McConnell Economics, Chapter 10

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Jin+Guice
Posts: 708
Joined: Sat Jun 30, 2018 8:15 am

McConnell Economics, Chapter 10

Post by Jin+Guice »

Discussion of the curriculum McConnell, Brue, Flynn Economics text, chapter 10.

Jin+Guice
Posts: 708
Joined: Sat Jun 30, 2018 8:15 am

Re: McConnell Economics, Chapter 10

Post by Jin+Guice »

Chapter 10 discusses aggregate expenditures in more detail. It adds net exports and government spending to the model and discusses the "multiplier effect."

The first section of this chapter discusses the multiplier effect. A dollar of spending by one person is a dollar of income for another person. This person will in turn spend some of that money. Since the money is spent more than once, an initial increase in expenditures (the book highlights that this is more likely to be due to investment spending than consumption, because investment spending has generally been more volatile), will result in a larger change in aggregate expenditures. This is the multiplier effect.

The magnitude of the multiplier effect is determined by the Marginal Propensity to Consume (MPC). A higher MPC will result in a higher multiplier effect and a lower MPC will result in a lower multiplier effect. Recall that when income is received it can be either be saved or used for consumption. If, on average, a higher proportion is used for consumption, the multiplier effect will be higher because each person spends a great proportion of the income they receive. Since one person's consumption is another's income, this ends up being an iterative process. Frankly, I find this confusing to understand or describe in words, but Table 10.1 helped me to understand it and I recommend checking it out if you are confused about how this process works.

Section 2 discusses how net exports impact GDP. GDP measures the amount of production that happens domestically. If production occurs domestically and is then exported to another country, GDP increases. If production occurs outside the country and is imported GDP will decrease (because this spending would initially be added to total consumption expenditures). Subtracting imports from exports gives us "net exports," which we can then add to consumption and investment in our total expenditures equation.

The next section deals with adding government spending to the aggregate expenditures model. Government spending will increase aggregate expenditures. The increase in aggregate expenditures will be equal to the increase in government spending times the multiplier (the same as discussed above). But governments need to fund this increase somehow. If the government funds the spending increase with a "lump-sum" tax equal to the amount of the increase,  aggregate expenditures will increase by the amount government spending (and taxation) increase by. 

Why?

Taxes reduce consumption by the amount of the tax increase multiplied by the MPC (and savings by the tax increase multiplied by MPS). So taxes decrease aggregate expenditures by some fraction of the tax increase. OTOH, government spending increases aggregate expenditures by the full amount of the spending increase. Thus, aggregate expenditures (GDP) increases. This is called the "balanced budget multiplier" and it is always 1, as long as the tax and government spending increase are the same. As with the other multiplier, there is a numerical example in the book, which I found very helpful.

Another important result of adding government expenditures and import/ exports to the "closed model" is that instead of Savings= Investments, we get Savings + Imports + Taxes = Investments + Exports + Government Spending

The final section of this chapter discusses recessionary and inflationary gaps using the aggregate expenditures model. To calculate this gap, we must first determine the amount of aggregate expenditures at which full employment would occur. If the amount of expenditures needed for full employment is greater than current expenditures, there is an inflationary gap, if it is less there is a recessionary gap. The magnitude of the gap is determined by the difference of current expenditure and "full employment expenditures."

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