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Now, in the previous lecture, we covered an enormous amount of ground.
Building up an analytical framework that allows us to understand the role that
exogenous changes, in particular, exogenous changes that impact on planned
aggregate expenditure. the role that those changes have in
leading to the creation of output gaps. This very important piece of analysis
that's had incredible influence both on the way that macroeconomists view the
economy and also on the way that governments view their role in managing
the macroeconomy. And that's going to be a key theme of of
this particular lecture. So, I'll take you back for a moment to
our analysis of the the effects of an exogenous fall in planned investment.
you'll recall that we started with the economy at its potential GDP.
We had, for whatever reason, a fall in planned investment that set up in the
first instance a situation of disequilibrium causing firms to adjust
downwards their production plans that has implications for income in the economy
which leads to changes to withdrawals and consumption.
In doing so, we have a transition to a new lower equilibrium level of GDP and a
creation of a contractionary output gap. You may have noticed something when we
went through this analysis. It's something when you first see it, I
think, it's actually quite extraordinary. Have a look at the diagram.
The process that I've just described was all because of a downward shift in
planned injections. And the magnitude of that downward shift,
the magnitude of the fall in planned injections is, of course, measured by the
distance between those two planned injections lines.
Through the mechanism that I've outlined, we end up with a contractionary output
gap with a level of equilibrium GDP below that of potential.
Have a look at the size of that output gap.
Or in other words, have a look at the change in equilibrium GDP.
It's pretty big. It's actually much larger than the
exogenous change in planned injections. What we have here is a situation, this
will be true in general, where we have a change in planned injections leads to a
change in GDP in the economy. Well, that change in GDP is actually
larger then the change in planned injections that began the whole process.
This is something which macroeconomists call the multiplier.
It's actually a very evocative piece of terminology.
It's as if the change in planned injections has had a multiplied effect on
GDP, has an effect on GDP, much larger than the initial exogenous change in
planned injections. That's actually a really significant
point. The existence of the multiplier tells us
that you don't necessarily need a very large change in planned injections for
there to be a relatively large change in equilibrium GDP.
In other words, small exogenous changes are perhaps capable of leading two large
output gaps. You don't need much of a change in
planned injections, according to this multiplier process, in order for there to
be a relatively large change in GDP. So, this concept of the multiplier
summarizes the effects of a change in exo, in exogenous expenditure on
equilibrium output. I'll show you in a moment that it's a
matter of logic. It's really just an application of the
circular flow of income. But it's a very important concept.
It tells us, for example, that you might have a change in planned injections equal
to, I don't know, pick a number, 50. The implication might be a change in the
economy's equilibrium, GDP of 150. If that was true, we would say that the
value of the multiplier, in this instance, equals 3.
So, sometimes it's useful and convenient to think of the multiplier just as a
number. A number which tells us by how much more
the eventually change in GDP is relative to the initial exogenous change and that
started the whole process off. So, let me take you through a slightly
different way of showing the multiplier and give you a very simple example of why
it is we would expect to see the multiplier in action.
I'm going to take a smaller scale economy to what we've been using, just to make
the point. So, I'm going to have a, a marginal
propensity to consume of 0.8. Nothing magical about that number, could
have chosen any number. but I do need a number, so let's just
choose 0.8. I'll assume there's no no endogenous
taxes, so the tax rate is, is 0. But I'll also assume a closed economy, so
there's no exports or imports. I don't need to make any of those
assumptions, you could do this with taxes, you could do this with an open
economy which you have exports and imports.
This makes the analysis much, much more messy.
Now, the multiplier was a key concept in the general theory.
And many people associate this concept of the multiplier with canes and most
economists, indeed, are introduced to this concept through reading the general
theory or learning about the basic Keynesian model.
The concept of the multiplier however was not developed by Keynes.
In fact, the first recorded mention of what we would recognize as the, as the
multiplier which was made by this scholar here, an economist called Giblin, who was
a professor of economics at my university, the University of Melbourne.
