# The transmission of shocks and The multiplier process

UNIT 14: UNEMPLOYMENT AND FISCAL POLICY
Introduction
● Fluctuations in aggregate demand affect GDP growth through a multiplier process
because households face limits on their ability to save, borrow, and share risks.
● An increase in the size of government following the Second World War coincided with
smaller economic fluctuations.
● Governments can use changes in taxes or government spending to stabilize the
economy, but the bad policy can destabilize it.
● If a single household saves, its wealth necessarily increases, but if all households
save this may not be true, because, without additional spending by the government
or firms to counteract the fall in demand, aggregate income will fall.
● Every national economy is embedded in the world economy. This is a source of
shocks, both good and bad, and places constraints on the kinds of policies that can
be effective.
14.1 The transmission of shocks: The multiplier process
Spending on investment projects tends to occur in clusters because:
● Firms may adopt new technology at the same time
● Firms may have similar beliefs about expected future demand
Changes in income influence spending, affecting the income of others, so indirect
effects through the economy amplify the direct effect of a shock to aggregate
demand created by an investment boom.
➔ If the total increase in GDP is equal to the initial increase in spending: We say
that the multiplier is equal to 1.
➔ If the total increase in GDP is greater or less than the initial increase in
spending: we say that the multiplier is greater than 1 or less than 1.
Multiplier process: A mechanism through which the direct and indirect effect
of a change in autonomous spending affects the aggregate output.
Aggregate consumption function: An equation that shows how consumption
spending in the economy as a whole depends on other variables.
➢ For example, in the multiplier model, the other variables are current
disposable income and autonomous consumption.
The multiplier is greater than 1 if the additional consumption spending resulting from
a temporary 1euro increase in income is greater than zero but less than 1euro (for
example 0,60).
14.2 The multiplier model
In this model there are two types of expenditure:
● Consumption
● Investment
Aggregate consumption spending has two parts:
● A fixed amount: how much people will spend, independent of their income EN
COMIDA POR EJEMPLO. This fixed amount, also known as autonomous
consumption is C0.
● A variable amount: this depends on the current income.
● The term C1 gives the effect of one additional unit of income on consumption, called
the marginal propensity to consume (MPC).
● A steeper consumption line means a larger consumption response to a change in
income. Households with low wealth smooth consumption very little if their income
falls sharply. The marginal propensity to consume for this group is closer to 0,8.
● Since the consumption function only explicitly includes current income, expectations
about future income will be included in autonomous consumption.
Autonomous consumption
This is the fixed amount that
households will spend that does
not depend on their current level
of income.
Consumption that depends on
income
The upward-sloping line denotes
the part of consumption that
depends on current income (and
hence on current output).
The marginal propensity to
consume
The slope of the consumption
line is equal to the marginal
propensity to consume.
● Consumption of non-durable goods
went down slightly more than disposable
income.
● Consumption of durables decreased much more dramatically than disposable
income.
Adding investment to the consumption line simply leads to a parallel upward shift of the
aggregate demand line.
The 45-degree line corresponds to the circular flow from unit 13, where:
● aggregate demand = aggregate output.
We can then say:
● Output = aggregate demand for goods produced in the home economy
Goods market equilibrium
Point A is called a goods market
equilibrium: the economy will continue
producing at that output level unless
something changes spending
behaviour.
The 45-degree line
The 45-degree line from the origin of the
diagram shows all the combinations in
which output is equal to aggregate
demand, meaning the economy is in
goods market equilibrium.
Consumption
The first component of aggregate
demand is consumption, which is
represented by the consumption line
introduced in Figure 14.2.
Investment
line simply leads to a parallel upward
shift of the aggregate demand line.
In this model there are just two components of aggregate spending:
● Consumption: because the marginal propensity to consume is less than one,
the consumption line is flatter than the 45-degree line.
● Investment: investment does not depend
on the level of output.
● Investment is similar to
autonomous consumption.
Changes in autonomous consumption or investment displace the old equilibrium because
they change aggregate demand, which in turn alters the level of output and employment.
Figure 14.5 The multiplier in action: An investment-led recession.
Goods market equilibrium
The economy starts at point A, in
goods market equilibrium.
