GDP and the Multiplier Process

Transcription

1 CHAPTER 12 GDP and the Multiplier Process LEARNING OBJECTIVES After reading this chapter, you should understand why economic fluctuations can develop from the temporary mismatch between saving by households and investment spending by firms; how the expenditure multiplier can magnify the economy s reaction to both foreign shocks and domestic policy initiatives; and what determines the size of the expenditure multiplier. Introduction fiscal policy the government s plan for spending and taxes. It is sometimes adjusted with a view to pushing aggregate demand in one direction or another. Each year, the government tables a budget in Parliament. The budget is a detailed statement of what the government will spend money on and how it will raise tax revenue. Sometimes the government adjusts its overall level of spending or taxation with a view to lowering unemployment or inflation. For example, the government might increase expenditures in an attempt to create jobs, or it might lower expenditures to lessen the overall demand for goods and services, so that firms are less likely to increase prices. This range of policies, the varying of government spending and taxes to stabilize the economy, is called fiscal policy. The purpose of this and the next chapter is to understand fiscal policy. This is accomplished by taking a behind the scenes look at the aggregate demand curve. A Simple Scale-Model Economy To examine the logic behind aggregate demand, we consider a simplified model economy whose main features are highlighted in Figure Notice that there are only households and firms in this flowchart. Nowhere in the chart is there any reference to the government, the rest of the world, or a financial sector since we ignore all these complications for now. Production takes place where firms are located in the flowchart. Firms use the labour time and the machines owned by households to produce goods and services. We have learned that the value of all these goods produced (i.e., firms total sales of final goods and services) equals the value of all the income earned by all households. After all, what do firms do with all the revenue they collect when they sell their commodities? They pay some of it as wages, some as rent payments, and some as interest on borrowed items. The amount left over is profit. In this simple economy, we assume no retained earnings, so all the profits are distributed as dividend income to shareholders. The arrow at the bottom of the flowchart indicates that all income earned in the production process is sent to households to do what they wish with it. 158

2 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 159 Savings Consumption Investment Figure 12.1 The Circular Flow of Income and Spending Households Production = Income Firms Production creates income and households spend part of that income. A balance of supply and demand requires that investment purchases by firms just make up for the lack of spending (saving) by households. These investment and saving decisions are made independently. Households can either spend the income (an amount we call consumption) or save it, and the two arrows indicating funds leaving households in the flowchart show these two possibilities. The funds that are spent travel directly back to the firms. If savings were zero, then the total amount of consumption expenditures by households would just equal their income. Since this total also represents the value of goods produced, there could be no problem of accumulating inventory for firms in this case. But since households do save, consumption is less than the total value of production. So, if there is not some other component of demand (in addition to consumption spending by households), then there will not be enough purchases to justify the level of production that the firms undertook to create the income in the first place. There is a second component of demand since (as a group) firms buy some of their own output. Some of the currently produced output is new machines and new factories. We call this category of expenditures on new plant and equipment investment spending. The system will be in equilibrium (i.e., firms will go on producing whatever level of output they have been producing) if the sum of household consumption purchases plus firms investment expenditures equals the amount of goods produced in that period. In other words, demand equals supply. consumption total spending by households on goods that satisfy current needs investment total spending by firms on new capital equipment Equilibrium in the Circular Flow of Income and Spending As just noted, equilibrium exists when supply equals demand. Since supply is the value of GDP and demand is the sum of the intended consumption spending by households (abbreviated as C) and the intended investment spending by firms (abbreviated as I), the equilibrium condition is GDP = C + I. There is another way of stating the equilibrium condition for this simple economy, and it follows from the fact that household saving is all income that is not consumed. Saving (abbreviated as S) equals GDP C. Combining this definition with the equilibrium condition given above (to eliminate GDP by substitution) yields I = S.

