Figure 3.

1:ConsumptionandDisposableIncome

a)Consumption(C)

3.3 :

ConsumptionC isafunctionofincome
andtaxes T.
Higherincomeincreases consumption,butlessthanoneforone.
Highertaxesdecrease consumptionbutlessthanoneforone.

As

rises,

falls,andsotheaverage propensity toconsume falls.

a)Consumption(C)
Keynesexpectedthe rich tosaveahigher proportionoftheirincome
thanthe poor.
Keynesianconsumptionfunctiondoesnot seemtomatchshortrun
(household)data,althoughitdoesmatchlongrun (crosscountryand
loneruntimeseries)data.

OtherFactorsThatMayAffectCurrentConsumption
Effectofchangesinexpected future income:Higher expectedfuture
incomeleadstomore consumptiontoday,sosavingfalls.
Effectofchangesinwealth:Increases inwealthraises current
consumption,solowers currentsaving.
Effectofchangesinreal interest rate
:Increased realinterestrate
hastwoopposing effects

OtherFactorsThatMayAffectCurrentConsumption
(i)Substitution effect:Positive effectonsaving,sincerateofreturnis
higher;greater rewardforsavingelicitsmore saving
(ii)Income effect:Forasaver,negative effect,sinceittakesless
savingtoobtainagivenamountinthefuture(targetsaving).
Foraborrower,positive effectonsaving,sincethehigherrealinterest
ratemeansaloss ofwealth.
*Empiricalstudieshavemixedresults;probablyaslightincreasein
aggregatesaving.

b)Investment(I)
Q:Whyisinvestmentimportant?
A:(i)Investmentsharplyfluctuates overthebusiness cycle
(morethananyotherspendingcomponent!Only1/6oftotalGDP,
butinthetypicalrecessioninvestmentaccountsformorethanof
totaldeclineinspending),
soweneedtounderstandinvestmenttounderstandthebusiness
cycle.
(ii)Investmentplaysacrucialroleineconomic growth thelongrun
productivecapacityoftheeconomy(capital,K,affects .

3.4 :

Investmentwillbetreatedasgiven tokeepthemodelsimple.

c)Governmentpurchases(G)
TogetherwithtaxesT,G describesfiscal policy thechoice
oftaxes andspending bythegovernment.G,TR andT will
betakenasexogenous.

TheDeterminationofEquilibriumOutput

3.5 :

Output isdeterminedbyequilibriuminthegoods market.

Theequilibriumconditionisproduction (supply)equalsdemand.
Thus,intheshortrun,outputisfullydeterminedbydemand without
anychangeinprice.
Assumingthatfirmsdontholdinventories,equilibriumcondition:

3.6

TheDeterminationofEquilibriumOutput

3.7 :
Inequilibrium,production (oroutput),Y,isequaltodemand.
Demand inturndependsonincome,Y,whichisitselftoproduction.
Production andincome areidenticallyequal.
Macroeconomistsalwaysusethreetoolstodetermineequilibrium:
Algebratomakesurethatthelogiciscorrect
Graphstobuildtheintuition
Wordstoexplaintheresult

TheDeterminationofEquilibriumOutput
From

3.7 , 1
3.8 :

3.8 characterizesequilibriumoutput(endogenous variable),

thelevelofoutputsuchthatproduction (orsupply)equalsdemand
thequantityofoutputproduced=thequantitydemanded.

TheDeterminationofEquilibriumOutput

Theterm
iscalledautonomous
(orindependent)spending partofthedemandforgoodsthatdoes
not dependonoutput (orincome).
When

, unplanned inventory
or
disinvestment:
.

TheDeterminationofEquilibriumOutput
Q:Isautonomousspending
positive?
A:Notalways,butitisverylikelytobe!
, and arepositive.
Balancedbudget:
If
(balancedbudget),then
1
0 andso

autonomousspendingispositive.
Onlyifthegovernmentwererunningaverylargebudget surplus if
taxes weremuchlargerthangovernment spending could
autonomousspendingbenegative.

TheDeterminationofEquilibriumOutput

iscalledthemultiplier (anumbergreaterthanone).

