Chap. 6 - Aggregate Expenditure Model

Question 1

The Aggregate Expenditures Model is used as a framework for what?

Answer 1

This model is used as a framework for determining equilibrium output, or GDP, in the economy.

Question 2

Describe the graph of the Aggregate Expenditures Model.

Answer 2

On the y axis there is Aggregate Expenditures and on the x axis there is GDP. There is a 45 degree line and the Aggregate Expenditures function passes through it. Where the 45 degree line and the AG Expend. Line cross is the equilibrium GDP for the country. Producing under the 45 degree line and on the Expenditure line is where spending is less than output. Producing above the 45 degree line and on the Expenditure line is where spending is more than output. Equilibrium is achieved where output (45 degree) = spending (Expenditure Line).

Question 3

Savings is also referred to as _____. Why?

Answer 3

Leakage. Remember that when people save, they are withdrawing spending from the flow of income and expenditures.

Question 4

Investment is also referred to as _____. Why?

Answer 4

Injection. When businesses invest, they are adding spending to the flow of income and expenditures

Question 5

If Aggregate expenditures was comprised solely of investment what would the rules for equilibrium be?

Answer 5

Leakage = Injections
Savings = Investments

Question 6

If savings is greater than investment what happens with GDP?

Answer 6

GDP is too high and output will fall

Question 7

If savings is less than investment what happens with GDP?

Answer 7

GDP is too low and output will rise

Question 8

What is the investment multiplier and its equation?

Answer 8

Investment multiplier came from Keynes who thought that if someone spent $1 on something and injects it into the economy that $1 becomes someones income. That person will then save and spend a portion of it depending on their MPC and MPS. The portion they spend will then become someone else’s income and keep on having this effect.
1/(1-MPC) or 1/MPS

Question 9

Firms in the economy decide to increase investment spending by five million dollars. If the MPC is equal to .75, the Investment Multiplier is equal to what? What does this mean?

Answer 9

Multiplier equal to 4 = 1/(1-.75) or 1/.25
Output in the economy will go up by 20 million dollars. This causes an upward shift in the Aggregate Expenditure Function.

Question 10

When looking solely at government spending and its relationship to GDP why is it a horizontal line?

Answer 10

Government spending is determined by a political process and is not based on the level of the GDP

Question 11

Since government spending is normally a horizontal line, because of political process, if added into the Aggregate Expenditure Function what happens to Ag Expenditure Function.

Answer 11

It shifts up by the amount of Government Spending

Question 12

Government spending mulitplier is the same as the investment multiplier, 1/(1-MPC). Since these two multipliers are the same they are sometimes jointly referred to as ______ _____?

Answer 12

Expenditure Multipliers

Question 13

Assume that the MPC is equal to 0.6. What does the government spending multiplier equal? What impact would a $5 billion increase in government spending have on equilibrium GDP? What about a $5 billion decrease in G?

Answer 13

Multiplier = 1/.4 = 2.5
$5 billion increase = $12.5 output, upward shift
$5 billion decrease = $12.5 output, downward shift

Question 14

A multiplier that is associated with a change in taxes is called _____?

Answer 14

Tax multiplier, not the same as a spending multiplier, it’s smaller.

Question 15

Give an example of the difference between spending multipliers and a tax multiplier.

Answer 15

If the government increases spending by $1 billion, the entire $1 billion is injected into the income stream. If they reduce taxes by $1 billion, only the MPC x $1 billion is injected into the income stream.

Question 16

What is the equation for the tax multiplier? Why is it negative?

Answer 16

-MPC/(1-MPC)

Since reducing taxes increases income and vice versa, the tax multiplier is negative

Question 17

Describe the change in C as taxes shift in the aggregate expenditures model.

Answer 17

An increase in taxes shifts C downward and a decrease in taxes shifts C upward with the expected impacts on equilibrium GDP.

Question 18

Let’s say the government increases taxes by $16 Billion with an MPC = 0.75. What impact would this have on equilibrium GDP?

Answer 18

The direct answer involves using the tax multiplier. $16 billion x -3 = a $48 billion decrease in the GDP.

Question 19

What does the Balanced-Budget Multiplier tell us?

Answer 19

Essentially, this multiplier tells us what the impact will be on the GDP if you increase both government spending and taxes equally.

Question 20

Assume the MPC is equal to .8. With an MPC of .8, the government spending multiplier is what? The Tax Multiplier? If government increases spending by $2 billion and increases the taxes by $2 billion what is the net affect?

Answer 20

Government Mult: 1/.2 = 5
Tax Mult: .8/.2 = -4
Government $2 billion injection equals a rise in GDP of $10 billion.
Tax increase $2 billion equals a decrease in GDP of $8 billion.
Net affect: GDP increases output by $2 billion

Question 21

What is an equation for the Balanced Budget Multiplier?

Answer 21

Gov. Spending Mult + Tax Mult. = 1
When government increases spending and taxes by the same amount GDP will increase by the initial amount by which it was increased.
Gov. spending increase of $2 bill.
Tax increase of $2 bill
Net Effect of changes = GDP increases $2 bill

Question 22

Let’s say that GDP = 1400 is the full employment output, or the equilibrium level we would like to obtain. Also assume that the MPC is equal to .6. If the economy was actually producing 1300 and the government wanted to implement policies to increase output to 1400 they would need to increase government spending by how much?
What is this gap called?

Answer 22

Gov. Mult. = 1/.4 = 2.5
1400 - 1300 = 100
100 = 2.5x
x = 40
The gap is called the recessionary gap.

Question 23

To change output in the economy from 1500 to 1400 you would have to reduce G by 40. In this case, the 40 in government spending is an ____ ______?

Answer 23

Inflationary Gap

Question 24

When G is used to increase output, it is called ______ ______ and when G is used to decrease output it is called ______ ______.

Answer 24

anti-unemployment policy

anti-inflationary policy

Question 25

Changes in NX have a similar impact on equilibrium GDP as changes in ______or _______spending have.
What is the multiplier for Net Exports?

Answer 25

investment
government
1/MPS or 1/(1-MPC)

Question 26

If the MPC were equal to 0.5 and there were an increase in NX equal to $15 million, the output would increase by how much?

Answer 26

NX multiplier = 1/.5 = 2
$15 mill. * 2 = $30 million
Just like investment and government spending, this also causes and upward shift in the ag. expenditure function.