Income and Spending Chapter #10

AD and Equilibrium Output The Keynesian model (flat AS curve) develops the theory of AD: ↑ in autonomous spending causes additional ↑ in AD (feed back) Total amount of goods demanded in economy is AD = C + I + G + NX Equilibrium output when: output produced = quantity demanded or Y = AD If AD ≠ Y => unplanned inventory (IU = Y – AD) signals firms to change Y Consumption, the largest component of AD, increases w/ income –Consumption function: (assumes TR = TA or Y = YD) –Intercept is consumption when income is zero (> 0 for subsistence consumption) –Slope is marginal propensity to consume 1 > c > 0. Since Y is spent or saved  consumption theory also explains saving Substitute consumption function into budget constraints for savings function: –Also increases w/ income since marginal propensity to save s = 1 – c > 0 Add all AD components : G, I, taxes & foreign trade (assume autonomous) Since consumption now depends on disposable income YD = Y + TR – TA, consumption function becomes Finally:

Equilibrium Income and Output Basic model of macro equilibrium assuming constant price and interest rates Equilibrium where Y=AD (45° line)  point E Arrows show how the equilibrium is reached through signals from unplanned inventory –For Y < Y 0, inventories ↓ & firms ↑ production –For Y > Y 0, inventories ↑ & firms ↓ production Solving equilibrium condition for equilibrium output, shows output as a function of MPC & A: To find how change in autonomous spending affects output use: Ex: If the MPC = 0.9, then 1/(1-c) = 10  $1B ↑ in G causes Y to ↑ by $10B Recipients of higher G increase their spending, recipients of that spending increase their own spending & so on

Saving and Investment For closed econ w/o government, in equilibrium, planned investment = savings –Vertical distance between AD & C = I (constant) –Vertical distance between C & 45° line = S  at Y 0 two vertical distances are equal & I = S National income accounting also gives S = I –Income is either spent or saved: Y = C + S –Without G or trade: AD = Y = C + I –Putting two together: C + S = C + I => I = S For open econ w/ government: –Income is either spent, saved, or paid in taxes: Y = C + S + TA - TR –Complete AD = Y = C + I + G + NX –Putting two together: C + S + TA – TR = C + I + G + NX I = S + (TA – TR – G) - NX

The Expenditure Multiplier By how much does $1 in autonomous spending raise equilibrium level of income? –Of additional $1 in income, $c is consumed –Output ↑ to meet ↑ expenditure by (1+c) –Output & income expansion cause further ↑ Successive rounds of increased spending, starting w/ initial autonomous demand ↑, give: (15) This geometric series simplifies to: General definition of multiplier is Effect of autonomous spending ↑ on equilib Y: –Initial equilibrium income Y 0 is at E –Autonomous spending ↑ shifts AD up by –New equilibrium income Y 0 ’ is at E’

The Government Sector The government affects the level of equilibrium output in two ways: 1.Government expenditures (component of AD) 2.Taxes and transfers Fiscal policy is government policy with regards to G, TR, and TA –Assume G and TR are constant, and that there is a proportional income tax (t) –The consumption function becomes: Combining with Using equilibrium condition Y=AD, equilibrium output is: Government sector flattens AD curve & reduces multiplier to Automatic stabilizer is any mechanism that automatically (w/o government intervention) ↓ output change in response to ↑ in autonomous demand –Business cycle is caused by shifts in autonomous demand, especially investment –Investment affects Y less w/ automatic stabilizers (ex. Proportional income tax) Unemployment benefits are another example of an automatic stabilizer  enables unemployed to continue consuming even though they do not have a job

Effects of a Change in Fiscal Policy Suppose government expenditures G increase –Changes in autonomous spending shift AD schedule upward by the amount of change –At the initial level of output, Y 0, the demand for goods > output, and firms increase production until reach new equilibrium (E’) The change in equilibrium income is: $1 ↑ in G => ↑ in income > $1 –If c = 0.80 and t = 0.25, multiplier α G = 2.5  $1 ↑ in G => ↑ in equilibrium income = $2.50 Suppose government increases TR instead –Autonomous spending ↑ by only c  TR, so output would increase by  G c  TR –The multiplier for transfer payments is smaller than that for G by a factor of c Part of any increase in TR is saved (since considered income) If government increases marginal tax rates, two things happen: –Direct effect is that AD is reduced since disposable income decreases, and thus consumption falls –The multiplier is smaller, and the shock will have a smaller effect on AD

The Budget Government budget deficits have been the norm in the U.S. since the 1960s Is there a reason for concern over a budget deficit? –Fear: government’s borrowing makes it difficult for firms to borrow & invest  slows economic growth Budget surplus = tax revenues TA, above initial expenditures (purchases of goods and services and TR): –Negative BS = budget deficit If TA = tY, Figure of BS as a function of income for given G, TR, and t –At low income budget is in deficit (gov. spends more than it receives in income) –At high income budget is in surplus (gov. receives more than it spends) Budget deficit depends on gov’s policy choices (G, t, and TR) & anything else that shifts the level of income –Example: ↑ I => ↑ Y  Budget deficit ↓ as tax revenues ↑

Effects of Government Purchases and Tax Changes on the BS How does fiscal policy affect the budget? OR Must an increase in G reduce the BS? –↑ in G reduces the surplus, but also increases income & thus tax revenues  Possibility that increased tax collections > increase in G The change in income due to increased G is equal to, a fraction of which is collected in taxes –Tax revenues increases by –The change in BS is