the short run

Each dollar (or other currency unit) change in exogenous

expenditures (such as investment)  more than a dollar change
(or: multiplied change) in GDP.
 Thus the name “multiplier”.
Assumptions – for simplification
 wages and prices are fixed

 there are unemployed resources in the economy

 ignoring the role of monetary policy, and assuming that financial markets do not
react to changes in the economy

 there is no international trade and finance

 using the total expenditure (TE) approach: how investment and consumption
spending interact with incomes to determine national output
Reminder:

The national
consumption
function

(QP shows the

level of potential
GDP)
Adding ‚investment’ to the graph
The total expenditure curve (TE)
shows the level of expenditure
desired or planned by consumers
and businesses corresponding to
each level of output.
The economy is in equilibrium at
the point where the TE = C + I curve
crosses the 45° line—at point E.
Point E is the macroeconomic
equilibrium, because at that point,
the level of desired expenditure on
consumption and investment
exactly equals the level of total
output.
The adjustment mechanism
At any other output, the total
desired spending on
consumption and investment
differs from the planned
production.
Any deviation of plans from
actual levels will cause
businesses to change their
production and employment
levels, thereby returning the
system to the equilibrium GDP.
The multiplier
Again: The multiplier is the impact of a 1 currency unit change in exogenous
expenditures on total output.
In the simple C + I model, the multiplier is the ratio of the change in total output to the
change in investment.
Why is it that the multiplier is greater than 1?
 There is a chain of secondary consumption spending set in motion by a primary
investment:
• If I hire people to accomplish a project for 10 000 €, they will save part of that
money, and spend another part, for example 6000 €.
• The money spent (6000 €) constitutes pay for other goods or projects. The
employees who did that job will, again, spend part of their income, so about 3600 €
from the initial sum.
Multiplier - formula
The multiplier is always the inverse, or reciprocal, of the marginal propensity to save.
It is thus equal to 1/MPS, or: 1/(1 – MPC).

1
With symbols only: ΔY = ∗ ΔI
1 − MPC
Fiscal policy in the
multiplier model
About fiscal programs (context)
• before Keynes: allocational role only  taxing and
spending

• since modern macroeconomics was developed:

impacts uncovered
 short-run movements of output, employment, and
prices
• the recognition leads to: the Keynesian approach to
macroeconomic policy
 active state intervention to moderate business
cycles
Impact of taxation on aggregate demand

Lower
disposable A reduction in
Extra taxes
consumption
lower our incomes tend to
spending will
disposable reduce our
reduce GDP and
incomes. consumption employment.
spending.
How gov’t fiscal policies affect output
With constant taxes:
Each dollar of taxes paid shifts the
consumption schedule to the right
by the amount of the tax.
A rightward shift also means a
downward shift, but the downward
shift is less than the rightward shift.
Why? Because the downward shift
is equal to the rightward shift times
the MPC (the slope of the
consumption function).
 the decline in consumption will
be smaller than the tax itself
Adding gov’t
spending in the
Keynesian cross
Fiscal policy multipliers
 government spending has been added to total expenditure, the
same way we added investment
 investment had a multiplier effect
 in the same way, government expenditures can have a multiplier
effect as well
Definition:
The government expenditure multiplier is the increase in GDP resulting
from an increase of 1 currency unit in government purchases of goods
and services.
1
Formula: ΔY = ∗ ΔG
1 − MPC
Government
expenditure
multiplier -
illustration
Task (Calculation)
Details:
In a Keynesian economy…
• MPC = ĉ = 0.75
• government expenditure increases from G = 100 to G’ = 150

Questions:
All other things held constant…
• What is the value of the multiplicator?
• What is the extent of change in the GDP (total output)?
Solution
1
We use the formula: ΔY = ∗ ΔG
1 − MPC

Thus, the multiplicator is:

1 1 1
= = =𝟒
1 − MPC 1 − 0.75 0.25

The change in GDP is:

ΔY = 4 ∗ (G′ − G) = 4 ∗ (150 − 100) = 4 ∗ 50 = 200

Tax multiplier – expenditure multiplier -
connection

The tax multiplier is smaller than the expenditure

multiplier by a factor equal to the MPC:
The Haavelmo theorem
(the balanced budget multiplier) - 1945
An equal increase in government expenditure
and taxation would lead to…

 a net increase in output

… as the multiplier effect of government

spending is greater than the fall in output
Trygve Haavelmo, Nobel Prize
winning Norwegian economist, implied by an equivalent increase in taxation.
1911-1999
 The relevance of wars
In the U.S., historically, economic expansions were the constant companions
of war.
Many scholars believe that the United States emerged from the Great
Depression largely because of the buildup for World War II.
But! Psychological factors triggered by a war can offset the increase in
government spending.
• consumers and investors become frightened, cautious  reduce spending
• depending on the war, oil prices can shoot up, lowering real incomes
+ economic sanctions
The accelerator rapid output
growth
principle of stimulates
investment
investment every
the effect is
contraction
amplified by
breeds revival
the multiplier
and
on investment
expansion
The multiplier
model and the
business cycle
the more
economic
growth rate output
slows growth
the capacity
of the
economy is
reached
The multiplier model - criticism
• an oversimplified picture of the economy
It omits…
• the impact of financial markets and monetary policy
• interest rates, despite them highly affecting the economy
• the interactions between the domestic economy and the rest of the
world
• the supply side of the economy as represented by the interaction of
spending with aggregate supply and prices
The state budget
Government budgets – the basics
A budget shows, for a given year, the planned expenditures of
government programs and the expected revenues from tax systems.
• Expenditures - a list of specific programs (education, welfare, defense,
etc.).
• Tax sources (income tax, social security taxes, etc.).
When revenues and expenditures are equal during a given period  the
government has a balanced budget.
When the government incurs a budget deficit, it must borrow from the
public to pay its bills.
 To borrow, the government issues bonds, that promise to pay money in
the future.
The economic consequences of
government debt
Deficit spending may be necessary to reduce the length and
depth of recessions…
… but high deficits during periods of full employment carry
serious consequences, including:
• reduced national saving
• reduced national investment
• slower long-run economic growth
Government debt vs. net debt
gov’t debt = public debt:
The total or accumulated borrowings by the government; the total value
of government bonds.
↔ net debt:
The debt held by the public, excludes debt held by the government itself.
Net debt is owned by households, banks, businesses, foreigners, and
other non-governmental entities.

Gross debt = the net debt + bonds owned by the government.

 The functions of the
government budget policy

setting taxes and public expenditures

set national priorities  allocating
 help dampen the swings of the
national output among private and
business cycle + contribute to the
public consumption and investment;
maintenance of a growing, high-
providing incentives to increase or
employment economy, free from high
reduce output in particular sectors
or volatile inflation
Actual, structural, and cyclical budgets
The actual budget records the actual expenditures, revenues,
and deficits in a given period.
The structural budget calculates what government revenues,
expenditures, and deficits would be if the economy were
operating at potential output.
The cyclical budget is the difference between the actual budget
and the structural budget. (It measures the impact of the
business cycle on the budget, taking into account the effect of
the cycle on revenues, expenditures, and the deficit.)
 short vs. long term  important for policymakers
The economics of debt and deficits
Are government deficits a burden, without impact, or even favourable?

 need to distinguish between short and long run

Short run:
• the world of the Keynesian multiplier model
• expansions and contractions
Long run:
• a full-employment situation
• actual output equals potential output
• the world of economic-growth analysis
External vs internal debt

Internal government
debt: owed by a
External debt: when
nation to its own
foreigners own a fraction
residents.
of the assets of a
country.
Gov’t debt and economic growth – long-
term effects (cons)
the costs of net subtraction
from the
servicing a large resources in the
external debt debtor nation

the inefficiencies
distorting
of levying taxes
effects on
to pay interest incentives
on the debt

debt economic growth

slows and future
displaces living standards
capital will decline
Do you have any
questions?
Assigned reading

Samuleson-Nordhaus textbook:
• pp. 437-452 (= pdf pages 460-475)
• pp. 630-638 (= pdf pages 652-660)
Thank you for your kind attention.