Question

Explain in detail the working of an expenditure multiplier using expenditure -output model. Draw appropriate graph and also explain its significance.

Answer 1

It is explained as follows.

Let's consider an increase in government spending. Higher government spending increases planned aggregate expenditure (AE), shifting the PAE curve upward. This increases equilibrium income. But the increase in income is higher than the increase in government spending.

In following graph, planned aggregate expenditure (PAE) and real GDP (Y) are measured vertically and horizontally respectively. Initial Equilibrium is at point A where 450 line intersects initial aggregate expenditure curve PAE0, with equilibrium GDP Y0 and planned aggregate expenditure E0.

When government spending increases from G0 to G1, the PAE0 line shifts upward to PAE1. New Equilibrium is at point B where 450 line intersects new planned aggregate expenditure curve PAE1, with higher equilibrium GDP Y1 and higher planned aggregate expenditure E1. Since (Y1 - Y0) > (G1 - G0), there is a multiplier effect.