2. The multiplier process aa Aa Eh The blue line (with a positive intercept) on the following graph shows an economy's aggregate expenditure line. The orange line is a 45-degree line illustrating the set of points for which real GDP and aggregate expenditure (AE) are equal. Initially, the economy isin equilibrium with consumption equal to $450 billion, investment equal to $100 billion, government purchases equal to $100 billion, net exports equal to $50 billion, and real GOP equal to $700 billion. You can assume for the purposes of this problem that investment, government purchases, and net exports are all autonomous. Use the calculator to help you answer the following questions. You will not be scored on any changes you make to the calculator. ‘Tool tip: Use your mouse to drag the green line on the graph. The values in the boxes on the right side of the calculator will change accordingly. You can also directly change the values in the boxes with the white background by clicking in the box and typing. When you click the Calculate button, the graph and any related values will change accordingly. AGGREGATE EXPENDITURE [Billions of dollars) Ets ee ace (Batons aaa 785 on Ageguigespencure | api) Gem OOr 705 70 fees morc, a fe (ea 0 ne Geyernment Purchases [Tog i ere a = ee I Pleea oP mr etdate (Geetionianmues) (exci) ‘Suppose that increased optimism among firm managers causes investment to increase by $50 billion. Enter "150" in the Investment box to illustrate the effect of this change. You can see that the increased Investment shifts the aggregate expenditure line up by $50 billion _v Explanation: Close In this model, investment is autonomous; that Is, it doesn't change when real GDP changes, Therefore, an increase in investment increases aggregate expenditure equally at every level of real GDP, resulting in a parallel shift of the aggregate expenditure line, ‘You will now analyze the effects of this increase in investment by examining what happens during a series of "rounds." In the first round, there is $50 billion of new spending (the initial increase in investment) and no new saving. ‘Assume that in each round, real GDP is equal to aggregate expenditure in the previous round. So if aggregate expenditure was $750 billion in round 1, then you can assume that real GDP is $750 billion in round 2. Shift thevertical green line in the calculator to the right so that it lines up with $750 billion. At this level of real GDP, aggregate expenditure now equals $780 billion, which means that aggregate expenditure is now $30 billion greater than real GDP in round 2 and $80 billion greater than the initial real GDP. These numbers are shown as "New ‘Spending This Round" and "Cumulative New Spending," respectively, in the following table. Because real GDP increased by $50 billion between round 1 and round 2, and because aggregate expenditure only increased by $30 billion, it must be the case that new saving of $20 billion was generated in round 2. This new saving Is shown in the last two columns of the table. Aggregate New Spending Cumulative: New Saving Cumulative Round Real GDP Expenditure ‘This Round New Spending This Round New Saving 1 700 750 50 50 - - 2 750 7380 30 80 20 20 3 780_¥ 738 _¥ iy | my (2 y () 35 ¥ 5 y 125 a) Repeat the process for round 3: Enter real GDP, aggregate expenditure, new spending (the amount by which aggregate expenditure exceeds real GDP in round 3), cumulative new spending (the amount by which aggregate expenditure exceeds the initial real GDP of $700 billion), new saving (the amount of the increase in real GDP from round 2 that does not go to new spending), and cumulative new saving (the sum of saving in rounds 2 and 3), Explanation: Close ~ In round 2, aggregate expenditure was $780 billion. You can therefore assume that round 3 starts out with a real GDP of $780 billion. Moving the vertical green line over to that level, you can see that this level of real GDP corresponds to a level of aggregate expenditure of $798 billion. Because aggregate expenditure exceeds real GDP by $18 billion, round 3 generates $18 billion of new spending. Adding this to the $80 billion of additional spending generated in rounds 1 and 2 brings cumulative new spending up to $98 billion. Because real GDP increased by $30 billion between rounds 2 and 3 and aggregate expenditure went up by only $18 billion, this means that round 3 also generates $12 billion in new saving. Adding this to the $20 billion of saving round 2 brings cumulative new saving up to $32 billion. ‘Suppose this process continued on and on. In the last line of the table, enter the final values of real GDP, aggregate expenditure, cumulative new spending, and cumulative new saving achieved once the multiplier process is complete (technically, after an infinite number of rounds). Explanation: Close A ‘The new equilibrium occurs at the intersection of the new aggregate expenditure line and the 45-degree line. From the diagram, you can see that this occurs at real GDP (and aggregate expenditure) of $825 billion. Because the economy started out at real GDP of $700 billion, this represents an increase of $125 billion, Because aggregate expenditure is $75 billion higher than it was immediately after the injection of new investment, this means that $50 billion of the $125 billion went to new saving.The marginal propensity to consume (MPC) in this economy is__0.6 ¥_, and the marginal propensity to save (MPS) is__ 0.4 v Explanation: Close © Because investment, government purchases, and net exports are assumed to be autonomous, consumption is the only component of aggregate expenditure that changes when income does. To measure the MPC, you can examine the initial reaction to the $50 billion increase in real GDP. As previously discussed, when real GDP increased from $700 billion to $750 billion, aggregate expenditure rose from $750 billion to $780 billion. Because $30 billion (60% of the $50 billion increase in real GDP) went to new consumption and the remaining $20 billion (40%) went to saving, the MPC is 0.6 and the MPS is 0.4. Another way that you can measure the MPC is to examine the size of the multiplier effect. Mathematically, the simple spending multiplier is equal to 1 / (1 - MPC). Because a $50 billion increase in investment leads to a $125 billion Increase in real GDP, you can solve for the multiplier as follows: Change in Spendi Change in Real GDP ge Sper. 1 - MPC 50 125 - MPC. 50 MPC = 125 Mpc = 0.4 MPC = 0.6