So, I'm, I kind of take great delight in telling this story, who in a public
lecture that he gave at the university in the early 1930s, first outlined the
concept of the multiplier. so whilst most people associate the
multiplier with the general theory in Keynesian economics, it actually has a
longer pedigree than that going back to my institution, which is something I like
to tell people, for fairly obvious reasons.
Anyway, let's develop this example of the, of the multiplier.
So, we've got this very simple economy we don't have to worry about the government
so much. there's no taxes, we don't have to worry
about exports and imports. So, let's think of this as being a very
simple economy in which we have essentially households and firms.
We'll assume it's initially in equilibrium, as we've defined.
But then there is an exogenous change. And the exogenous change is a $100
decrease in planned investment. Now, you gotta remember that when a firm
undertakes a huge investment expenditure, it's buying perhaps some capital
equipment. It's actually purchasing production,
production maybe of other firms, there will be firms out there that are in the
business of producing capital equipment. So, when firms decided to decrease their
planned investment, this has implications for other firms production in the
economy. If there's $100 less planned investment
expenditure and that's going to imply in the first instance, a reduction in
production of $100. There'll be $100 less capital equipment
produced. What does that mean?
Well, from the circular flow of income idea from this idea that production and
income are two different ways of saying the same thing, this economy now has $100
less income as a result of the cutback in production.
What does that really mean? It means households now have a reduction
in their income of $100. Now, if that was the end of the story,
there wouldn't actually be a multiplier. If that was the end of the story, what we
have here is a $100 decrease in planned investment has led to a $100 decrease in
production, a $100 decrease in income. In other words, $100 decrease in GDP.
But here's where the multiplying comes in.
It's not the end of the story because how did households respond to their income
being reduced by $100? They cutback on their consumption.
They don't cut their consumption by the full $100 however, and this is where the
marginal propensity to consume comes in, because it works in both directions.
I introduced the concept I talked about an increase in income, what that means
for consumption expenditure. It works the other way as well.
If households find that their income has been reduced, they cutback on their
consumption, but not by the whole amount of their reduction in income.
They might dip into some some saving, for example, to make sure that their
consumption doesn't have to fall by the full amount of the income that falls.
For the marginal propensity to consumer 0.8, when households experience a 100
dollar fall in their income, a cutback on their consumption by $80.
But what does that mean? It means for firms, they're not going to
cut back on their production by $80. That means, in this economy, there is $80
less income. That means, households now face an income
cut of $80. Just like a, an additional round.
how do households respond to that $80 reduction in their income?
They cutback on their consumption. With a marginal propensity to consume of
0.8, they cutback their consumption by $64, and this just keeps going on, and
on, and on. Firms cut their production by $64, income
falls by $64, and so on, until eventually the whole thing will run out of steem.
The main point, however, is that our initial $100 decrease in planned
investment, is clearly going to have a much larger overall affect on GDP than
$100. In this case, this can be an additional
$80 less consumption, followed an by additional $64 less consumption, followed
by even more cutbacks in consumption as this cycle plays itself out.
So, you can see, I think from this very simple example, that the initial
exogenous change, in this case, the $100 falling plan investment, is just the
beginning of a long and complicated chain of events that leads to an overall change
in GDP, which is a matter of logic, will be much larger.
It works in the other direction. Suppose we had a $100 exogenous increase
in consumption of itself, that will bring forward $100 extra production, leading to
an additional $100 worth of income that flows back to households, who increase
their consumption by $80. Remember, marginal propensity to consume
equals 0.8. $80 of production, $80 of income, and so
on. So, the existence of the multiplier seems
like not too surprising result. Once we think of the way exogenous
changes in the economy flow through in the first instance to changes in
production, what that means for income, how households respond to that income
change, and how this process is repeated over multiple rounds.
Each round getting just that little bit smaller and it gets that little bit
smaller because when households have an income change, they adjust their
consumption by some proportion of that income change.
So, let's just think logically about the multiplier and about some of the things
that might might be relevant in this context.
