Macroeconomic Relationships: Aggregate Spending and Output

Introduction

• The lecture introduces the third macroeconomic relationship: the link between aggregate spending and overall output.
• Focus on how increases in spending can affect real GDP through the multiplier effect.

Multiplier Effect

• Describes how an initial change in spending can lead to a larger effect on real GDP.
• Multiplier: A factor by which an initial change in spending is magnified.
• Formula:
  • Multiplier = Change in Real GDP / Change in Initial Spending
  • This value must be greater than 1, indicating that spending has a larger effect on GDP.

Mechanism of the Multiplier Effect

• When a dollar is spent, it becomes income for someone else, who then spends part of it, perpetuating the cycle.
• This cycle amplifies the initial spending, contributing to a larger increase in GDP.

Dependency on Marginal Propensity to Consume (MPC)

• MPC: The fraction or percentage of income that a person will spend.
• Multiplier can also be calculated using MPC:
  • Multiplier = 1 / (1 - MPC)
• As MPC increases, the multiplier effect also increases.

Example Calculation

• Given: An economy with an MPC of 0.75 and an increase in spending by 100 units.
• Calculation:
  • Convert MPC to Multiplier:
    • Multiplier = 1 / (1 - 0.75) = 4
  • Effect on GDP: Change in Real GDP = Initial Spending x Multiplier
  • So, Change in Real GDP = 100 x 4 = 400
• Conclusion: A 100 billion increase in spending results in a 400 billion change in real GDP when MPC is 0.75.