A fall in investment
The fall in investment cuts aggregate
demand by €1.5 billion, and the
economy moves vertically downward
from point A to point B.
Firms cut back
With demand lower, firms cut back
production and reduce employment.
With output and employment lower,
incomes fall by €1.5 billion. This is
the move from B to C.
A fall in consumption
Once households’ incomes fall, they
reduce their consumption, because
they may be credit-constrained. The
consumption equation tells us that
this kind of behaviour initially leads
to a fall in aggregate consumption of
0.6 times the fall in income. This is
the distance from point C to point D.
Firms cut back again
Firms respond by cutting production,
output falls, and the economy moves
from point D to point E.
… and so on
The process will go on until the
economy reaches point Z.
The new aggregate demand line
This goes through point Z and shows
the new goods market equilibrium of
the economy following the
investment shock.
The fall in output as a result of the
shock
The total fall in output exceeds the
initial size of the decline in
investment; output has fallen by
€3.75 billion.
The multiplier is equal to
2.5 (3.75/1.5)
The total change in output
is 2.5 times larger than the
initial change in
investment.
The first round effect is that the fall in investment cuts aggregate demand by 1.5
billion→ lower spendings = lower production = lower incomes = further decline in
spending.
Credit- constrained households reduce spending→further cuts in production and
income.
Consumption equation tells us that this kind of behaviour leads to a fall in aggregate
consumption 0.6 times the fall in income.
A multiplier of 2.5 is unrealistically large. Once taxes and imports are introduced in
the model, the multiplier shrinks.
Summary of the multiplier model:
● A fall in demand leads to a fall in production and an equivalent fall in
income:
→further fall in demand→further fall in production
● The multiplier is the sum of all these successive decreases in
production
Note that this economy is one in which we assume there are underutilized
resources in the form of spare capacity in production facilities and
underemployed labour.
For the multiplier process:
→ to work in the same way in response to a rise in investment, the assumption of
spare capacity and fixed wages means that costs will not rise when output goes up,
so firms will be happy to supply the extra output demanded without adjusting their
prices.
→ otherwise, some of the increased spendings will translate into higher prices or
wages rather than higher real output.
We can now calculate how much output will increase or decrease using the value of the
multiplier times the change in autonomous demand.
14.3 Household target wealth, collateral, and consumption
spending
Credit constraints = restricciones credenciales
Figure 14.6 Aggregate demand in the Great Depression
The 1929 peak
Point A shows the initial situation of the economy.
A fall in investment
This shifts the aggregate demand curve from the
pre-crisis to the crisis level.
A normal recession The 1933 through
The economy would normally be at point B. However, instead of a typical downswing (from A
to B), output fell by much more than can be
explained by the multiplier process alone, which is
shown by the move from B to C.
Figure 14.7 Household wealth: Key concepts.
Expected future earnings from employment
These are represented by the orange rectangle.
Financial wealth
This is the green rectangle.
The household’s ownership stake in the house
This is the blue rectangle.
This is the sum of the green, blue, and orange
rectangles.
Households also hold debt
This is shown by the red rectangle.
The household’s net worth
Also called material wealth. We find it by taking the
total assets (excluding expected future earnings),
which is the value of the house plus financial
wealth, and then subtracting the debt it owes.
The value of the house
This is equal to the household’s equity in the
Target wealth
For the household shown in the figure, expected
house, plus what it owes to the bank (the
mortgage).
broad wealth (orange + green + blue) is equal to
target wealth.
14.4 Investment spending
Figure 14.9 Investment, expected rate of profit, and the interest
rate in an economy with two firms.
Firm A
Firm A has three investment projects of different
scale and rate of profit. They are shown in
decreasing order of the expected rate of profit.
Firm B
Firm B also has three different investment projects.
The decision to invest
If the interest rate remains at 5%, Firm A goes
ahead with project 1 and Firm B does not invest at
all. But if the interest rate was 2%, A would
undertake projects 1 and 2 and B would undertake
all three of its projects.
The decision to invest
The lower panel aggregates the potential
investments of the two firms, arranged by the
expected profit rate as before.
Aggregate investment increases
Investment in the economy increases after a fall in
just one.
➢ In Figures 14.10a–c, we look at how a change in profit expectations affects
investment.
