In last week's readings, chapter 9 from the textbook, and from the AD – AS Model (part 2 of 3) video, we learnt about the multiplier effect on GDP from spending an additional dollar. Specifically, we learnt that an autonomous increase in spending (an increase that is not related to, or is independent of, income levels) – say $100 – would lead to an increase in GDP that is greater than the autonomous increase (greater than $100). This effect can be explained by the circular flow diagram. The spending of $100 by one person becomes an income of $100 to a second person. This person would then spend a portion of that $100, which becomes income for a third person. The third person would spend a portion of that portion and so on.
With the assumption that government spending, (G), investment spending (I), and international trade spending (NX), are determined independently of income, the oversimplified multiplier formula (1÷ (1 – mpc)) allows us to determine the factor by which GDP will increase. However, one must remember to be cautious when using the oversimplified multiplier formula to determine the true multiplier effect. In the real world, this formula overstates the true factor (the actual multiplier), and one reason for this is from our assumptions about G, I, and NX. Other reasons include inflation (which we will address in chapter 10) and income taxation (which we will address in chapter 11).
In the related video lecture for chapter 9 (AD – AS Model, (part 2 of 3)), we explored (albeit briefly), relaxing the assumption on investment and allowed for a portion of domestic investment to be dependent on income. For this discussion, we will explore relaxing the assumption on net exports – in particular, on imports. From our previous video lecture (see AD – AS Model, (part 1 of 3)), we know that higher GDP leads to higher incomes, and some of this higher income is spent on foreign goods. In a similar way, our exports are dependent on the foreign country’s GDP. If their GDP increase, it would lead to higher incomes and a greater opportunity to purchase our goods and services (our exports). With this in mind, we can relax the autonomous assumption on net exports and conclude that while the level of exports is independent of our GDP (income), the level of our imports is dependent on income. But what implication does this have on our multiplier? Would the multiplier effect be no different, smaller, or larger compared to assuming net exports is income independent? Furthermore, would having positive net exports make a difference?
1. From Chapter 9, review the multiplier analysis (sections 9-6, 9-7, & 9-8) on pages 179 to 186 from the textbook ( W. J. Baumol and A. S. Blinder (2020), Macroeconomics: Principles and Policy, 14 th edition). This may help with providing your answer.
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