Thecloser isto1,thelarger themultiplier;thehigher MPC,the

larger themultiplier.
Forexample,

if

0.6, themultiplier

2.5,

sooutputincreasesonaverageby2.5x$1billion=$2.5billionif
increasesby$1billion.

If

0.9, themultiplier

10.

MultiplierEffect
Q:Wheredoesthemultipliereffect comefrom?
A:Anincreasein increasesdemand.Theincreaseindemand then
leadstoanincreaseinproduction.Theincreaseinproduction leads
toanequivalentincreaseinincome.Theincreaseinincome further
increaseconsumption,whichfurtherincreasesdemand,andsoon.
Multipliereffect
Aseriesofinduced increases(ordecreases)inconsumption
spendingthatresultsfromanincrease(oradecrease)inautonomous
spending;thiseffectamplifiestheeffectofeconomicshockson
production (Y orrealGDP)

Multipliers

3.8 :

Spending(orexpenditure)multiplier:

or

or

Governmentpurchasesmultiplier:

Taxmultiplier:

or

TheDeterminationofEquilibriumOutput
TheKeynesiancrossprovidesbasicintuitionaboutthebuilding and
solving ofmodels,thedeterminationofoutput,andtheroleoffiscal
policy.
First,plotproductionasafunctionofincome:sinceproduction and
income areidenticallyequal,therelationbetweenthemisthe45
degreeline,thelinewithaslopeequalto1.
Second,plotdemandasafunctionofincome.Therelationbetween
demandandincomeisgivenby

3.5 :
.

TheDeterminationofEquilibriumOutput
AggregateDemand:

Demanddependsonautonomous spending andonincome

viaitseffectonconsumption.
Thelineisupward sloping buthasaslopeofless than 1.

Figure 3.2:EquilibriumintheGoodsMarketUsing
theKeynesianCross

TheDeterminationofEquilibriumOutput
Inequilibrium,production equalsdemand.Equilibriumincomeisthe
productoftwofactors:autonomous spending andamultiplier.
Considertheeffectsonoutputofanincreaseinautonomous
spendingby$1billionbecauseofanincreaseinconsumer
confidence.
Theaggregatedemand(Z orAD)scheduleshiftsupward,meaning
thatateachlevelofincome,aggregatedemandishigher byan
amount$1billion.

Figure 3.3:TheEffectsonOutputofanIncreaseinAutonomous
SpendingBecauseofanIncreaseinConsumerConfidence

TheDeterminationofEquilibriumOutput

$1 billion becauseofthemultiplier effect

Thefirstroundincreaseindemand (thedistanceAB)equals$1
billion.
Thisfirstroundincreaseindemandleadstoanequalincreasein
production,or$1billion,bythedistanceAB.
Thisincreaseinproductionof$1billionimpliesthatincomes
increasesby$1billionshownbythedistanceBC
(Recall:income =production).
ThesecondroundincreaseindemandshownbythedistanceCD
$
.
equals$

TheDeterminationofEquilibriumOutput
Thissecondroundincreaseindemandleadstoanequalincreasein
productionshownbythedistanceCD,andthusanequalincreasein
income shownbythedistanceDE.
Thethirdroundincreaseindemandequals$1
(theincreasein
incomeinthesecondround)
$ ,andsoon.
Totalincreaseinoutput

$1

$1

$1

TheDeterminationofEquilibriumOutput
Productiondependsondemand,whichdependsonincome,whichis
itselfequaltoproduction.
Demand Production Income More demand
More production More income ,andsoon.
Theendresultisanincreaseinoutput thatislarger thantheinitial
shiftindemand,byafactorequaltothemultiplier.
Thesize ofmultiplierisdirectlyrelatedtothevalueofMPC:
thehigher theMPC,thelarger themultiplier.

Example (3.1):EquilibriumOutput
Usethefollowinginformationtocalculateequilibriumoutput(all
valuesareintrilliondollarsof2005dollars):
Consumption:
Investment:
Governmentpurchases:
Netexports
Taxes:
Governmenttransfer
payments

$1.0 0.75
$1.9
$2.0
$0
$2.5
$2.0

Example (3.1):EquilibriumOutput

$1.0
$1.0 0.75
$4.525 0.75

Equilibriumcondition:

$4.525 0.75

0.75
$4.525
0.25Y $4.525

$ .
.