➢ In the two-firm economy in Figure 14.10a, the expected rate of profit for each
project rises because of an improvement in the supply-side conditions in the
economy. The height of each column rises, and as a result, there is more
investment at a given interest rate.
Interest rate at 5%
With the interest rate equal to 5%, only one project
Improvement in supply conditions
The improvement in supply conditions increases
the expected rate of profit for each project.
Effect on investment
For the same interest rate, investment rises: two
Interest rate at 2%
With the interest rate equal to 2%, and the initial
desired capacity, investment is shown by the
darker coloured blocks.
Higher forecast demand
Pressure on existing capacity from higher forecast
demand raises the desired size of each project, so
investment rises to include the lighter coloured
blocks.
Figure 14.10a The aggregate economy, where the expected rate of
profit rises for a given set of projects (supply effect).
Potential investment projects
In an economy with many thousands of firms, all
their potential investment projects are represented
by a downward-sloping aggregate investment
function.
Investment increases
In response to a fall in the interest rate, investment
increases from C to E.
An increase in profit expectations
This shifts the investment function to the right: if
the interest rate is held constant at 4%, investment
increases from C to D.
14.5 The multiplier model: Including the government and net
exports
We assume that firms are willing to supply any amount of goods demanded, so:
When we include the government and interactions with the rest of the world through exports
and imports, aggregate demand can be split into these components:
➔ aggregate demand = consumption + investment + government spending + net
exports.
To understand the aggregate demand function as shown above, it is useful to go through
each component in turn:
14.6 Fiscal policy: How governments can dampen and amplify
fluctuations

Figure 14.11a Fiscal expansion can offset a decline in private
consumption.
Goods market equilibrium
The economy starts at point A, in goods
market equilibrium, at which aggregate
demand is equal to output.
The economy moves into recession
This occurs after a fall in consumer
confidence, reducing c0
. The aggregate
demand line shifts downward and the
economy moves from point A to point B.
Fiscal stimulus: a rise in G
Suppose that the government then
increases spending, from G to G′, in
order to counteract the decline in
aggregate demand. AD shifts back up
and the economy moves to point C.
Figure 14.11b Government austerity can worsen a recession.
Goods market equilibrium
The economy starts at point A in goods
market equilibrium, at which aggregate
demand is equal to output.
The economy moves into recession
This occurs after a fall in consumer
confidence, reducing c0
. The aggregate
demand line shifts downward and the
economy moves from point A to point B.
Austerity policy
Suppose that the government then
reduces spending from G to G′, in a bid
to offset the deterioration of its budget
balance. The recession then feeds back
to raise government transfers and
reduce tax revenue.
14.7 The multiplier and economic policymaking
When we apply the model to the real world, it is important to realize that there is no
single multiplier that applies at all times.
Crowding out = There are two quite distinct uses of the term. One is the observed
negative effect when economic incentives displace people’s ethical or
other-regarding motivations. In studies of individual behaviour, incentives may have
a crowding out effect on social preferences.
A second use of the term is to refer to the effect of an increase in government
spending in reducing private spending, as would be expected for example in an
economy working at full capacity utilization, or when a fiscal expansion is associated
with a rise in the interest rate.
If increased government production were offset exactly by reduced private sector
production, then the multiplier would be zero. In 2012 a study published by Alan
Auerbach and Yuriy Gorodnichenko, two economists, showed how the multiplier
varies in size according to whether the economy is in a recession or in an expansion.
This is exactly the insight that policymakers needed in 2008. For the US, their study
suggested a \$1 increase in government spending in the US raises output by about
\$1.50 to \$2.00 in a recession, but only about \$0.50 in an expansion.
14.8 The government’s finances
From the paradox of shift, we learned that in a recession, it is counterproductive for the
government to offset the automatic stabilization of the economy. Why are stimulus policies
often followed by policies of austerity? The answer is government’s debt = The sum of all the
bonds the government has sold over the years to finance its deficits, minus the ones that
have matured.
Financial crises also raise government debt. Governments borrow both to bail out
failing banks and to support the economy in the lengthy recessions that follow
financial crises. The UK’s debt-to-GDP ratio rapidly doubled to more than 80% after
the 2008 global financial crisis.