3 160 MACROECONOMICS saving income that is not spent on current consumption consumption function the relationship between total consumption spending and total household income; graphed by holding all other determinants of consumption constant marginal propensity to consume the ratio of the change in consumption to the change in disposable income. Graphically, the MPC is the slope of the consumption function. This alternative statement of the equilibrium condition says that the injection of funds by firms investment spending has to be the same magnitude as the amount of funds withdrawn from the circular flow of income and spending by households saving. Only if there is this balance between the injection and withdrawal of funds will overall demand equal supply. We are using the term investment differently from its everyday interpretation. When an individual household buys a Canada Savings Bond, most people refer to that as an investment in government bonds. Economists call it an act of saving, not investment. The term investment is reserved for purchases of new capital equipment by firms. Economists use terms in this way to stress the fact that households saving decisions and firms investment decisions are separate. As a result, there is no reason to assume that intended saving and intended investment will automatically equal each other. After all, households make decisions about how much to save without having any knowledge of what firms may need in terms of new plant and equipment. Similarly, firms make investment decisions without any reference to whether households want to do much saving that period. Let us examine what happens when households become worried about the future, perhaps fearing the loss of jobs. In this situation, households decrease consumption and increase saving. Doing so throws the initial equilibrium out of balance. With decreased household spending, there is not enough demand to justify the pre-existing level of production, so firms will have to lay some people off. And these job losses do not constitute the whole story. Those laid off will earn less, so there will be a smaller amount of income flowing to households along the bottom arrow in Figure The result is yet another decrease in household consumption expenditures, and firms will have to lay off even more people. When households react to their fears of layoffs, they set in motion a chain of events that causes the very layoffs they feared. The anticipation of a recession can cause a recession. Many people find this fact discouraging. They become even more concerned when they realize that the recession can feed on itself, with each round of layoffs leading to less household spending and thus to still more layoffs. Does this vicious circle of lower incomes and lost jobs keep feeding on itself forever? To answer this question, we have to make more specific assumptions about how households behave. Let us assume that household spending depends on household income as summarized in Figure We see from this graph that consumption spending goes up when income goes up. When we take annual consumption and total income data and plot it, the result is a set of observations that form the straight line labelled C. Economists call this relationship the consumption function, and they call the slope of this line the marginal propensity to consume or MPC. The marginal propensity to consume is positive, but it has a value that is less than one. The consumption function has this slope because, when people get an extra dollar of income, the increase in consumption is always some fraction of that dollar, such as 90 cents, with the remainder, 10 cents in this example, being saved. We can emphasize the fact that the marginal propensity to consume is a fraction by adding a 45º line to the graph as in Figure A 45º line shows

4 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 161 Consumption Spending C Figure 12.2 The Consumption Function MPC = Δ C Δ Income Δ Income Δ C Household spending rises with income. The amount consumption increases with each unit increase in income (the slope of the consumption function) is called the marginal propensity to consume (MPC). Example: MPC = 0.6 Income all those points at which consumption would be equal to income (i.e., where saving is zero). When people s incomes vary, they spend more than current income during low-income periods (perhaps by drawing down bank balances), and they spend less than current income during high-income periods (using leftover funds to build up bank balances). Saving is negative in the first case and positive in the second. The second case is shown in Figure Consumption Positive Saving C Figure 12.3 Consumption and Saving Income not spent by households is called saving. Spending 45 Income What we wish to show graphically is that level of total income and production that will just be bought by households and firms, assuming that households make their spending decisions according to this consumption relationship. We simplify at this stage by assuming that firms have fixed investment plans. We assume that firms want to spend an amount on new equipment equal to the height of the line labelled I in Figure 12.4.

