GDP, AD and the Multiplier

Hello, I'm Dr Paul Siegel,

and I'm reading in the Economics of Development at King's College London.

In this lecture,

I'll be talking about how he analysed the interaction between

aggregate demand and the supply side of the economy.

So in this module I'll summarise what we've learned about GDP,

aggregate demand and the multiplier,

and then I'll start to describe how we use them to analyse the macro economy.

We first looked at this in the lecture on

the circular flow of income and the multiplier effect.

But the key point will be making in this lecture

is that the model of aggregate demand on its own

only tells us what happens to the amount of output and employment.

But it doesn't tell us something about prices

or what happens to inflation in the economy.

So a more complete model of the economy needs to account for prices and inflation,

which also means accounting for the supply side of the economy.

And that's what we're going to learn about today.

You'll recall the components of GDP when we look at GDP from the expenditure side.

Now, remember, in the economy, expenditure equals income equals production,

measured as value added so GDP refers to all these things.

But from the point of view of man economic analysis,

we look at GDP from the expenditure side and that's going to be

because we can explain the different components of expenditure to go into GDP.

And also we think the government's can then directly

affect those components of GDP from the expenditure side.

So what are the components of GDP? If you remember, GDP is C plus I plus G plus X minus m.

That is, GDP is equal to consumption C,

which is expenditure on consumer goods and services

plus investment I,

which is expenditure on new capital goods

that are being produced so infrastructure,

investment equipment, buildings and so on.

The third component is government spending G

as government spending on goods and services,

and we have to be careful not to include transfers between households here.

So when government taxes one household in

order to transfer money to another household,

maybe for unemployment insurance or for child benefit or something like that,

it appears in the government budget as spending by the

government because it goes out of the government's budget.

But the government isn't spending that money on goods and services,

so it doesn't count in this government spending G component of GDP.

Instead, when the household receives the government benefit,

maybe the child benefit.

They then spend it on goods and services, and it's only when they spend it.

That counts as consumption spending by that household.

So government spending G is government expenditure on goods and services,

which doesn't include transfers between households.

And then the final component is net exports, which is exports.

X months imports m and remember that M accounts

for imports that are already included in C.

I N G.

Because some component of consumption,

spending and investment spending and government spending

some of that expenditure that's being made is

actually going on imported goods and services.

And so we need to extract that.

Take that out in order to just be left with the component of C I N G.

That is spent on domestically produced goods and services

and then, of course,

exports our goods and services that we've produced

by there being purchased by someone else.

The kind of our GDP, because it's our domestic production,

so G d p equals C plus I plus G plus X minus M

because expenditure is equal to income,

as we talked about in the lecture on the circular flow of income

expenditure is equal to income.

So we can also say why capital y, which is total income in the economy,

is equal to C plus I plus G plus X minus and total

income can be broken down into the different components of aggregate demand.

And the crucial point we had from the circular flow was that your expenditures,

my income and vice versa.

And that's gonna be very important in thinking about

the knock on effects of various different government policies,

the effects of various shocks to the economy

and therefore how we model the overall macro economy. So what we talked about in the

lecture on the circular flow of income and the multiplier model

was when you get an initial change in someone's expenditure,

that initial expenditure has an impact on GDP directly through C I, G, X or M.

But in addition there knock on effects,

there are additional stages to the process via the multiplier effect.

So in a nutshell,

if expenditure increases

by one agent

and we've talked about an increase in

government spending But it might also equally be

just a sudden increase in investment spending by

some firms that I'm feeling very optimistic.

For instance,

their initial expenditure directly increases

aggregate demand and therefore GDP.

But then the people who receive the income that they're spending well,

they've got higher incomes now, so they're going to

increased their expenditure as well.

And therefore we get the additional process of further stages and

we get the multiply process leading to multiple rounds of expenditures and

the overall impact on the economy is going to be larger

than the initial effect of the the first injection of expenditure.

How much that happens. The size of that effect depends on what we call leakages,

and the leakage is our income that some receives

that they don't spend and they include taxation,

saving and the propensity to spend on imports.

So the higher the level of taxation,

the higher the level of saving and the higher the level of imports in the economy.

The lower is the multiplier because that

means any initial injection of expenditure,

a smaller share of that expenditure gets passed

through to the next round of additional expenditures.

Now, when we made that analysis.

The assumption was that output can go up or down in response to aggregate demand.

But we ignored what we call supply side constraints.

What I mean by that. Well, first of all,

I suppose aggregate demand keeps going up. We're in a boom.

We've got very high growth. People want to spend more and more.

Well,

you might find at some point that firms can't find enough workers

to produce extra goods that are being demanded at the going wage.

They might have to pay higher wages in order to attract more workers,

and firms are having to pay higher wages.

That means their costs are going up,

and so they might raise their prices so prices might go up or equally.

We might find that in response to all this increase in demand for their products,

firms just put up prices directly.

Uh, in response to that demand

because they find that they can still sell.

They still sell everything they're producing at the

higher price because demand is so high.

So again, in the boom, we find that firms would be putting up prices.

Conversely, suppose we're in a recession,

then aggregate demand is low GDP is low,

and the story we had when we talk about demand about output

and employment might be utterly fine as far as it goes.

But we can also say something about prices again,

which is that if people are spending less than firms want to produce,

then prices might decline to or at least inflation might slow down.

So instead of prices rising at 4% per year,

then maybe they rise of just 2% instead because of that decline in aggregate demand.

So we need to include something in our model that

allows us to discuss that aspect of the economy.

And in the rest of this lecture,

we'll talk about how we can include an analysis of the supply side of the economy to

give us a complete model of the macro economy in the short and the medium run.

Now, to be clear, this won't tell us much about the long run,

which is the question of economic growth over time,

and that's something that you'll learn about in a separate lecture.

But what we're talking about now it's the model that we use to analyse booms and busts

and the business cycle

and that requires us to think about maybe the next year or two.

And what the government can do about the business cycle.

Recessions, booms, output, unemployment, prices over that kind of time horizon.