$18.1 trillion

0.75
$2.0 $2.5

$1.9

$2.0

Example (3.1):EquilibriumOutput
b)Nowsupposethatfullemploymentoutput(potentialGDP)equals
$19.0trillion.Ifequilibriumoutputequalstheamountyoucalculatedin
part(a),usethevalueforthegovernmentpurchasesmultiplierto
calculatehowmuchgovernmentpurchaseswouldhavetochangefor
equilibriumoutputtoequalpotentialGDP(assumingthattaxesremain
unchanged).
(Ans.)
Governmentpurchasesmultiplier:

$0.225 trillion

$225 billion

Example (3.1):EquilibriumOutput
c)Nowsupposethatfullemploymentoutput(potentialGDP)equals$19.0
trillion.Ifequilibriumoutputequalstheamountyoucalculatedinpart(a),
usethevalueforthetaxmultipliertocalculatehowmuchgovernmenthasto
changeforequilibriumoutputtoequalpotentialGDP(assumingthatG
remainunchanged).
(Ans.)
Taxmultiplier:

$0.3 trillion $300 billion

Noticethatbecausethetaxmultiplierissmaller (inabsolutevalue)than
thegovernmentpurchasesmultiplier,thecutintaxesneedstobelarger
thantheincreaseingovernmentpurchasestoresultinthesame increase
inequilibriumoutput.

Example (3.1):EquilibriumOutput
d)Useagraphtoillustrateyouranswer.
(Ans.)

Multiplier
Q:Byhowmuchdoesa$1increaseinautonomousspendingraisethe
equilibriumlevelofoutput?
A:

autonomous spending
, called the multiplier

Theamountbywhichequilibriumoutputchangeswhen
autonomousaggregatedemandincreasesby1unit
Thelarger themarginalpropensitytoconsume(MPC),thelarger the
multiplierbecauseahighMPCimpliesthatalarger proportionofan
additionalincomewillbeconsumed,andthusaddedtoaggregate
demand,therebycausingalarger inducedincreaseindemand.

Multiplier

Q:Whyfocusonthemultiplier?
A:Becausethemultiplierispotentiallypartoftheexplanationofwhy
outputfluctuates.Themultipliersuggeststhatoutputchangeswhen
autonomousspending(includinginvestment)changesand thatthe
changeinoutputcanbelarger thanthechangeinautonomousspending.

Themagnitudeoftheincomechangerequiredtorestoreequilibrium
dependsontwofactors:
(i)Thelarger theincreaseinautonomousspending,thelarger theincome.
(ii)Thelarger theMPC thatis,thesteeper theaggregatedemand
schedule thelarger theincomechange.

TheGovernmentSector
Wheneverthereisarecession,peopleexpectanddemandthatthe
governmentshoulddosomethingaboutit.
Q:Whatcanthegovernmentdowithrespecttoaggregatedemand?
A:(i)Governmentpurchasesofgoodsandservices(G)
(ii)Taxes(T)andtransfers(TR)affecttherelationbetweenoutputand
income,Y.
Fiscalpolicy
Thepolicyofgovernmentwithregardtothelevelofgovernment
purchases,theleveloftransfers,andthetaxstructure.

TheGovernmentSector
Q:Whathappenstothevalueofthegovernmentspendingmultiplier
ifwetakeintoaccountthetaxrate thathouseholdspayontheir
income?
A:Supposethatthegovernmentimposesaproportionalincometax,
collectingafraction,t,ofincomeintheformoftaxrates:
.

TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

paypartofeverydollarofincomeintaxes andareleftwithonly
1
dollars

TheGovernmentSector
Equilibriumcondition:

3.9 :

Forexample,
Themultiplieris

0.2 20% and

.

0.75.
.

2.5.

Proportionalincometaxesreduce themultiplierbecausetheyreduce
theinducedincreaseofconsumptionoutofchangesinincome.
Theinclusionoftaxesflattens theaggregatedemandcurve(ZZline)
andhencereduces themultiplier.