5 162 MACROECONOMICS Figure 12.4 Consumption and Investment In the simplified model economy, total spending (demand) is the sum of household consumption (C) and investment spending by firms (I). Spending C + Ι C Ι Income = Production Figure 12.4 involves two schedules of spending intentions, one for each of the two groups in our model economy: households and firms. It contains the upward-sloping consumption line (the households decision rule showing that spending increases with income) and the horizontal investment line (the firms decision rule showing their fixed investment plans). Figure 12.4 also shows these two plans combined (labelled as the C + I line). By adding the C and I lines together vertically, we get an overall intentions-to-buy schedule that shows how much total spending will be at all possible levels of national income. We can use Figure 12.4 to illustrate the equilibrium level of GDP. For any level of total output measured along the horizontal axis, we can read off the corresponding height of the total spending line to determine total demand for goods. Equilibrium occurs where supply (the distance along the production axis) is just equal to demand (the height up to the C + I line). But it is difficult to compare a horizontal distance to a vertical one. We solve this problem by again adding a 45º line as in Figure The 45º line transfers horizontal measures into vertical measures of the same distance. Consider the intersection of the total spending line with the 45º line. At this point, the height of the total spending line (demand) is equal to the value of goods and services produced and the income that this production generates (supply) since the right-angled triangle in Figure 12.5 involves sides of equal length. This point determines equilibrium. The Multiplier Process Earlier in this chapter, we considered a situation in which households were worried about job loss. That concern led to caution, and they increased their savings. This decreased spending led to the very recession that people feared. We now have the tools that allow us to understand this process in more detail. A multiplier process is set in motion whenever there is a change in any component of total spending, and the same process unfolds whichever direc-

6 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 163 Spending C + Ι C Figure 12.5 Equilibrium GDP Supply of goods (GDP) equals demand (C + I) at the level of GDP given by the intersection of the total spending line and the 45 line. 45 Income = Production tion the change in spending pushes the economy. Let us consider an increase in investment spending by firms, and you can consider a decrease in spending by households on your own for review. Suppose firms spend an additional $1 billion on new equipment. We are interested in determining how much this event will change the nation s GDP. It turns out that the resulting change in GDP is a multiple of the original $1 billion change in investment spending. We call this ratio of changes the multiplier: writing this ratio of changes in compact form, we have multiplier = ΔGDP/ΔI. We now derive a formula for this multiplier. When producers respond to the extra investment demand of $1 billion by creating that additional amount of new machines and equipment, they will employ additional workers, and an additional $1 billion of income will be created. This fact is illustrated in Figure 12.6 by the plus 1 entry by the investment and production components of the flowchart. Once this extra income reaches the households, they do some additional spending. To have a specific numerical example, we take the marginal propensity to consume to be 0.6. In other words, 60 cents of every additional dollar gets spent, and 40 cents is saved. Given this assumption, there is an induced increase in consumption demand because of the additional $1 billion of income earned. Thus, there is a second round of increased expenditure equal to $600 million. This fact is indicated by the plus 0.6 entry by the consumption component of the flowchart. Firms have to increase the level of production again. They have met the new investment demand, but they have not yet met the $600 million of extra demand by households. So once firms create more jobs for that demand, they will have created $600 million more income, so six-tenths of that $600 million will get spent by the next group of people who get hired. This fact is indicated by the plus (0.6) 2 entry by the production and consumption components of the flowchart. We can see that, when all these amounts of extra income are added together, the overall increase in production is multiplier the ratio of the change in overall demand to the original change in the one component of demand that created that set of adjustments in expenditure. It measures how much real GDP would increase if interest rates, the exchange rate, and prices stayed constant.

7 164 MACROECONOMICS Figure 12.6 The Multiplier Process C ( ( 0.6 ) ) When firms react to each rise in demand by increasing production, more income and another increase in demand is created. As a result, the overall increase in output exceeds the initial rise in demand. Households S Ι ( + 1 ) Firms Income = Production ( ( 0.6 ) ) ($1 billion) times ( (0.6) ). Thus, the multiplier, ΔGDP/ΔI, is ( (0.6) ). This infinite sum has a finite total equal to 1/(1 0.6) or 2.5. For this numerical example, then, the expenditure multiplier is 2.5. The easiest way to see that the multiplier is 2.5 is to multiply both sides of the multiplier equation by 0.6: multiplier = ( (0.6) ) (0.6)(multiplier) = (0.6 + (0.6) ). Subtracting the second line from the first yields (1 0.6)(multiplier) = 1, or multiplier = 1/(1 0.6). We should remember, of course, that we picked the marginal propensity to consume value of 0.6 as an arbitrary example. We should also remember that each additional dollar of income must be either consumed or saved. Thus, if we define the marginal propensity to save (MPS) as the change in saving divided by the change in income, then we have MPC + MPS = 1, and multiplier = 1/(1 MPC) = 1/MPS. Do not let all these formal expressions for calculating the multiplier distract you from the basic intuition behind why there is a multiplier in the first place. You can think of the multiplier working like a ripple effect. The ripples, created when you throw a pebble into water, spread across the pond. In the same way, getting a new job means you have more income to spend. That creates another job and so on, but in ever smaller amounts. Similarly, the ripples moving across the pond eventually die down. We now illustrate the multiplier in terms of an income-expenditure diagram in Figure The initial equilibrium is point A. Now assume that investment increases by an amount equal to ΔI. The higher level of investment spending raises the I line, and therefore the position of the C + I line,