First of all, the size of the multiplier itself, that can change.
It'll be larger if, for example, the marginal propensity to consume is larger.
In other words, if out of each income change, households adjust their
consumption by a larger amount, then as a matter of logic, that must mean that the
multiplier effect itself will be larger. Should the tax rate be smaller, we're now
dealing with a world where the government does levy taxes.
A smaller tax rate means each time income adjusts household's disposable income is
affected more than if the tax rate was larger.
So that must have implication for the multiplier or, if what's called the
marginal propensity to import is smaller. So, if out of any change in income
households devote a relatively smaller proportion of that change to purchasing
imports, and that must mean the multiplier will be larger as well.
What this means is that across different economies, perhaps even across different
time periods in the same economy, the value of the multiplier might be larger
or smaller, depending on some of these key structural features of the economy.
The other thing about this very simple multiplier analysis is it basically
treats a whole lot of different things in the economy as pretty much having the
same effect on the economy. In particular, those three components of
planned injections, investments exports, and government spending, multiplier, as
I'm presenting it here, assumes that they all have pretty much the same effect upon
the ultimate flow of equilibrium GDP. There's a symmetry between investment,
exports, and government expenditure. later in this lecture, I'm going to talk
about government expenditure and why that might be a little bit different.
But let's just explore this symmetry between those three components of of
planned injections. I'm going to do it using just a little
bit of algebra because this is probably the quickest way to to show it.
In algebra, it's not difficult but if this is something you feel uncomfortable
with, as long you are aware of the intuition, I think that's fine.
So, we've noted before in this Keynesian model, a notion of equilibrium is being
equivalence between output and planned aggregate expenditure.
So, we've seen that, we've made extensive use of that concept.
If we take out a complete model of household consumption and substitute that
into this expression, then we can arrive at this sort of expanded view of the
equilibrium condition. I'm not saying anything different here.
What I've done is to write out what the consumption function looks like in its
complete form. Note that I'm dealing only with
equilibrium here, so that's why I've got the little superscript e above or next to
Y, every time you see that. Now, I've got equilibrium GDP both the
left-hand side and the right-hand side of the equation.
So, with some elementary Algebra, I can just isolate the GDP on the left-hand
side. And I get this expression here, which
really just reminds us that the economy's equilibrium is at a fundamental level
determined by all of these exogenous aspects of the economy as well as by the
marginal propensity to consume and the tax rate.
So, we've explored that fall is just an algebraic reminder of that fact.
Why do I want to write the economy's equilibrium in this way?
because I can now take each of these variables in turn and ask the question,
should either one of those variables change, what will be the ultimate change
on equilibrium GDP? And I've just written this out for you.
this may or may not be terribly clear, but if you work your way through it, you
should be able to see what's going on here.
The question I'm asking here is, suppose the only aspect of the economy to change
was exogenous consumption, what are the implications for the change in
equilibrium GDP? And given this equation, star, here, you
can see that that's going to be whatever the change in consumption is with this
term, 1 divided by 1 minus c bracket 1 minus T at the front.
So, that just gives us a little formula for calculating what the change will be
for equilibrium GDP when consumption changes.
And you can see that nature of the formula is pretty much the same no matter
whether it's a change in exogenous consumption or planned investment or
government spending or exports. What this tells us is that a $1 change in
either of those components will have exactly the same implications for
equilibrium GDP as a $1 change in any other of those components.
So, as far as equilibrium GDP is concerned, it doesn't really matter much
if it's planned investment that's changing by dollar, or government
spending, or exports, or exogenous consumption.
What happens to equilibrium GDP is exactly the same.
The only exception is taxes, which is a bit complicated because it has this
marginal propensity to consume out the front.
So, we'll just put that to one side. But certainly, for the other exogenous,
components in the economy as far as the multiplier process is concerned, it
really doesn't really matter which one of those changes.
Later in this lecture, I do have a where I want to focus on government because in
the real world, things are probably a little bit more complicated than this
model suggests. We'll certainly come back to that.