Expenditure Mulitplier: The Keynesian Model

Question 1

What happens to prices and quantity sold in the very short term?

Answer 1

In the very short term, the price level is fixed, and aggregate demand determines the total quantity sold.

Question 2

What model is used to understand Aggregate Demand (AD)?

Answer 2

To understand AD, we study the aggregate expenditure model.

Question 3

What comprises Aggregate Planned Expenditure (AE)?

Answer 3

Aggregate planned expenditure (AE) is the sum of planned consumption (C), planned investment (I), planned government expenditures (G), planned exports (X), and planned imports (M) subtracted, which equals real GDP (Y).

Question 4

How do consumption and imports relate to real GDP?

Answer 4

Consumption (C) and imports (M) depend on real GDP (Y), such that increases in Y increase AE, and increases in AE subsequently increase Y.

Question 5

What primarily influences consumption and saving?

Answer 5

Consumption and saving depend primarily on disposable income (YD), which is real GDP minus taxes plus transfer payments.

Question 6

What does the consumption function show?

Answer 6

The consumption function shows the relationship between disposable income (YD) and consumption (C)—an increase in YD leads to an increase in C.

Question 7

What does the saving function show?

Answer 7

The saving function shows the relationship between disposable income and saving—an increase in YD leads to an increase in savings (S), with the sum of changes in consumption (ΔC) and savings (ΔS) equaling the change in disposable income (ΔYD).

Question 8

What is the Marginal Propensity to Consume (MPC)?

Answer 8

The Marginal Propensity to Consume (MPC) is the fraction of an increase in disposable income that is consumed, calculated as ΔC/ΔYD, and it represents the slope of the consumption function

Question 9

What is the Marginal Propensity to Save (MPS)?

Answer 9

MPS is the fraction of additional disposable income that is saved, represented as ΔS/ΔYD, and is the slope of the saving function.

Question 10

How do the Marginal Propensity to Consume (MPC) and MPS relate to each other?

Answer 10

The MPC and MPS are complementary; added together they equal 1 (MPC + MPS = 1).

Question 11

What factors can shift the consumption and saving functions aside from changes in disposable income?

Answer 11

Influences that can shift these functions include changes in expected future disposable income, changes in real interest rates, and changes in wealth.

Question 12

How does an increase in expected future disposable income, a decrease in real interest rates, or an increase in wealth affect the saving and consumption functions?

Answer 12

An increase in expected future disposable income, a decrease in real interest rates, or an increase in wealth typically shifts the saving function downward and the consumption function upward.

Question 13

What is the relationship between consumption, saving, and real GDP?

Answer 13

Consumption and saving are functions of real GDP, since an increase in real GDP leads to an increase in disposable income (YD).

Question 14

What does the import function describe?

Answer 14

The import function relates the amount of imports to real GDP.

Question 15

What is the Marginal Propensity to Import?

Answer 15

The Marginal Propensity to Import is the fraction of additional income (ΔY) that is spent on imports, calculated as ΔM/ΔY.

Question 16

What determines Real GDP (Y) and how is Aggregate Expenditure (AE) influenced?

Answer 16

Components of aggregate expenditure interact to determine Real GDP (Y), and AE is influenced by Y. An increase in Y leads to an increase in AE.

Question 17

What are the two parts of Aggregate Planned Expenditure (AE)?

Answer 17

AE has two parts: Autonomous Expenditure (A) which is the part that does not vary with income (I + G + EX), and Induced Expenditure (N) which is the part that does vary with income (C – I).

Question 18

What happens when actual aggregate expenditure does not match planned expenditure?

Answer 18

When actual aggregate expenditure does not equal planned expenditure, if the level of real GDP is not consistent with plans, there can be unplanned increases or decreases in inventories.

Question 19

What is Equilibrium Expenditure?

Answer 19

Equilibrium expenditure is the level of aggregate expenditure where AE equals real GDP, typically where the AE curve crosses the 45° line on a graph.

Question 20

What occurs when real GDP is above its equilibrium value?

Answer 20

If real GDP is above the equilibrium value, AE is less than real GDP, leading firms to experience unplanned inventory increases, prompting them to decrease production, thereby moving GDP toward equilibrium.

Question 21

What occurs when real GDP is below its equilibrium value?

Answer 21

If real GDP is below the equilibrium value, AE is greater than real GDP, causing firms to sell all production and more, leading to unplanned inventory decreases. This prompts firms to increase production, raising GDP toward equilibrium.

Question 22

What is the multiplier in macroeconomics?

Answer 22

The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP.

Question 23

What effect does an increase in autonomous expenditure have on real GDP?

Answer 23

An increase in autonomous expenditure increases real GDP, which leads to a further increase in aggregate planned expenditure, resulting in subsequent increases in real GDP.

Question 24

What are induced effects in the context of the multiplier?

Answer 24

Induced effects refer to the secondary impact where the total increase in real GDP is greater than the initial increase in autonomous expenditure.

Question 25

How is the multiplier calculated?

Answer 25

The multiplier is calculated as the change in real GDP divided by the change in autonomous expenditure, which is 1 divided by (1 minus the slope of the AE function).

Question 26

Why is the multiplier greater than 1?

Answer 26

The multiplier is greater than 1 because of induced effects, meaning that the initial spending leads to further rounds of spending, amplifying the initial impact.

Question 27

What factors lead to a larger multiplier?

Answer 27

A larger multiplier can result from a higher slope of the AE function, a higher Marginal Propensity to Consume (MPC), a lower marginal tax rate, or a lower marginal propensity to import.

Question 28

How do recessions and depressions relate to the multiplier effect?

Answer 28

Recessions and depressions often begin with expenditure fluctuations that are magnified by the multiplier effect, leading to larger swings in economic activity than the initial change would suggest

Question 29

What does the aggregate demand curve show?

Answer 29

The aggregate demand curve shows the relationship between real GDP demanded and the price level, with other factors held constant, and it can be derived from the AE curve.

Question 30

How does an increase in the price level affect the AE curve and equilibrium real GDP?

Answer 30

An increase in the price level shifts the AE curve downward, due to wealth and substitution effects, which lowers equilibrium real GDP and is represented by a movement up and to the left on the AD curve.

Question 31

What effect do non-price variables have on AE and AD curves?

Answer 31

Changes in non-price variables (like autonomous expenditures) can shift both AE and AD curves.

Question 32

How does a change in AE affect the AD curve in the short run?

Answer 32

In the short run, an increase in AE leads to a rightward shift in the AD curve, increasing the price level, which then lowers AE somewhat, offsetting the increase in Y to some extent, so the multiplier is smaller.

Question 33

What happens to the multiplier in the long run according to the vertical LAS?

Answer 33

In the long run, because the LAS is vertical, a large enough increase in the price level can cause a decrease in AE that totally offsets the initial increase, resulting in a multiplier of 0.