8 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 165 by ΔI. The new equilibrium point is where the now relevant C + I line intersects the 45º line, point B. Figure 12.7 makes it clear that the overall increase in GDP exceeds the initial change in investment spending that causes the expansion, so a multiplier effect does exist. The multiplier is the ratio of the GDP change distance to the investment change distance. Δ Ι C, I A Equilibrium After Ι B Δ Ι Δ GDP C + Ι After Ι C + Ι Figure 12.7 The Multiplier Process The multiplier is a ratio, the resulting change in total production divided by the initial change in demand. The steeper is the total spending line, the bigger is the multiplier. 45 Δ GDP A More Realistic Model Economy Income = Production Now that we understand the basic principles, let s make our model economy more realistic by adding a government and a foreign sector. These additional features are included in Figure As before, we start our discussion of how the economy works with firms. Production takes place there, and the total value of production creates the nation s pre-tax income (GDP), which starts on its way over to households near the bottom of the flowchart. But the government takes some of this income in the form of taxes (abbreviated as T), so there is a withdrawal of funds at that point. What is left to make it all the way over to the households is called disposable income; it is that part of pre-tax income that households can dispose of as they wish. Thus, the existence of government means an additional withdrawal of funds (taxes) from the circular flow. As before, more funds are withdrawn at the household stage for savings. Consumption is noticeably smaller than total production in this case since households consume only a fraction of their disposable income, and disposable income is only a fraction of pre-tax income. It is pre-tax income that equals the value of production. Furthermore, some of the household expenditures are not for our products at all. They are for products imported from the rest of the world (imports is abbreviated as IM), so yet another withdrawal of funds from the circular flow occurs at the top of the flowchart. Funds flow the other way too. The rest of the world buys some of our products, and those incoming funds are shown in Figure 12.8 by the arrow indicating exports (abbreviated as X). Firms still do some investment spending on new machines and equipment, and the government buys some goods and services (government spending is abbreviated as G). All these arrows pointing toward the disposable income household discretionary income; the sum of all incomes earned during the period after transfer payments have been added and taxes have been subtracted

9 166 MACROECONOMICS firms in Figure 12.8 show that there are many more components to aggregate demand in this more complicated and realistic model economy. Figure 12.8 The Circular Flow in a More Complex Setting Ι M Rest of World C X The Canadian economy is more complex than the scale model economy. There are several injections of funds (I, G, X) and several withdrawals of funds (S, T, IM). Equilibrium still requires that total injections equal total withdrawals. Households Disposable Income S Ι GDP T Firms Government G But despite this extra detail, the reasoning that we used before still applies. The equilibrium level of national product is reached when the sum of all the demands is just balanced by the level of production, that is, GDP. Things are a bit more complicated here solely because total demand is no longer just consumption plus investment. In this more general setting, total demand is consumption + investment + government spending + net exports, or total demand = C + I + G + (X IM). This fact means that when we draw an income-expenditure diagram to show the determination of equilibrium graphically, we do not just add up the C line and the I line. We now have to draw in three more lines: an export line, a government expenditure line, and an import line. And we must do some adding and subtracting to derive the total spending line. Nonetheless, the economic reasoning is the same. Equilibrium occurs where the total spending line intersects the 45º line. Two points are worth emphasizing. First, since both taxes and imports rise when people s incomes are higher, the subtraction of these components makes the slope of the total spending line (labelled C + I + G + X IM from now on) much flatter than in our previous discussion. Remember that the taxes levied on high-income individuals are greater than those levied on lowincome individuals. As a result, when the consumption line gets pulled down because of taxes, it gets pulled down more at the high-income end of the graph than at the low-income end, and this flattens the total spending line. This flatter total spending line means that when we consider a change in total expenditure, such as a change in investment or government expendi-

