Question

Suppose the economy is operating at potential GDP, something like was the case for the U.S. in mid-2018. The unemployment rate has reached historic lows, suggesting that the economy is at full employment. Now suppose that due to an economic slowdown in Europe, U.S. export sales decline. Use the income-expenditure model to analyze the impact this decrease in export expenditures will have on U.S. GDP and employment. Show graphically and explain your economic reasoning. To make this more concrete, here are some specific numbers to work with. Suppose potential GDP occurs where Y = $10,000 billion. Suppose that the marginal propensity to consume is 0.75. If we assume that both taxes and imports are given then the simple expenditure multiplier formula applies. Suppose exports fall by $100 billion. Use the multiplier formula to estimate the change in GDP Suppose further that for every one percentage point that GDP fails below potential, the unemployment rate will rise by half of one percentage point. How much then will the unemployment rate rise due to the decrease in exports?

Answer 1

A $100 billion decrease in U.S. exports leads to a $400 billion GDP decrease due to the multiplier effect. This results in a 2 percentage point increase in the unemployment rate, as each 1% GDP drop below potential raises unemployment by 0.5%.

Step-by-step explanation:

When the economy is operating at potential GDP and there is a decrease in U.S. exports due to a slowdown in Europe, this would result in a decrease in U.S. export sales and negatively impact the economy. According to the income-expenditure model, a fall in exports reduces aggregate expenditures, which leads to a multiplier effect on the decline in GDP. A $100 billion decrease in exports, combined with a marginal propensity to consume (MPC) of 0.75, implies an expenditure multiplier of 1/(1 - MPC) = 4. Therefore, GDP would decrease by 4 times the change in exports, resulting in a $400 billion decrease in GDP from its potential level. This reduction in GDP would likely increase employment rates, as a lower GDP suggests reduced production and potentially less demand for labor.

If potential GDP is at $10,000 billion and for every one percentage point GDP decreases below potential, unemployment rises by half a percentage point, we can calculate the increase in unemployment rate as follows: The $400 billion drop in GDP is 4% of the potential GDP ($10,000 billion), so the unemployment rate would increase by 2 percentage points (half of 4%).

In a graphical representation, this is shown by a leftward shift in the aggregate expenditure line on the Keynesian cross diagram, indicating a new equilibrium at a lower GDP level than potential GDP, which is characteristic of a recessionary gap.