THE MULTIPLIER MODEL IN PERSPECTIVE

The simplest multiplier model has been enormously, influential in business-cycle theory over the last half century. But it gives an oversimplified picture of the economy. One of the most important omissions will the impact of financial markets and monetary policy on the economy. Changes in output tend to affect interest rates, which in turn come back and affect the economy. Additionally, the simplest multiplier model omits the interactions between the domestic economy and the rest of the world. Finally, the model omits the-supply side of the economy as ‘represented by the interaction of spending with aggregate supply and prices. All these shortcomings will be remedied in later chapters. and it is useful to keep in mind that this first model is really a stepping stone on the path to understanding the economy in all its fascinating complexity.

While the relationships presented here have been simplified, their essence will remain valid even when extended to situations involving’ government fiscal policy, monetary policy. and foreign trade. The -main point to retain is that the multiplier analysis holds when there are unemployed resources. With excess capacity, an increase in aggregate demand can raise Out put levels. By contrast, if an economy is producing at capacity, there is no room for when aggregate Indianan increases. In conditions 01 full employment, then, demand increases lead to higher prices rather than to output increases.

When investment or other spending increases in an economy excess capacity and unemployed workers, much of the extra spending will end up in extra real output, with only small increases in the price level. However, as the economy reaches its capacity, it is not possible to coax out more production at the going price level, Hence. at full employment, higher spending in higher price levels rather than higher real output or employment.

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