10 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 167 ture or exports, it will involve a smaller multiplier effect. Try drawing two income-expenditure diagrams on your own, one with a fairly flat total spending line, and one with a steep total spending line. A change in government spending shifts both lines vertically by the same distance, but the multiplied change along the GDP axis is much smaller when the total spending line is flatter. Since Canadians have a high propensity to import goods and services and we face high marginal tax rates, Canada s multiplier has been estimated to be noticeably less than two. It is therefore misleading to give a lot of emphasis to the multiplied effects that follow expenditure changes. Once a realistic slope for the total spending line is considered, the very term multiplier has a misleading connotation. This means that we must have modest expectations about how much fiscal policy can do to reduce a recession. With a small multiplier, it takes a large increase in government spending or a large tax cut to significantly raise GDP. Since it is difficult for governments to contemplate large spending increases or big tax cuts when they are trying to avoid a budget deficit, the small expenditure multiplier makes it difficult for the government to create many jobs. Inflation and the Multiplier We started our study of business cycles by noting that we would focus on the problems of unemployment and inflation. But so far in this chapter, we have simplified the analysis by assuming that all increases in demand lead to more workers being hired. There has been no mention of firms raising prices in response to the higher demand for their products. We now fill in this gap. Variations in domestic prices cause reactions on the part of our central bank, the Bank of Canada. Officials at the Bank try to limit inflation. Thus, when the price level rises, they push up the level of interest rates. The higher borrowing costs cause firms to revise downward their investment spending plans. As a result, the higher is the price level, the lower is the investment spending component of total spending, so the lower is the position of Canada s C + I + G + X IM line. A similar effect operates through the net export component of total spending since variations in domestic prices affect our country s international competitive position. The more expensive our products are, the less successful we are in selling goods to the rest of the world. To allow for both the investment and net export responses to the price level, we must draw a whole family of total spending lines, one for every possible level of domestic prices. In Figure 12.9, we see two members of this family of total spending lines. The lower one is the total spending line for price level P 1, which stands for a high price level. Expensive domestic goods mean low export demand and a high level of imports, so the result is a low position for the total spending line in the graph. We also see a higher total spending line in Figure 12.9 corresponding to price level P 2, which stands for a lower level of domestic prices. These lower prices lead to high export sales and a smaller amount of imports. The result is a higher position for the total spending line.

11 168 MACROECONOMICS Figure 12.9 Derivation of the Aggregate Demand Curve Higher domestic prices mean that Canada sells fewer net exports. Also, the Bank of Canada reacts by raising borrowing costs so investment spending is lower too. The inverse dependence of total spending on the price level is summarized by the negative slope of the aggregate demand curve. Expenditures Domestic Price Level P P A 1 B 2 C + Ι + G + X ΙM with Low Domestic Price (P 2 ) C + Ι + G + X ΙM with High Domestic Price (P ) Real GDP 1 Aggregate Demand Real GDP The lower quadrant in Figure 12.9 summarizes this relationship. If the price level is high at P 1 then the lower spending line is relevant, and GDP is given by point A. This combination of values for price and real GDP is recorded in the lower quadrant by point 1. If the price level is lower at P 2 then there is higher spending, and GDP is given by point B. This second combination of values for price and real GDP is recorded in the lower panel of Figure 12.9 by point 2. So we have two points in the summary quadrant of the graph that show combinations of domestic price and output for which firms just manage to sell all their current output. We join all such dots and call the resulting summary line the aggregate demand curve. In the preceding chapter, the aggregate demand curve was introduced and, in this chapter, the details behind it have been provided. Now we can understand more precisely how government policy changes affect the position of the aggregate demand curve. The effect of an increase in government spending is shown in Figure Higher government expenditures shift up the entire family of total spending lines, so this policy moves the position of the summary line, the aggregate demand curve, to the right. Now that we are summarizing the whole multiplier process in terms of the position of the aggregate demand curve, we see that the expenditure multiplier represents how much the aggregate demand curve moves horizontally per unit of vertical shift in the family of total spending lines. So the expenditure multiplier summarizes what would happen if prices stayed constant. As illustrated in Figure 12.11, prices would stay constant only if the aggregate supply curve were horizontal. In that case, an expansion in government spending, for example, would shift the economy from point A to

