Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 10 Income and Spending Learning objectives äUnderstand that in the most basic model of aggregate demand, spending determines output and income, but output and income also determine spending. In particular, consumption depends on income, but increased consumption increases aggregate demand, and therefore, output. äUnderstand that increases in autonomous spending increases output more than one for one. In other words, there is a multiplier effect. äUnderstand that the size of the multiplier depends on the marginal propensity to consume and on tax rates. äUnderstand that increases in government spending increase aggregate demand, and, therefore tax collections. However, tax collections rise by less than the increase in government spending, so increased government spending increases the budget deficit. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 2 AD and Equilibrium Income oConsumption Function oConsumption Function: Describes the relationship between consumption spending and disposable income. Chapter 10: Income and Spending(1)(1) oMarginal Propensity to Consume oMarginal Propensity to Consume: The increase in consumption per unit increase in income.(2)(2)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 AD and Equilibrium Income Figure 10-1: The Consumption Function Chapter 10: Income and Spending Consumption Y The consumption function shows the level of consumption spending at each level of disposable income. The slope of the consumption function is given by the marginal propensity to consume.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 AD and Equilibrium Income oThe Consumption Function and Aggregate Demand oThe Consumption Function and Aggregate Demand: (3)(3)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 The Consumption-Income Relationship BOXBOX 10-1 C = YD

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 AD and Equilibrium Income oEquilibrium Income oEquilibrium Income: (3)(3) (4)(4) (5)(5) (6)(6) (7)(7)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 AD and Equilibrium Income Figure 10-2: The Consumption Function, AD and Equilibrium Output Aggregate demand Y The vertical distance between AD and C is given by I + G + NX At E, supply equals demand. Y0Y0E

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 C, S, I, and Equilibrium: Why is Chap. 3 different from Chap.10? BOXBOX 10-2 In Chapter 3: In the long run the AS curve is vertical and that level of output is determined by amount of capital and labour through the production function. In Chapter 10: In the very short run the AS curve is horizontal and that level of output is determined by aggregate demand.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 The Multiplier oMultiplier oMultiplier: The amount by which equilibrium output changes when autonomous aggregate demand increases by one unit. Chapter 10: Income and Spending oFor c < 1… (8)(8) (10)(10) (9)(9)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 The Multiplier Table Total Increase Increase in Production Increase in Demand Round ………… ………

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 Fiscal Policy in the Very Short Run oFiscal Policy oFiscal Policy: The policy of the government toward the level of government spending, the level of transfers, or the level of taxes. Chapter 10: Income and Spending(11)(11) (12)(12) oBy adding the other components…

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 Fiscal Policy in the Very Short Run Chapter 10: Income and Spending(13)(13)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 Fiscal Policy in the Very Short Run Chapter 10: Income and Spending(14)(14) (15)(15) oAutomatic Stabilizer oAutomatic Stabilizer: Any mechanism in the economy that automatically reduces the amount by which output changes in response to a change in autonomous spending. oDiscretionary Fiscal Policy oDiscretionary Fiscal Policy : When the government changes a variable under its control (e.g., government spending) in response to a change in the economy.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Fiscal Policy in the Very Short Run Chapter 10: Income and Spending (16)(16) (17)(17)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 Fiscal Policy in the Very Short Run Figure 10-3: Endogenous Taxes and Aggregate Demand Aggregate demand Y AD’ has a higher intercept but a flatter slope. The intercept is larger because the term cTA is no longer in the intercept. The slope is smaller because the marginal propensity to consume out of total income is now c(1 -t), which is smaller than c.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 Fiscal Policy in the Very Short Run Figure 10-4: The Effects of an increase in government purchases Aggregate demand Y The increase in government spending shifts the AD curve up and income rises.E’ Y1Y1 Y0Y0E

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 The Government Budget in the Very Short Run oBudget Surplus oBudget Surplus: The excess of the government’s revenues, taxes, over its total expenditures, consisting of purchases of goods and services and transfer payments. oBudget Deficit oBudget Deficit: An excess of expenditures over revenues. Chapter 10: Income and Spending (18)(18) (19)(19)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 The Government Budget in the Very Short Run Figure 10-5: The Budget Surplus Budget surplus Y The higher the level of income, the higher are tax receipts and the higher the budget surplus. Income, Output 0 The lower the level of income, the lower are tax receipts and the higher the budget deficit.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 The Government Budget in the Very Short Run How do changes in fiscal policy affect the budget? OR Does an increase in government purchases reduce the budget surplus? Chapter 10: Income and Spending (20)(20)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 The Government Budget in the Very Short Run Chapter 10: Income and Spending oBalanced Budget Multiplier oBalanced Budget Multiplier: Increase in output that results from equal increases in taxes and government purchases. oFull Employment Budget Surplus oFull Employment Budget Surplus: The budget surplus at the full employment level of income or at potential output.(21)(21) (22)(22)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 The Government Budget in the Very Short Run Figure 10-6: Actual and Cyclical Adjusted Budget Deficit,

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 The Foreign Sector oTaking foreign trade into account…. Chapter 10: Income and Spending(23)(23) oMarginal Propensity to Import oMarginal Propensity to Import: The increase in the demand for imports that results from a one-unit increase in domestic import.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 The Foreign Sector Chapter 10: Income and Spending In equilibrium….. (24)(24)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 Chapter Summary Output is at its equilibrium when the aggregate demand for goods is equal to the level of output. Aggregate demand consists of planned spending by households on consumption, by firms on investment goods, and by government on its purchases of goods and services and also includes net exports. When output is at its equilibrium level, there are no unintended changes in inventories and all economic units are making precisely the purchases they had planned to make. Chapter 10: Income and Spending

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 25 Chapter Summary (cont’d) The level of aggregate demand is itself affected by the level of output (equal to the level of income). The consumption function relates consumption spending to income. The multiplier is the amount by which a $1.00 change in autonomous spending changes the equilibrium level of output. Government purchases and and government transfer payments act like increases in autonomous spending I their effects on the equilibrium level of income. Chapter 10: Income and Spending

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 26 Chapter Summary (cont’d) The budget surplus is the excess of government receipts over expenditures. The actual budget surplus is also affected by changes in tax collection and transfers resulting from movements in the level of income that occur because of changes in private autonomous spending. When foreign trade is taken into account, exports add to and imports subtract from autonomous spending. Chapter 10: Income and Spending

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 27 The End Chapter 10: Income and Spending