Question

What is the multiplier effect? Use a \(45^{\circ}\) -line diagram to illustrate the multiplier effect of a decrease in government purchases

Short answer

The multiplier effect is the increase in final income arising from any new injection of spending. On a 45-degree line diagram, a decrease in government purchases shifts the aggregate demand curve downward and creates a new, lower point of equilibrium since the overall spending in the economy decreases. The multiplier effect can be observed as the vertical distance between the initial and new equilibrium points which is greater than the decrease in government purchases. It represents the amplified effect this spending change has on the economy.

Step-by-step solution

Understanding the 45-degree line diagram

A 45-degree line diagram is used in economics to demonstrate aggregate demand and illustrate macroeconomic equilibrium. The 45-degree line represents all points where aggregate expenditure equals total output or income. On this graph, the vertical axis represents aggregate expenditure and the horizontal axis represents national income or output.

Illustrating the Initial Equilibrium

Draw a line from the origin at a 45-degree angle. This line represents all points where aggregate expenditure equals total output. Initially, there will be an aggregate demand curve which intersects the 45-degree line at some point. This point is the initial equilibrium where aggregate income equals aggregate expenditure.

Showing the Decrease in Government Purchases

A decrease in government purchases means less spending in the economy. This will shift the aggregate demand curve downward since aggregate expenditure will decrease. As a result, a new, lower point of equilibrium on the 45-degree line is created.

Illustrating the Multiplier Effect

The multiplier effect is the amplifying effect that occurs in the economy. It can be seen on the graph as the vertical distance between the initial and the new equilibrium points is greater than the amount government purchases decreased by. It can also be calculated as the change in final income divided by the change in initial spending.

Key concepts

45-degree line diagram

The 45-degree line diagram is a fundamental tool used in macroeconomics to depict the relationship between total output and total expenditure. Imagine a graph with two axes: the vertical one for aggregate expenditure and the horizontal for national income or output. The line that rises from the origin at a perfect 45-degree angle represents where expenditure and income are exactly equal, point for point. This line is critical because it visualizes the point of equilibrium where the economy is neither losing nor gaining income.

Through this diagram, economists can illustrate various macroeconomic scenarios, such as the effects of government spending cuts. The initial intersection of the aggregate demand curve with the 45-degree line indicates the initial point of equilibrium. Shifts in this curve result in a new equilibrium, showing how changes in spending can lead to proportional changes in national income.

Aggregate demand

Aggregate demand represents the total demand for goods and services within an economy at a given overall price level and in a given time period. It is a core concept that helps to understand the level of economic activity and its fluctuations. Components of aggregate demand include consumer spending, investment by businesses, government purchases, and net exports (which is exports minus imports).

In the context of the 45-degree line diagram, an aggregate demand curve is plotted to show how changes in expenditure levels affect the economy's output. When, for example, government spending decreases, the aggregate demand curve shifts downward, indicating that, for the same level of income, the total demand in the economy is now lower.

Macroeconomic equilibrium

Macroeconomic equilibrium is a state where aggregate demand matches aggregate supply, meaning that the economic output is in balance with the total spending. It's the point where the economy is stable, without any external pressure to either expand or contract. In the 45-degree line diagram, this balance is depicted as the point where the aggregate demand curve intersects the 45-degree line.

When this equilibrium is disturbed, for instance by a reduction in government spending, balance is restored only after some adjustment. The resulting new equilibrium will show the extent to which income has adjusted as a consequence of the multiplier effect. This is crucial because it demonstrates how even small changes in spending can have wider implications for the overall economy.

Aggregate expenditure

Aggregate expenditure is the total amount spent on an economy’s goods and services, at a given price level and period of time. It includes consumption, investment, government purchases, and net exports. The aggregate expenditure model is used to demonstrate the relationship between total spending and real GDP at various price levels.

Understanding how aggregate expenditure relates to the overall economic activity is important. When it increases, businesses respond by raising production, thus increasing employment and income. Conversely, when aggregate expenditure decreases, production slows, leading to a reduction in income and employment. The 45-degree line diagram effectively shows how fluctuations in aggregate expenditure, influenced by factors such as government spending, can affect national income levels.