12 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 169 Expenditures P G Domestic Price Level 1 G 45 } C + Ι + G + X ΙM for P } C + Ι + G + X ΙM for P 2 1 Real GDP Figure Shifts in the Aggregate Demand Curve Any increase in spending shifts the total spending line up by that amount and so it shifts the aggregate demand curve to the right by that amount times the expenditure multiplier. P 2 Aggregate Demand After G Real GDP point B. However, the aggregate supply curve is not horizontal. It has a positive slope. Thus, the actual intersection point that the economy moves to following a policy intended to create jobs is not point B. The basic multiplier formula yields an overestimate of the true outcome. In fact, we obtain a smaller increase in real output, such as that given by point C. Some of the effect of the policy is dissipated in the form of higher prices. Price Aggregate Supply Figure Inflation Shrinks the Multiplier A C B Aggregate Demand The multiplier indicates how much output would increase following a rise in spending if prices stayed constant. But, since the aggregate supply curve is positively sloped, prices rise and the actual increase in real output is smaller. Real GDP Thus, there are two broad categories of reasons why government demand-management policy does not work as well as some would like. First, when the government raises its expenditures, it cannot move the aggregate

13 170 MACROECONOMICS demand curve very far to the right. With high tax rates and a high propensity to import goods and services as our incomes increase, the expenditure multiplier is simply too small. Thus, the first stumbling block is that it takes a major policy initiative to move the demand curve very far to the right. Second, even if the government does engineer a noticeable movement of the demand curve to the right, it has to confront the fact that the aggregate supply curve can be fairly steep. This forces the increase in demand to result mostly in inflation, with the policy having only limited effect on real output and therefore on job creation. Putting these two considerations together, we are justified in having modest expectations about how well the government can create jobs. Fiscal policy can be used to ward off a major collapse in aggregate demand, but the government cannot fine-tune the economy. Some readers may find the two-quadrant diagrammatic derivation of the aggregate demand curve confusing. The algebraic derivation presented below offers a second way to understand this topic. For simplicity, this algebraic treatment concerns the simple scale-model economy that we considered at the start of this chapter, one that has no government or foreign trade. Thus, the negative slope of the aggregate demand curve follows only from the central bank adjusting interest rates in response to price changes, not from the dependence of net export demand on the relative price of domestically produced goods. In this scale model economy, the relationships that define the components of aggregate demand are: GDP = C + I C = C* + c(gdp) I = I* br r = r* + a(p P*) Definition of aggregate demand Consumption function Investment function Monetary policy The first equation states that the total of all goods produced, the GDP, must be purchased by either households (C) or firms (I). The household consumption function is the second equation as shown above in Figure 12.3 (page 161). C* stands for the vertical intercept in that figure, and c denotes the marginal propensity to consume (the slope of the line shown in Figure 12.3). As discussed above, c is (realistically) assumed to be a positive fraction. Firms investment spending on new plant and equipment depends inversely on the cost of borrowing. To capture this fact, we specify investment as an inverse function of the interest rate (r) in the third equation. I* is the intercept of this equation, and b is a positive parameter that defines the magnitude of the firms reaction to changes in the interest rate that they must pay on their loans. Finally, the fourth equation defines the behaviour of the central bank. The bank s goal is stable prices, that is, the bank wants to keep the price level (P) from either rising or falling. To pursue this goal, the bank adjusts the nation s interest rate so that the current value is above (or below) its long-run average value (r*) whenever the observed price level is above (or below) its target value (P*). The bank assumes that by raising the interest rate, it will induce firms to cut back their spending. This reduction in aggregate demand is intended to increase firms unsold inventories, which (in turn) should

