1. Prepared by: Jamal Husein C H A P T E R 14 © 2006 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Aggregate Demand and Fiscal Policy

2. 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Learning Objectives  Why do governments cut taxes to increase economic output?  Why is the U.S. economy more stable than it was prior to World war II?  If consumers become more confident about the future of the economy, can that confidence lead to faster economic growth?  If a government increases spending by $10 billion, could total GDP increases by more than $10 billion?

3. 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Behind the AD Curve: A short Run Analysis  The demand for goods and services determines output, or the level of GDP, at least in the short run.  The short run is a period of time during which prices do not change, or change very little.  In the short run, producers supply all of the output that is demanded.  In the short run, the economy rapidly adjusts to reach the equilibrium level of output, where total demand equals production, i.e., AD equals AS.

4. 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Shifts in Aggregate Demand Output, y Price, P SRAS y0y0 A shift in AD curve from AD 0 to AD 1 increases output from y 0 to y 1. AD 1 y1y1 AD 0

5. 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Shifts in Aggregate Demand Output, y Price, P y0y0 An increase of government spending of $10 billion will initially shift original AD by $10 billion (from A to B). Total AD will increase by more than $10 billion after a period of time due to the multiplier effect. Initial shift y1y1 Original AD y2y2 Final AD A B C

6. 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Consumption Function & the Multiplier  The relationship between consumer spending and income is called the consumption function:  C a = autonomous consumption spending, or the amount of consumption spending that does not depend on the level of income.  by = induced consumption, or the amount of consumption induced by higher income.  b= marginal propensity to consume (MPC).  y= level of income in the economy. C=Cby a 

7. 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Consumption Function  The consumption function is a line that intersects the vertical axis at C a. the value of autonomous consumption spending.  When income equals zero, the value of total consumption (C) equals C a. It corresponds to the amount of consumption that does not depend on the level of income.

8. 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The MPC & the MPS  The slope of the consumption function is the marginal propensity to consume (MPC), or the value of b in the linear equation.  For each additional dollar of income received, a consumer will spend part of it and save the rest.  The fraction that the consumer spends is given by his or her MPC or the slope of the consumption function b.  The MPC is always less than one

9. 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The MPC & the MPS  The fraction that the consumer saves is determined by his or her marginal propensity to save (MPS).  For example, if b (MPC) = 0.6, then 60 cents of each additional dollar are consumed and 40 cents (MPS =.4) are saved.  The sum of the MPC and the MPS is always equal to one MPC + MPS = 1

10. 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Changes in the Consumption Function  The consumption function can change for two reasons: A change in autonomous consumption A change in the marginal propensity to consume  Factors that cause autonomous consumption to change are: Consumer wealth, or the value of stocks, bonds, and consumer durables held by the public (Franco Modigliani). Consumer confidence.

11. 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Changes in the Consumption Function  Factors that cause the marginal propensity to consume to change are: Consumers’ perceptions of changes in income. Studies show that consumers tend to save a higher proportion of a temporary increase in income, and spend a higher proportion of income if the increase in income is perceived to be permanent. Changes in taxes, as we will see later in this chapter.

12. 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Changes in the Consumption Function Impact of a change in autonomous consumption Impact of a change in the marginal propensity to consume

13. 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Determining Aggregate Demand  We stack up the amount of investment on top of consumption function.  At any level of output (income), total demand for goods and services can be read of the C + I line.  In an economy without government or the international sector, AD will be determined by consumption (C) and investment spending (I).

14. 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Determining Aggregate Demand  Equilibrium output, where y = C+I, is found where the 45 0 line intersects the demand line (C+I).  The y * level of output means that firms are producing precisely the level of output necessary to meet the consumption and investment demands by households and firms. Demand Output, y C C+I 45 0 y* CaCa C a + I E

15. 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Multiplier  The model of AD can be used to explain what happens to equilibrium output (employment) if there is a change in investment spending (an autonomous expenditure);  An increase in investment, i.e., from I 0 to I 1 (called ∆I) will shift the initial C+I 0 curve upward by ∆I to C+I 1 ;  The intersection of C+I 1 curve with the 45 degree line shifts equilibrium from E 0 to E 1 ;  As a result AD increases from Y 0 to Y 1 ;

16. 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Multiplier  The change in AD (∆y) is greater than the increase in I, which is the general result that the increase in output always exceeds the increase in investment;  This explains the multiplier or why the final shift in AD is greater than the initial shift in AD;  The Multiplier is a number that shows by how much equilibrium output will change as a result of a change in the value of autonomous expenditures.  For example, if b = 0.75, then the multiplier equals 4. A one-dollar increase in autonomous consumption or in investment, will increase equilibrium income by 4 dollars.

17. 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Multiplier Demand Output, y C C+I 0 45 0 y0y0 CACA I0I0 E0E0 y1y1 E1E1 C+I 1 I1I1 y0y0 y1y1 ∆y∆y ∆I∆I

18. 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Multiplier in Action (millions $) Round of Spending Increase in Demand Increase in GDP and Income Increase in Consumption 1$10 $8 2886.4 3 5.12 4 4.096 5 3.277 ………… Total50 million 40 million 1 Multiplier Multiplier = (1 – MPC)

19. 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Government Spending and Taxation  Both the level of government spending and the level of taxation, through their influence on the demand for goods and services, affect the level of GDP in the short run.  Using taxes and spending to influence the level of GDP (shift the AD curve) in the short run is known as Fiscal Policy.  Government purchases of goods and services are a component of total spending; Total Spending including government = C + I + G