The debt-to-GDP ratio may also fall even when there is a primary budget deficit, as
long as the growth rate of the economy is higher than the interest rate. Inflation helps
a country reduce its debt ratio because the face value of government bonds (the
level of debt) is denominated in nominal terms.
Lessons from the discussion of fiscal policy and government debt are:
– Automatic stabilizers play a useful role
– If additional fiscal stimulus is used, this ought to be reserved later: if a
stimulus is not reversed, the government debt-to-GDP ratio will rise
– Financial crises and wars increase government debt
– Inflation reduces the debt burden of the government: likewise, deflation
increases it
– An ever-increasing debt ratio is unsustainable: but there is no rule that
says exactly how much debt is problematic.
– If the growth rate is below the interest rate, is it necessary to run
primary government surpluses as they stabilize and reduce the debt
ratio: attempting to reduce the debt radio rapidly, however, is
counterproductive if it depresses growth
14.9 Fiscal policy and the rest of the world
Foreign markets matter
➔ Fluctuations in growth in important markets abroad can explain why the
economy moves into an upswing or downswing: this is a change in the net
export component of aggregate demand, that is, (X − M).
Imports dampen domestic fluctuations
➔ As we have seen, the size of the multiplier is reduced by the marginal
propensity to import.
➔ When autonomous demand goes up, it stimulates spending, and some of the
➔ This dampens the domestic upswing.
Trade constrains the use of fiscal stimulus
➔ The upturn in the French economy led French households to increase their
spending, but much of this was on foreign goods.
➔ The French stimulus spilled over to countries that produced more competitive
products.
➔ The French stimulus policy mostly benefited its trading partners who had
more competitive goods.
● This experiment
highlights the limits of using a
fiscal stimulus to successfully
stabilize a deep recession.
● Injecting more
aggregate demand stimulated
spending, but not spending on
French output.
● The multiplier was very
low and the spillover effects to
other economies meant that
most of the stimulus leaked out of France.
14.10 Aggregate demand and unemployment
Two models for thinking about total output, employment, and the unemployment rate
in the economy:
– The supply side (labour market) model: focuses on how labour is
employed to produce goods and services (wage-setting curve and
price-setting curve model)
– The demand side (multiplier) model: explains how spending decisions
generate demand for goods and services and,
as a result, employment and output.
We assume that labour productivity is
constant and equal to λ so the production
function is:
Cyclical unemployment = The increase in unemployment above equilibrium
unemployment caused by a fall in aggregate demand associated with the
Labour market equilibrium
The economy is initially at
labour market equilibrium
at point A with
unemployment of 5%. The
level of aggregate demand
must be as shown by the
aggregate demand curve
labelled ‘normal’.
A boom
Consider a rise in
investment that shifts the
aggregate demand curve
up to AD (high), so that
output and employment
rise. The economy is at B:
with the boom,
unemployment falls below
employment is called
cyclical employment.
A slump
If the aggregate demand
curve shifts down, then
through the multiplier
process, output and
employment fall to C.
Unemployment rises above
unemployment is called
cyclical unemployment.
– We have assumed that prices, wages, the capital stock, technology and
institutions are constant.
– We use the term short run to refer to these assumptions.
– The labour market is a medium-run model where wages and prices can
change, unlike in the multiplier model, which is a short-run model.
– So a short-run equilibrium in the multiplier model may not be a medium-run
equilibrium in the labour market model.
14.11- CONCLUSION
Economies often experience shocks to aggregate demand, such as a decline in
business investment or an increase in desired savings by households. These shocks
tend to be amplified by the process described by the multiplier. In addition to their
first-round effects, there are second-round or other indirect effects due to further
declines in spending.
In the second half of the twentieth century, the advanced economies enjoyed a great
decline in economic instability, which was due in part to larger governments and the
existence of automatic stabilizers that moderated swings in aggregate demand.
While active fiscal policy played its part, it had a mixed record. France discovered in
the early 1980s that a poorly planned fiscal expansion can lead to a fiscal deficit with
little benefit to the domestic economy.
In 2008, the world was reminded that even the rich countries can suffer from
economic crises, and the importance of fiscal policy in deep recessions was
reaffirmed. Unfortunately for the Eurozone, the hardest-hit countries were unable to
implement the necessary fiscal stimulus because of fears of sovereign debt crises.

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