14 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 171 induce firms to lower prices (and to bring the overall price index back to the bank s target path). Parameter a defines the degree of aggressiveness that the central bank displays as it pursues this price stability objective. When the four equations are combined (eliminating variables C, I, and r by substitution), the one remaining relationship is the equation which defines the nation s aggregate demand function: GDP = (1/(1 c))(z abp), where Z = (C* + I* br* + abp*). By rewriting this relationship in change form, ΔGDP = (1/(1 c))(δz abδp), we can see that it clarifies two things. First, the expenditure multiplier is ΔGDP/ΔZ = 1/(1 c), as we derived less formally earlier in this chapter. Second, since the slope of the aggregate demand curve (in price-output space) is rise/run = ΔP/ΔGDP, the expression that defines this slope is: slope of the aggregate demand curve = (1 c)/ab. This expression confirms that the slope of the demand curve is negative as long as the marginal propensity to consume is a fraction and as long as parameters a and b are both positive. The only one of these propositions that is in doubt is the one concerning the central bank parameter a. In some cases, the bank cannot manipulate the interest rate, and we must acknowledge this possible situation by setting the bank s reaction parameter to zero (a = 0) in some instances. The aggregate demand curve becomes vertical, not negatively sloped, in this situation. We explore the significance of this infrequent, but important, development in later chapters. SUMMARY Here is a review of the key concepts covered in this chapter. We have understood how equilibrium GDP gets determined, and we have used this understanding to follow through the expenditure multiplier process. By deriving both the multiplier formula and how the position of the aggregate demand curve depends on the multiplier, we were able to appreciate why Canada s multiplier is small. In the next chapter, we will use this set of tools to examine the government s fiscal policy in more detail and to determine the effect of this policy on the government s deficit and on our national debt. SUGGESTIONS FOR FURTHER READING T. Courchene, Social Canada in the Millennium: Reform Imperatives and Restructuring Principles (Toronto: C.D. Howe Institute, 1994). Fiscal policy involves attempts to stabilize the economy through the multiplier process while adjusting government spending and taxes, but getting the timing right is a challenge when there are so many fiscal agreements between

15 172 MACROECONOMICS Ottawa and the provinces; Courchene s book is a landmark evaluation of these sharing arrangements. WEB LINKS Department of Finance Canada click on Economic and Fiscal Info, then on Budget Information to learn the department s views on macroeconomics. Click on Hotlinks to gain access to many other related topics. QUESTIONS TO TEST YOUR UNDERSTANDING 1. Assume that consumption and investment expenditures are determined by the following decision rules: C = Y and I = Y, where Y stands for real GDP. What is the equilibrium value of GDP? 2. The greater the slope of the consumption function, (I) the smaller is the marginal propensity to save and (II) the greater is the expenditure multiplier. a. I and I. b. I, but not II c. II, but not I d. neither I nor II 3. If all of every dollar of increased income goes to savings, taxes, or imports, then the government expenditure multiplier on GDP is a. zero b. one c. infinity d. 1/(1 MPC) e. none of the above 4. The self-correction process for a recessionary gap includes (I) a downward shift in the short-run aggregate supply curve and (II) an upward shift in the total expenditure line. a. I and II b. I, but not II c. II, but not I d. neither I nor II 5. If the horizontal shift in the aggregate demand curve is $10 billion and the multiplier is four, then what must have been the vertical shift in the total expenditure line? 6. Western governments are tempted to adjust the levels of government spending and taxation with a view to lowering unemployment. Political support for such initiatives is limited, however, if these policies lower the incomes of those who already have jobs. Use the tools of aggregate supply and demand curves to investigate this possibility. Have your scale model

16 CHAPTER 12: GDP AND THE MULTIPLIER PROCESS 173 economy start with a level of actual real GDP that coincides with its potential value. Then analyze an increase in government spending. Remember that the effect on unemployment follows from what happens to real GDP, and that the effect on the real incomes of those already employed follows from what happens to the real value of those individuals wages. Their real wages are determined by dividing their nominal wage (which is a shift influence for the short-run aggregate supply curve) by the price of goods.