20. 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Government Spending  Increases (decreases) in government spending shifts the C+I+G curve upward (downward), just as changes in investment; Demand Output, y C+I+G 0 45 0 y1y1 Demand Output, y C+I+G 0 45 0 y0y0 y0y0 C+I+G 1 y1y1

21. 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Impact of Taxes  The consumption function becomes:  After taxes and transfers are taken into account, national income becomes personal disposable income: Y d = y - T or  For example, if taxes increase by $1, after- tax income will decline by $1. Since the MPC is b, this means that consumption (C) will fall by b×$1 and the C+I+G curve will shift downward by b×$1 ;

22. 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Impact of Taxes  Increases (decreases) in taxes shifts the C+I+G curve downward (upward) and impact total demand and equilibrium output. Demand Output, y C+I+G 45 0 y1y1 Demand Output, y C+I+G 45 0 y0y0 y0y0 C+I+G y1y1

23. 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Impact of Taxes  The multiplier for taxes is less than that for government spending;  Decreasing government spending (G) by $1, will shift the C+I+G curve downward by $1;  However, increasing taxes by $1, consumers will cut back their consumption by a fraction of $1 (b×$1), thus the C+I+G curve will shift downward by less than $1, or exactly by b×$1;

24. 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Government Spending and Taxation  We use a special terminology to describe fiscal policy;  Government policies directed towards increasing AD and GDP are called expansionary policies such as tax cuts and increases in government spending;  Government policies directed towards decreasing AD and GDP are called contractionary policies such as tax increases and government spending cuts

25. 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Government Spending and Taxation  Budget deficit, the difference between government spending and its revenue, will be impacted by government policies;  An increase in government spending or a reduction in taxes ( expansionary policies) will increase the government's budget deficit;  A decrease in government spending or an increase in taxes ( contractionary policies) will decrease the government's budget deficit

26. 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Fiscal Policy in Action  According to Keynesian economics, expansionary fiscal policy—tax cuts and increased government spending—could pull the economy out of a recession or depression.  During the 1930s, however, politicians did not believe in Keynesian fiscal policy, largely because they feared the consequences of budget deficits.  Although government spending increased during the 1930s, so did taxes, resulting in no net fiscal expansion.

27. 27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Fiscal Policy in Action  It was not until the early 1960s, during the Kennedy administration, that modern fiscal policy came to be accepted. Tax cuts were used to try to reduce unemployment.  Estimating the actual effects the tax cuts had is difficult, but from 1963 to 1966, both real GDP and consumption grew at rapid rates. This rapid growth suggests that the tax cuts had the effect, predicted by Keynesian theory, of stimulating economic growth.

28. 28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Fiscal Policy in Action  From 1966 to 1969, the unemployment rate fell below 4%, and fiscal policy was used in economic policy again.  A temporary surcharge tax, enacted in 1968, raised the taxes of households by 10%.  But since the tax was temporary, it did not have a major effect on permanent income, and the decrease in demand was smaller than economists had anticipated. Households simply saved less during that period.

29. 29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Fiscal Policy in Action  During the 1970s there was no net change in fiscal policy. Mild changes in taxes were enacted in 1975, after the economy went into a recession in 1973.  Significant tax cuts were enacted in 1981, but these tax cuts were justified on the basis of their impact on supply, not demand.  A major tax increase was passed under President Clinton that successfully brought the budget into balance.

30. 30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Fiscal Policy in Action  By year 2000, the federal budget began to show surpluses that set the stage for tax cuts that were passed by President George W. Bush.  Post September 11, 2001, the president and the Congress became less concerned with balancing the budget and authorized new spending programs to provide relief to victims and to stimulate the economy

31. 31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Automatic Stabilizers  Certain taxes and transfers act as automatic stabilizers for the economy.  When income is high, the government collects more taxes and pays out less transfer payments, thereby reducing spending.  When output is low, the government collects less taxes and pays out more in transfer payments, putting more funds into the hands of consumers.

32. 32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Automatic Stabilizers  As such automatic stabilizers prevent consumption from falling as much in bad times and from rising as much in good times.  Other factors contributing to the stability of the economy is that consumers base their spending decisions on permanent income and not just their current level of income.

33. 33 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Growth Rate of U.S. GDP, 1871-2000

34. 34 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exports and Imports  Exports (X) and imports (M) affect AD through their influence on how foreigners demand goods and services produced in the U.S.  An increase in exports means an increase in demand for U.S. goods and services, while an increase in imports means an increase in demand for foreign goods and services by U.S. residents.

35. 35 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exports and Imports  To recognize the impacts of exports and imports on AD and GDP, we take two steps and ignore government spending and taxes for the moment:  Add exports, X, which we assume to be autonomous because they depend on foreign income, to other sources of spending; and  subtract imports, M, which depends on the level of domestic income, from total spending by U.S. residents y = C + I + (X – M)

36. 36 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exports and Imports  Consumers will buy more foreign goods and services (M) as income rises; imports = M = my  Additional spending on U.S. goods and services out of additional income can be obtained by subtracting m or the (marginal propensity to import) from b or the MPC. MPC for domestic spending = b – m

37. 37 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exports and Imports  For example, if b = 0.8 and m = 0.2, then MPC for domestic spending = b – m = 0.8 – 0.2 = 0.6 Demand Output, yy*y* C a +I+X 45 0 Demand Slope = (b – m) In an open economy, the level of equilibrium income is determined by the intersection of total demand for U.S. goods and services with the 45 degree line.

38. 38 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exports and Imports Demand Output, y 45 0 y1y1 Demand Output, y 45 0 y0y0 y0y0 C a +I+X y1y1 An increase in exports Will increase the level of Aggregate Demand. An increase in marginal propensity to import will decrease the level of AD. ∆X∆X