Factors that shift the consumption function 1. Changes in wealth – shift the consumption function. – Example: value of stocks, bonds, consumer durables. 2. Changes in consumer expectations – Shift the consumption function. – Example: Pessimistic expectations decrease autonomous consumption. 3. Taxes and Transfers – Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down. 4.Prices – Affect the purchasing power of assets. Shift up in AE line Shift right in AD line Or Shift down in AE line Shift left in AD line Shift up in AE line Shift right in AD line Or Shift down in AE line Shift left in AD line Shift AE line Movement Along AD line Shift AE line Movement Along AD line

Determinants of Investment Interest Rates Tax Incentives Technical Change Expectations about the strength of demand Political Stability and the rule of law Shift AE line Shift AD line Shift AE line Shift AD line

Government expenditures are determined by the budget process: The president, Congress and the Senate. Shift AE line Shift AD line Shift AE line Shift AD line

National Incomes GDP of other countries Relative Prices Exchange Rates Shift AE line Shift AD line Shift AE line Shift AD line

Recessionary/Inflationary Gap?

Which AE line will cause a recessionary gap? Which AE line will cause an inflationary gap?

= 7,000-6,000 =1,000 A recessionary gap occurs when actual GDP falls SHORT of full employment GDP To increase AE, we need an increase in C, I, G or NX To eliminate a recessionary gap, AE must rise.

To Eliminate a Recessionary/Deflationary Gap Increase Consumption by a sufficiently large price drop, a decrease in taxes or an increase in transfers. Increase Investment – tax incentives. – lower interest rates Increase Government Spending Increase Exports and reduce Imports: make dollar weaker (increasing supply of dollars)

= 7,000-8,000 =-1,000 An inflationary gap occurs when equilibrium GDP is higher than full employment GDP To decrease AE, we need a decrease in C, I, G or NX To eliminate an inflationary gap, AE must fall.

To Eliminate an Inflationary Gap Decrease Consumption by a sufficiently large price increase, an increase in taxes or a decrease in transfers. Decrease Government Spending Increase interest rates to decrease spending Decrease net exports and increase imports: stronger dollar.

3.If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

4.If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

10/24/2015© 2002 Claudia Garcia-Szekely13 Fiscal Policy Changes in Government Spending and/ or Taxes. Induce a change in Aggregate Spending. Increase AE Decrease AE