Lecture

Lecture 66
KEYNESIAN
KEYNESIAN ECONOMICS
ECONOMICS &
&
FISCAL
FISCAL POLICY
POLICY
 AGGREGATE
AGGREGATE OUTPUT
OUTPUT AND
AND
INCOME
INCOME -- 11
• Each
Each period
period (weeks,
(weeks, months,
months, years,
years,
etc),
etc), firms
firms produce
produce some
some aggregate
aggregate
quantity
quantity ofof goods
goods and
and services.
services.
• We
We call
call this
this aggregate
aggregate output
output (Y).
(Y).
• We
We have
have seen
seen that
that GDP
GDP (Y)
(Y) can
can be
be
calculated
calculated in in terms
terms of
of either
either income
income or or
expenditures.
expenditures.
 AGGREGATE
AGGREGATE OUTPUT
OUTPUT AND
AND
INCOME
INCOME -- 22
• We
We will
will use
use the
the variable
variable YY to
to refer
refer to
to
both
both aggregate
aggregate output
output and
and aggregate
aggregate
income,
income, because
because they
they are
are the
the same
same
seen
seen from
from different
different points
points of
of view.
view.
 AGGREGATE
AGGREGATE OUTPUT
OUTPUT AND
AND
INCOME
INCOME -- 33
• What
What happens
happens when
when output
output increases?
increases?
• What
What happens
happens when
when output
output is
is cut?
cut?
• In
In any
any given
given period
period there
there is
is an
an exact
exact
quality
quality between
between aggregate
aggregate output
output
(production)
(production) and
and aggregate
aggregate income.
income.
 AGGREGATE
AGGREGATE OUTPUT
OUTPUT AND
AND
INCOME
INCOME -- 44
• Aggregate
Aggregate output
output can
can also
also be
be looked
looked
on
on as
as the
the aggregate
aggregate quantity
quantity supplied,
supplied,
because
because that
that is
is the
the amount
amount firms
firms are
are
supplying
supplying (producing)
(producing) during
during thethe
period.
period.
 AGGREGATE
AGGREGATE OUTPUT
OUTPUT AND
AND
INCOME
INCOME -- 55
• In
In the
the lectures
lectures which
which follow,
follow, we
we use
use
the
the phrase
phrase aggregate
aggregate output
output (income),
(income),
rather
rather than
than aggregate
aggregate quantity
quantity
supplied,
supplied, but
but keep
keep in
in mind
mind that
that the
the two
two
are
are equivalent.
equivalent.
 INCOME,
INCOME, CONSUMPTION
CONSUMPTION AND
AND
SAVING
SAVING -- 11
• In
In the
the analysis
analysis which
which follows,
follows, we
we are
are
initially
initially going
going to
to assume
assume aa simple
simple
world
world withwith nono government
government and and aa
‘closed’
‘closed’ economy
economy -- i.e.
i.e. no
no imports
imports and
and
no
no exports.
exports.
• With
With their
their income,
income, households
households cancan
either
either consume
consume or or save.
save.
 INCOME,
INCOME, CONSUMPTION
CONSUMPTION AND
AND
SAVING
SAVING -- 22
• Total
Total household
household saving
saving in
in the
the economy
economy (S)
(S)
is
is by
by definition
definition equal
equal to
to income
income (Y)
(Y) minus
minus
consumption
consumption (C):
(C):

Saving
SavingIncome
Income –– Consumption
Consumption

S
S Y
Y –– C
C
 INCOME,
INCOME, CONSUMPTION
CONSUMPTION AND
AND
SAVING
SAVING -- 33
• The
The triple
triple equal
equal sign
sign means
means this
this isis an
an
identity
identity -- something
something that
that is
is always
always true.
true.
• In
In our
our simple
simple economy,
economy, in in which
which there
there
is
is no
no government,
government, there
there are
are two
two types
types of of
spending
spending behavior
behavior -- spending
spending by by
households
households or or consumption
consumption (C) (C) andand
spending
spending by by firms,
firms, or
or investment
investment (I)
(I)
 THE
THE 45 LINE
45 00
LINE
• Divides
Divides the
the angle
angle between
between the the
two
two axes
axes of
of aa graph
graph in
in half
half
• Has
Has the
the important
important property
property that
that
from
from any
any point
point onon it,
it, the
the vertical
vertical
and
and horizontal
horizontal distances
distances
measured
measured along
along the
the axes
axes areare
equal
equal
 THE 450 LINE

