Lecture Six Short-run equilibrium Multiplier Adding the government sector Fiscal Policy and Aggregate Expenditure Model

 Assumption: price is fixed in the short run  Aggregate expenditure is the planned total spending on final goods and services  AE = C + I (no government, no trade)  The equilibrium output is that out put which creates total spending just sufficient to produce that output (Y = AE)  Saving equals planned investment (S = I)  No unplanned changes in inventories 2Lecture 6

 AE = C + I  C = C 0 + cY  Consumption is a function of dispensable income  C0: autonomous consumption  c: marginal propensity to consume (MPC), c = ΔC/ ΔY  I = I g : Planned investment is not a function of GDP, investment is autonomous expenditure  AE = C 0 + cY + I g ; AE = Y  (C 0 + I g ) + cY = Y  Y e = (C 0 + I g )/(1-c); equilibrium output is equal to autonomous expenditure divided by (1 – MPC)  Similarly, ΔY e = Δ(C 0 + I g )/(1-c). (Δ means “changes in”) 3Lecture 6

 At short-run equilibrium; S = I g  S= Y – C, C = C 0 + cY  S = -C 0 + (1-c)Y or S = -C 0 + sY  Saving is a function of dispensable income  s: marginal propensity to save (MPS), s = ΔS/ ΔY, s = 1 - mpc  S= I g  -C 0 + sY = I g  Y e = (C 0 + I g )/s; equilibrium output is equal to autonomous expenditure divided by MPS (s = 1 - c ).  Similarly, the change in equilibrium output is equal to the change in autonomous expenditure divided by marginal propensity to save. 4Lecture 6

 Suppose that France has an MPC (Marginal Propensity To Consume) of 0.22 and a real GDP (Gross Domestic Product) of $431 billion. Also suppose that its investment spending decreases by $9 billion.  Calculate (correct to 1 decimal place) France's new level of real GDP in the aggregate expenditures model. 5Lecture 6

 Suppose that France has an MPC (Marginal Propensity To Consume) of 0.22 and a real GDP (Gross Domestic Product) of $431 billion. Also suppose that its investment spending decreases by $9 billion.  Calculate (correct to 1 decimal place) France's new level of real GDP in the aggregate expenditures model.  Recall ΔY e = Δ(C 0 + I g )/(1-c)  ΔY e = = $9/(1-0.22) = $11.54 billion  New GDP = Old GDP + change in GDP (-) = $431 - $11.54 = $ billion 6Lecture 6

o 45 o Real domestic product, GDP (billions of dollars) (C + I g ) Aggregate expenditures (billions of dollars) (C + I g ) Through a multiplier effect, an initial change in investment spending can cause a magnified change in domestic output 7Lecture 6

 Multiplier  the ratio of a change in the equilibrium GDP to the change in autonomous expenditure (investment spending) Changes in GDP = multiplier x initial change in spending  The “initial change in spending”  associated with investment spending because of investment’s volatility  associated with investment spending results from either a change in the real interest rate or a shift of the ID curve  may create a multiple increase in GDP and a decrease in spending may be multiplied into a large decrease in GDP  There is also a multiplier effect associated with autonomous consumption changes 8Lecture 6

Rationale:  spending generates income  change in income will cause both consumption and saving to change 9Lecture 6

(1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round 3rd round 4th round 5th round All other rounds Total 10Lecture 6

(1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round3.75 3rd round 4th round 5th round All other rounds Total 11Lecture 6

(1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round rd round 4th round 5th round All other rounds Total 12Lecture 6

(1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round rd round th round th round All other rounds Total$20.00$15.00$ Lecture 6

The Multiplier Process (MPC=.75)  I = $5 billion 14Lecture 6

 MPS and the multiplier are inversely related  Multiplier = 1/MPS = 1/(1-MPC)  Recall ΔY e = Δ(C 0 + I g )/(1-c)  Multiplier = change in equilibrium output/change in autonomous expenditure  Multiplier = ΔY e /ΔAE 15Lecture 6

 The larger the MPC (and the smaller the MPS), the greater the size of the multiplier Lecture 6

