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Explain The Operation Of The Keynesian Multiplier

Essay, Research Paper

a)? Explain the operation of the Keynesian

multiplierThe easiest way to

explain the way in which the multiplier works according to Keynes is to

construct a simple model.? This model

will have two particular simplifying features, in that it will focus

exclusively on the demand side of the economy, and it will not include either

government activity or the foreign sector.?

In order to construct this model, we will assume that all prices and wages

are fixed within the economy, and that there are unemployed workers seeking

jobs and firms that are not operating at their highest possible profitable

capacity.? From these two assumptions,

it follows that the output of firms is being limited not by unavailability of

labour, but demand.? Firms will be

producing at a level of output determined by demand.Demand in this

model will come from two sectors, namely households and firms, since these are

the only sectors currently represented in the model.? Households will be generating demand for consumption, which is

defined as the part of their personal disposable income which households choose

to spend rather than save, and firms will be generating demand for

investment.? We can make the general

rule that the more personal disposable income households have, the higher their

consumption will be.? This is very much

a rule of thumb, because the amount of the income which households choose to

spend and the amount they choose to spend are affected by many factors, but for

the purposes of this model this rule will suffice.? From this we are able to graph the consumption function, which

shows the relationship between personal disposable income and the level of

consumption which households will desire:Having said that

demand in this model comes from households and firms, we can establish that in

this model aggregate demand will be equal to consumption demand by households

and investment demand by firms.?

Investment demand is defined as the amount which firms plan to invest in

physical capital, such as machinery, and in building up their inventories.? For the purposes of this model, we will

assume that investment demand is constant.?

In fact there are a number of factors that affect the level of

investment demand, but because there is no clear link between investment demand

and any other of the variables in this model it will be easier to assume that

it is constant.? Having established

this, we are able to graph aggregate demand, including the consumption function

of households and the investment demand of firms:This model will be

in short-run equilibrium when the amount of desired spending is exactly

equalled by the amount of output that is actually produced.? The following graph shows all the points

where output is equal to desired spending as a 45 degree line, and the one

equilibrium point where this line crosses the aggregate demand schedule:At this point in

the model, we can introduce the notion of the multiplier by showing what will

happen if there is, for whatever reason, an increase in investment demand.? On the graph below, an increase in

investment demand has caused the aggregate demand schedule to shift upwards,

and therefore has caused a change in the level of output, from A to B:It is clear that

there has been a greater change in output than there has in investment

demand.? The ratio of the change in

output to the change in demand is the multiplier.The gradient of

the aggregate demand schedule is determined by household?s marginal propensity

to consume, that is to say the fraction of each extra pound earned by

households which they will spend rather than save.? It follows that the multiplier will also be very closely related

to the marginal propensity to consume, and it is.? In this simple model, the multiplier is equal to 1 over 1 minus

the marginal propensity to consume (1/(1-mpc).?

Therefore, if the marginal propensity to consume is 0.7 (that is to say,

for each extra pound earned, households spend 70 pence), the multiplier will be

equal to 1/(1-0.7)=1/0.3=3.33.?

Therefore, if demand increases by 1, output will increase by 3.33. b)? Discuss the effects of the introduction of

the government and of foreign trade in the simple static multiplier model of

the economy.The effects of

introducing the government into this model are twofold.? Firstly, aggregate demand is changed to

incorporate government spending on goods and services within the economy, and

secondly the personal disposable income of consumers is changed because they

have to pay some of their income to the government in taxes.? We would expect the former to have a

positive effect on output, and the latter to have a negative effect.? In order to build government into the model,

we will initially assume that all taxation takes the form of direct taxation,

thereby avoiding the necessity of distinguishing between market and basic

prices.The effect of

government spending is quite simply to shift the aggregate demand schedule

upwards, because more demand has been introduced into the economy.? It follows that the equilibrium point for

output and income will also change, the precise amount of the change depending

on the multiplier of the economy.? This

can be shown in a graph thus:The effect of

taxation, on the other hand, will be to rotate the consumption function, and

therefore the aggregate demand schedule.?

The taxation which needs to be taken into account is net taxation.? Since we are assuming that all taxes in the

model are direct taxes, net taxes are equal to direct taxes minus transfer

benefits, transfer benefits being the amount of money which the government pays

out to households by way of benefits and social security.? In order to show the effects of taxation, it

will be easiest to present a worked example.?

Assume that the marginal propensity to consume in an economy is

0.7.? Without taxes, we would therefore

expect households to spend 70p for each additional pound they earn.? However, if tax is set at 20% or 0.2, this

changes things.? They will now spend 0.7

times whatever they have left of their extra pound after taxation.? Therefore, if they earn one extra pound they

will pay 20p in taxes, and then spend 70 per cent of the remaining 80p, which

comes to 56p.? So their new marginal

propensity to consume could be expressed as MPC*(1-t), where MPC is their old

marginal propensity to consume and t is the level of net tax.When government

spending and net taxes are considered together, it will be noticed that

although net taxes lower output and government spending raises output, if

government spending is exactly equal to net taxes, output will go up.? This is because all of the tax money is

being spent, whereas if this money had been left with households some of it

would have been saved.? This is the

principle of the balanced budget multiplier – an increase in government

spending accompanied by an equal increase in net tax will increase output. Introducing

foreign trade into the model means taking account of both exports and

imports.? From these we can work out net

exports as a percentage of GDP.? For the

purposes of this model, we will assume that export demand is independent of the

domestic market and that it is constant.?

Import demand is decided by the marginal propensity to import (MPZ),

which is defined as the proportion of each extra pound earned which a household

desires to spend on imports.? Net

exports are equal to total exports minus total imports.The effect of

foreign trade on the aggregate demand schedule is once again to rotate it.? The aggregate demand schedule which includes

consumption demand (C), investment demand (I) and government spending (G) will

have a slope equal to marginal propensity to consume (MPC).? But having added in exports (E) and imports

(Z), we can see that an extra pound of income would increase consumption demand

by MPC, it would also increase import demand by MPZ.? Therefore, the slope of the new aggregate demand schedule will be

equal to MPC – MPZ.From all this, we

can find the final multiplier for the economy.?

Without government or foreign trade, we discovered that the multiplier

was: ??????????????????????????????????? multiplier =

1 / (1 – MPC). The introduction

of government means that we must redefine MPC to account for taxes, so that the

multiplier becomes: ??????????????????????? ??????????? multiplier = 1 / (1 – (MPC * (1 – t))). With the

introduction of foreign trade, we must also account for the marginal propensity

to import, so that the multiplier becomes: ??????????????????????????????????? multiplier =

1 / (1 – (MPC * (1 – t)) – MPZ) Therefore, if we

assume a marginal propensity to consume of 0.7, a tax rate of 0.2 and a

marginal propensity to import also of 0.2, we can see that the multiplier will

be equal to: ??????????????????????????????????? multiplier =

????? 1 / (1 – (0.7 * (1 – 0.2)) – 0.2) ??????????????????????????????????????????????????????????? 1

/ (1 – (0.7 *? 0.8) – 0.2) ??????????????????????????????????????????????????????????? 1

/ (1 – 0.36) ??????????????????????????????????????????????????????????? 1

/ 0.64 ??????????????????????????????????????????????????????????? 1.5625