APPENDIX

FORMULAS AND THE FOR EQUILIBRIUM MULTIPLIER INCOME

In the chapter, we developed the logic of the income-expenditure model and generally relied on graphical analysis. However, we also referred to a few formulas. In this appendix, we explain where these formulas, both for equilibrium income and the multiplier, come from. Specifically, in this appendix, we do three things: Derive a simple formula for calculating equilibrium output for the simplest economy in which there is no government spending or taxes. Derive the multipliers for the economy with the government. Derive equilibrium output with both government and the foreign sector. To derive the formula for equilibrium following steps: output, we use simple algebra in the

1 We know that equilibrium output occurs where output equals planned expenditures, and we know that planned expenditures equal C + I, therefore, output = planned expenditures = C + output = C +

2 Next, we substitute the symbol y for output; more important, we substitute for the consumption function, C = (Ca + by):
y= (Ca + by) +1

3 Collect all terms in y on the left side of the equation:

4 Factor the left side: y(1 - b) = Ca + I

5 Divide both sides by (1 .., b):

* _ (Ca

+ 1) (1-b)

where y* means the equilibrium level of output. This is the formula for equilibrium output in the text. Now let's find the multiplier for investment in this simple economy. To do that, we use the formula we just derived and calculate the equilibrium income at one level of investment, which we call the original level, and then calculate the equilibrium income at some other level of investment, which we call the new level. (We will "calculate" in general terms, not in specific numerical quantities.) What we will get is a formula for the change in output that results from the changes in investment. For the original level of investment at 10,we have
(Ca
Yo

+ 10)

(1- b)

For a new level of investment at

II' we have

The change in output, /1y, is the difference between the two levels of output that occur at each level of investment:
/1y

= Yl -

Yo

Substituting for the levels of output, we have

(C. + 11)
/1y

(CII -

+ 10)

(1 _ b)

(1 - b)

Because the denominator in both expressions is the same (1 - b), we can put the numerators over that common denominator:

Finally, because (11-10> is the change in investment, M, we can write

/1 _
.y -

M
(1 - b)

or

..

-=-/1y

(1- b)

Therefore, because the multiplier is the ratio of the change in income to the change in investment spending, we have the multiplier =
/1y

= __ 1_

(1-

b)

Here is another way to derive the formula for the multiplier. This way helps to illustrate its underlying logic. Suppose investment spending increases by $1. Because spending determines output, output will rise by $1. However, because consumption depends on income, consumption will increase by the marginal propensity to consume times the change in income. This means that as output rises by $1, consumption will increase by (b x $1). Because spending determines output, this additional increase in consumer demand will cause output to rise further (b x $1). But again, as output and income increase, consumption will increase by MPC times the change in income, which in this case will be b x (b x $1) or!J2 x $1. As we allow this process to continue, the total change in output will be
/1y

= $1 x ($1 x b) x ($1

X b2)

x ($1

X b3) .

or
/1y

= $1 x (1 + b + b2 + b3 + ... )

The term in parentheses is an infinite series whose value is equal to

-(I1

b)

Substituting this value for the infinite series, we have the expression for the multiplier:
/1y

= $1

x-(1- b)
1

Now we introduce government spending and taxes. Government spending is another determinant of planned expenditures, and consumption spending depends on after-tax income, so consumption equals CII + bey - 1). Following the same steps we used for equilibrium output without government, we do the same, but now with government: output

= planned expenditures = (C + I + G)
CII

y =

+ b(y - T) + 1+ G

We first collect all terms in y on the left and leave the other terms on the right:

y-by= CII-bT+l
We then factor the left side:

+G

y(1 - b) = CII - bT + 1+ G
We then divide both sides by (1 - b)
* _ (CII-bT+l+G) y -

(1-

b)

Using this formula and the method just outlined, we can find the multiplier for changes in government spending and the multiplier for changes in taxes: government spen d'mg m ultlp li er = -- 1

(1- b)

. l'ler = -- -b tax mu 1 tlp

(I- b)

The multiplier for an increase in government spending is larger than the tax multiplier for a reduction in taxes in the same amount as an increase in government spending. Government spending increases total demand directly. Reductions in taxes first affect consumer's incomes. Because consumers will save a part of their income increase from the tax cut, not all of the tax cut is spent. Therefore, the tax multiplier is smaller (in absolute value) than the government spending multiplier. As we explained in the text, because government spending has a larger multiplier than taxes, equal increases in government spending and taxes, called balanced-budget increases, will increase total output. For equal dollar increases in both taxes and government spending, the positive effects from the spending increase will outweigh the negative effects from the tax increase. To find the balanced-budget multiplier, just add the government spending and tax multipliers: balanced-budget multiplier = government spending multiplier + tax multiplier -b 1

=--+-(1- b) (1- b)
b) (1- b) =1 (1=--

The balanced-budget multiplier equals one; a $10 billion increase in both taxes and government spending will increase GDP by $10 billion. Finally, we derive equilibrium output with government spending, taxes, and the foreign sector. First, recall that equilibrium output occurs where output equals demand. We now must include planned expenditures from both the government

sector and the foreign sector. Planned expenditures exports minus imports:

from the foreign sector are

output = planned expenditures = (C + 1+ G + X - M) Consumption depends on disposable income:

and imports depend on the level of output: M=my Substitute the equations for consumption and imports into the equation where output equals demand: y = CII+ b(y - 1)+ 1+ G + X - my Collect all terms in y on the left and leave the other terms on the right: y-(b-m)y= Factor the left side: Y Divide both sides by CII-bT+I+ G+X

[1- (b-m)]
m)]:

= CII- bT+I + G+X

[1- (b y

(CII-bT+I+G+X) [1- (b -

m)L.

This is the expression for equilibrium income with government in an open economy. It can be used, following the method we outlined, to calculate multipliers in the open economy. '