 A $1 billion increase in investment will cause a:  A) (1/MPS) billion increase in equilibrium GDP.  B) (MPS) billion increase in equilibrium GDP.  C) (1 - MPC) billion increase in equilibrium GDP.  D) (MPC - MPS) billion increase in equilibrium GDP.  Assume the consumption schedule for a private closed economy is C = Y, where C is consumption and Y is gross domestic product. The multiplier for this economy:  A) is 3. B) is 4. C) is 5. D) cannot be determined from the information given. Lecture 617

 Assume the MPC is 2/3. If investment spending increases by $2 billion, the level of GDP will increase by:  A) $3 billion. B) $2/3 billion. C) $6 billion. D) $2 billion. Lecture 618

 Simplifying Assumptions  government purchases do not cause any shift in consumption or investment schedules  net tax revenues are derived totally from personal taxes  taxes do not vary with GDP  Government spending (G is autonomous expenditure  Taxes affect disposable income 19Lecture 6

 Increases in public spending shift the AE schedule upward and result in higher equilibrium GDP  Examples  suppose government add 40 billion of purchases  suppose government impose 40 billion of lump- sum tax 20Lecture 6

GDPTDICaCa SaSa IgIg NXGAE $370$40$330$ Equilibrium Levels of Employment, Output & Income Consumption spending is lower 21Lecture 6

GDPTDICaCa SaSa IgIg NXGAE $370$40$330$345$ - 15$20$35$ Equilibrium Levels of Employment, Output & Income 22Lecture 6

GDPTDICaCa SaSa IgIg NXGAE $370$40$330$345$ - 15$20$35$40$ Equilibrium Levels of Employment, Output & Income 23Lecture 6

o 45 o C + I g GDP (billions of dollars) C + I g + G G= $40 +$80 l Impact of $40 billion in government purchases on equilibrium GDP Aggregate expenditures (billions of dollars) 24Lecture 6

o 45 o GDP (billions of dollars) C + I g + G C a + I g + G l Equilibrium GDP reduced by $40 billion Aggregate expenditures (billions of dollars) Lecture 6

 C = Y,I = 15, G = 15  AE = C + I + G  AE = Y = Y  AE = Y at equilibrium  Y = Y  50 = 0.2Y  Y e = 50/0.2 = 250  Recall equilibrium output is equal to autonomous expenditure divided by (1 – MPC)  Autonomous expenditure = = 50, 1 – MPC = 1 – 0.8 = 0.2  Y e = 50/0.2 = Lecture 6

 T = 10, I = 20, G = 15  C = (Y-10)  AE = C + I + G  AE = (Y-15) = Y –  AE = Y  AE = Y at equilibrium  Y = Y  42 = 0.2Y  Y e = 42/0.2 = 210  Taxes affect disposable income, which affect consumption 27Lecture 6

 C = C 0 + c(Y-T), I = I g and G  AE = C + I + G  AE = C 0 + c(Y-T) + I g + G  Y = AE at equilibrium  Y = C 0 + c(Y-T) + I g + G  Y e = (C 0 - cT+ I g + G)/(1-c) 28Lecture 6

 Equilibrium GDP may or may not provide full employment  Recessionary Expenditure Gap  Increasing autonomous expenditure has a multiplier effect 29Lecture 6

Real GDP (billions of dollars) (C a + I g + G) 1 o 45 oRecessionary Gap = $20 billion (C a + I g + G) Aggregate expenditures (billions of dollars) Full Employment GDP20 Recessionary gap - When aggregate expenditures are inadequate to bring about full employment Recessionary gap - When aggregate expenditures are inadequate to bring about full employment 30Lecture 6

 Two different policies that a government might pursue to close a recessionary expenditure gap and achieve full employment:  1. Increase government spending  2. Lower taxes  Both work by increasing aggregate expenditures 31Lecture 6

 France is falling 2.0% above its targeted income of $18,000 and has a marginal propensity to consume of 0.6.  By using the multiplier model, what change in government expenditures would be needed to achieve this target?  Recall, Multiplier = ΔY e /ΔAE  Multiplier = 1/(1-MPC) = 1/(1-0.6) = 2.5  ΔY e = 2%*$18,000 =$360  ΔAE = $360 / 2.5 = $144  Government must increase its expenditure by $144 to close the output gap. Lecture 632

 Chapter 8.4 and 9 (exclude 9.3)  Homework 6 Lecture 633