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7.7: Aggregate Demand and Equilibrium Output

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  • Our objective in this chapter was to extend the model of Chapter 6 to include a government sector and fiscal policy in aggregate demand. To do this we continued to assume that wages, prices, money supply, interest rates, and foreign exchange rates are constant. We also continued to make the important distinction between autonomous expenditure and induced expenditure, which leads to the existence of a multiplier. The equilibrium condition is still Y = AE and AD = AS, output and income equal to planned expenditure. Even though the model is more complex, it still shows us that fluctuations in autonomous expenditures, working through the multiplier, cause fluctuations in Aggregate Demand, output, income, and employment.

    In our model, there are five sources of fluctuation in autonomous expenditures. In addition to the autonomous parts of consumption and imports the model includes autonomous investment, exports and government expenditures. The link between changes in national income and the induced changes in consumption expenditure is also more complex. As a result, the multiplier is determined by the marginal propensity to consume (MPC), the net tax rate (t), and the marginal propensity to import (MPM). Government expenditure and the net tax rate are policy variables. Other expenditure decisions are driven by market forces. The net tax rate and the marginal propensity to import are sources of leakage from the income stream, in addition to the marginal propensity to save. They reduce the size of the multiplier.

    Nevertheless, changes in autonomous expenditures are still the sources of business cycles. If business changes planned investment expenditure in response to changed expectations about future markets, or if changes in economic conditions in other countries change exports or imports, the multiplier translates these changes into larger changes or fluctuations in income and employment. Government expenditure plans and net tax rates are fiscal policy tools that could be used to moderate or offset these fluctuations through a combination of automatic and discretionary fiscal policy.

    Figure 7.10 shows the relationship between equilibrium income and output, and the link between changes in aggregate expenditure, aggregate demand, and equilibrium income. In the upper diagram a fall in autonomous expenditure from A0 to A1 reduces AE and equilibrium Y from Ye0 to Y′e , which is the fall in A times the multiplier.

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    Figure 7.10: AE, AD and Equilibrium Output

    The fall in autonomous expenditure and equilibrium is a leftward shift in the AD curve in the lower diagram. The size of that shift in AD is the change in equilibrium income in the upper diagram, namely the fall in A times the multiplier. Because the price level is constant, giving a horizontal AS curve at P0, the fall in equilibrium determined by AD/AS is the same as the horizontal shift in AD.

    The multiplier in Canada

    The multiplier plays a key role in the AE and AD/AS model of the economy. But what is the size of the multiplier in Canada? A simple statistical estimate, using Statistics Canada annual data for real GDP and consumption expenditures, gives a Canadian marginal propensity to consume out of national income \(c(1 − t) = 0.54\), and marginal propensity to import \(m = 0.34\). Using these estimates, we get a multiplier for Canada:

    \(\displaystyle\frac{\Delta Y}{\Delta A} = \displaystyle\frac{1}{(1 - 0.54 + 0.34)} = \displaystyle\frac{1}{1 - 0.2} = 1.25\)

    If you recall, in Chapter 6 we had an estimate of the Canadian marginal propensity to consume out of disposable income of \(MPC = 0.88\). If there were no taxes or imports, an \(MPC = 0.88\) would mean a multiplier of about 8.33. The difference between the multipliers 1.25 and 8.33 shows clearly the automatic stabilization coming from the net tax rate and marginal propensity to import.