1. Lecture Seven Review: Short-run equilibrium Adding the government sector Lump sum tax and net tax

2.  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 7

3.  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 7

4.  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 4Lecture 7

5.  Simplifying Assumptions  Government purchases do not cause any shift in consumption or investment schedules  Lump sum tax: taxes do not vary with GDP  Government spending (G is autonomous expenditure  Taxes affect disposable income 5Lecture 7

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 6Lecture 7

7. GDPTDICaCa SaSa IgIg NXGAE $370$40$330$345 39040350360 41040370375 43040390 45040410405 47040430420 49040450435 51040470450 53040490465 55040510480 Equilibrium Levels of Employment, Output & Income Consumption spending is lower 7Lecture 7

8. GDPTDICaCa SaSa IgIg NXGAE $370$40$330$345$ - 15$20$35$40 39040350360- 10203040 41040370375- 5202540 43040390 020 40 450404104055201540 4704043042010201040 490404504351520540 5104047045020 040 530404904652520- 540 550405104803020- 1040 Equilibrium Levels of Employment, Output & Income 8Lecture 7

9. GDPTDICaCa SaSa IgIg NXGAE $370$40$330$345$ - 15$20$35$40$440 39040350360- 10203040450 41040370375- 5202540460 43040390 020 40470 450404104055201540480 4704043042010201040490 404504351520540500 5104047045020 040510 530404904652520- 540520 550405104803020- 1040530 Equilibrium Levels of Employment, Output & Income 9Lecture 7

10. o 45 o C + I g GDP (billions of dollars) 470 510 550 510 550 470 C + I g + G G= $40 +$80 l Impact of $40 billion in government purchases on equilibrium GDP Aggregate expenditures (billions of dollars) 10Lecture 7

11. o 45 o GDP (billions of dollars) C + I g + G C a + I g + G l Equilibrium GDP reduced by $40 billion 470 510 550 -20 -40 Aggregate expenditures (billions of dollars) 510 550 470 11Lecture 7

12.  C = 20 +0.8 Y,I = 15, G = 15  AE = C + I + G  AE = 20 + 0.8 Y + 15 +15 = 50 + 0.8 Y  AE = Y at equilibrium  50 + 0.8 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 = 20 + 15 + 15 = 50, 1 – MPC = 1 – 0.8 = 0.2  Y e = 50/0.2 = 250 12Lecture 7

13.  T = 10, I = 20, G = 15  C = 20 +0.8 (Y-10)  AE = C + I + G  AE = 20 + 0.8 (Y-15) + 15 +15 = 20 +0.8Y – 8 + 15 + 15  AE = 42 + 0.8Y  AE = Y at equilibrium  42 + 0.8 Y = Y  42 = 0.2Y  Y e = 42/0.2 = 210  Taxes affect disposable income, which affect consumption 13Lecture 7

14.  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) 14Lecture 7

15.  Equilibrium GDP may or may not provide full employment  Recessionary Expenditure Gap  Increasing autonomous expenditure has a multiplier effect 15Lecture 7

16. Real GDP (billions of dollars) (C a + I g + G) 1 o 45 oRecessionary Gap = $20 billion (C a + I g + G) 0 510 530 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 16Lecture 7

17.  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 17Lecture 7

18.  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 718

19.  Taxes and transfer payment affect consumption  Lump sum tax, DI = Y - T  Net tax, NT = tY, t net tax rate  DI = Y – NT = (1-t)Y 19Lecture 7

20.  Assume C = 20 + 0.8DI  T = 10  DI = Y-10  So C = 20 + 0.8(Y-10) C = 20 + 0.8Y – 8 = 12 + 0.8Y  Each dollar of lump sum tax reduces autonomous consumption by 0.8 dollar (80 cents) 20Lecture 7

21.  Assume C = 20 + 0.8DI  t = 10%  DI = (1-t)Y  So C = 20 + 0.8(1 – 0.10)Y C = 20 + 0.72Y  Each extra dollar of national income increase DI by $0.9 (90 cents), out of which household spend 72 cents and save 18 cents. 21Lecture 7

22. Real Consumption C Real GDP and Income Y C = 20 + 0.8Y, t = 0 C = (20-0.8*10) + 0.8Y 300 20 12 260 22Lecture 7 252

23. Real Consumption C Real GDP and Income Y C = 20 + 0.8Y, t = 0 C = 20 + 0.72Y, t = 0.10 300 20 236 260 ΔC/ΔY = MPC(1-t) = 0.8 x 0.9 What about Multiplier? 23Lecture 7

24.  Government spending (G) shift AE vertically  Net tax (increasing tax rate) reduces DI, therefore lowers consumption, rotate AE to the right (slope of AE is reduced)  AE and C has the same slope MPC × (1-t)  Multiplier effect is given by the combination of the two  Multiplier = 1/(1-MPC x (1 –t))  The change of equilibrium GDP is given by G x multiplier. 24Lecture 7

25. YCIAE 40080 50080 60080 (a) No Government  AE = C + I  C = 20 + 0.8Y  I = 80  Autonomous Expenditure of 100  Multiplier = 5  Y e = 100 × 5 = 500 YCIAE 40034080420 50042080500 60050080580 25Lecture 7

26. YCIGAE 61080 71080 81080 (b) T = 10, G = 50 AE = C + I + G  C = 20 + 0.8(Y-10)  C = 12 + 0.8Y  I = 80  G = 50  Autonomous Expenditure of 142  Multiplier = 5  Y e = 142 × 5 = 710 YCIGAE 6105008050630 7105808050710 8106608050790 26Lecture 7

27. YNTDICIGAE 200800 357800 400800 (c) Tax t = 0.10, G = 0  AE = C + I  C = 20 + 0.8(1-0.10)Y  C = 20 + 0.72Y  I = 80  Autonomous Expenditure of 100  Multiplier = 1/(1-0.8(1- 0.10))= 3.57  Y e = 100 × 3.57 = 357 20180164244 35.7321.3277357 40360308388 27Lecture 7

28. YNTDICIGAE 5008050 535.78050 550805 (d) Tax t = 0.1, G = 50  AE = C + I + G  C = 20 + 0.8(1-0.1)Y  C = 20 + 0.72Y  I = 80, G =50  Autonomous expenditure =150  Multiplier = 1/(1-0.8(1- 0.1)) = 3.57  Y e = 150×3.57 = 535.7 YNTDICIGAE 5045038050510 535.753.6482.1405.750535.7 5505549541650546 28Lecture 7

29. o 45 o GDP (billions of dollars) AE’ AE Autonomous expenditure is increased by 42 (intercept effect) AE shifts up Slope = 0.8, multiplier = 5, Y* =710 500 Aggregate expenditures (billions of dollars) 142 100 Y = AE 710 G = 50, T = 10 29Lecture 7

30. o 45 o GDP (billions of dollars) AE’ AE Autonomous expenditure is increased by 50 (intercept effect) AE becomes flatter (t = 0.1, slope = 0.8 × (1-0.1) = 0.72; slope effect) 500 Aggregate expenditures (billions of dollars) 150 100 Y = AE 537.5 G = 50, t = 0.1 30Lecture 7

31.  Chapter 8.4 and 9 (exclude 9.3)  Understand how taxes and government spending affect equilibrium GDP  Homework 7 Lecture 731