2.4 (Investment and the Multiplier) This chapter assumes that investment is autonomous. What would happen to the size of the multiplier if investment increases as real GDP increases? Explain.
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3.1 (Shifts of Aggregate Demand) Assume the simple spending multiplier equals 10. Determine the size and direction of any changes of the aggregate expenditure line, real GDP demanded, and the aggregate demand curve for each of the following changes in spending:
a. Spending rises by $8 billion at each income level
b. Spending falls by $5 billion at each income level
c. Spending rises by $20 billion at each income level
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To answer these questions, let's start with the concept of the multiplier effect.
The multiplier effect refers to the phenomenon where an initial change in spending leads to a larger overall impact on the economy. This occurs because when someone spends money, it becomes income for someone else, and that person in turn spends some of that income, creating a chain of spending. As a result, every dollar spent has a multiplying effect on the economy.
To calculate the multiplier, we can use the formula:
Multiplier = 1 / (1 - MPC)
Where MPC (Marginal Propensity to Consume) is the portion of each additional dollar of income that is spent rather than saved. The MPC is usually a fraction between 0 and 1, indicating that some portion of income is saved.
Now let's answer the questions:
2.4: If investment increases as real GDP increases, it means that there is a positive relationship between investment and GDP. In this case, the multiplier effect becomes larger. This is because the initial increase in investment triggers an increase in income, which leads to higher consumption, and subsequently, more spending. As a result, the multiplier effect amplifies the impact of investment on GDP.
3.1:
a. If spending rises by $8 billion at each income level, we can calculate the change in real GDP demanded and aggregate expenditure using the multiplier. Since the multiplier is given as 10, the change in real GDP demanded will be 10 times the initial change in spending, which is $8 billion. Therefore, the change in real GDP demanded would be $80 billion ($8 billion × 10). The aggregate expenditure line and the aggregate demand curve would shift upward by $8 billion each.
b. Similarly, if spending falls by $5 billion at each income level, the change in real GDP demanded would be -$50 billion ($5 billion × 10) since the multiplier is still 10. The aggregate expenditure line and the aggregate demand curve would shift downward by $5 billion each.
c. If spending rises by $20 billion at each income level, the change in real GDP demanded will be $200 billion ($20 billion × 10) based on the multiplier of 10. Thus, the aggregate expenditure line and the aggregate demand curve would shift upward by $20 billion each.
Remember, the multiplier effect plays a significant role in determining the overall impact of changes in spending on real GDP and the aggregate demand curve.