450
Demand

0 a
Output, y
Any point on the 450 line corresponds to the same vertical and
horizontal distances. The distance 0a equals the distance Aa.
 THE
THE SIMPLEST
SIMPLEST KEYNESIAN
KEYNESIAN
CROSS
CROSS
•• Uses
Uses the
the 45
4500 line
line
•• A
A graph
graph with
with the
the demand
demand for for goods
goods and
and services
services onon the
the
vertical
vertical axis
axis and
and output
output (( yy )) on
on the
the horizontal
horizontal axis
axis
•• The
The government
government and and foreign
foreign sector
sector are
are omitted
omitted from
from this
this
model
model
•• Only
Only consumers
consumers and and firms
firms cancan demand
demand output
output
•• Consumers
Consumers demand
demand consumption
consumption goods goods and
and firms
firms demand
demand
investment
investment goods
goods
•• Assume
Assume initially
initially that
that consumers
consumers and and firms
firms demand
demand aa fixed
fixed
amount
amount ofof goods
goods
 CONSUMPTION
CONSUMPTION AND
AND
INVESTMENT
INVESTMENT DEMAND
DEMAND
• Consumption
Consumption demand
demand is is “C”
“C”
• Investment
Investment demand
demand isis “I”
“I”
• Total
Total demand
demand is
is “C
“C ++ I”
I”
• In
In the
the short
short run,
run, demand
demand determines
determines output
output
• Output
Output == demand
demand
• Output
Output == demand
demand == C C ++ II
 THE KEYNESIAN CROSS

450
Demand

E
C+I
C+I Demand

0 Output , y
y*

At equilibrium output y*, total demand Ey* equals output 0y* .

 THE
THE SIMPLE
SIMPLE KEYNESIAN
KEYNESIAN
CROSS
CROSS
•• Superimpose
Superimpose the the horizontal
horizontal lineline –– CC ++ II (demand)
(demand) –– onon
the
the 45
4500 diagram
diagram
•• Total
Total demand
demand is is fixed
fixed atat CC ++ II and
and is
is independent
independent of of the
the
level
level of
of GDP
GDP
•• Equilibrium
Equilibrium output
output is is at
at y*,
y*, the
the level
level of
of output
output at
at which
which
the
the demand
demand lineline crosses
crosses the the 45
4500 line
line at
at point
point EE
•• Output
Output measured
measured on on the
the horizontal
horizontal axisaxis equals
equals demand
demand
by
by consumers
consumers and and firms
firms
•• Since
Since E E isis on
on the
the 45 4500 line,
line, thethe vertical
vertical distance
distance Ey*
Ey*
equals
equals thethe horizontal
horizontal distance
distance 0y* 0y*
 THE KEYNESIAN CROSS

450
Demand

E
C+I
C+I Demand

0 Output , y
y*

At equilibrium output y*, total demand Ey* equals output 0y* .

IF
IF ECONOMY
ECONOMY PRODUCES
PRODUCES AT
AT A
A HIGHER
HIGHER
LEVEL
LEVEL OF
OF OUTPUT
OUTPUT THAN
THAN EQUILIBRIUM
EQUILIBRIUM
• More
More goods
goods and
and services
services are
are being
being produced
produced
than
than are
are desired
desired by by consumers
consumers and
and firms
firms
• Extra
Extra goods
goods will
will pile
pile up
up as
as demand
demand fell
fell short
short
of
of production
production
• Firms
Firms will
will react
react by
by cutting
cutting back
back on
on production
production
• The
The economy
economy rapidly
rapidly adjusts
adjusts toto reach
reach thethe
equilibrium
equilibrium level
level of
of output
output
 EQUILIBRIUM OUTPUT

450
Demand

E
C+I
C+I Demand

0 Output, y
y*
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line.
 EQUILIBRIUM OUTPUT

450
Demand

E
C+I
C+I Demand

0 Output, y
y* y1
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1),
 EQUILIBRIUM OUTPUT

450
Demand

E1

}
excess
E production
C+I
C+I Demand

0 Output, y
y* y1
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall.
 IF
IF ECONOMY
ECONOMY PRODUCES
PRODUCES AT
AT A
A LOWER
LOWER
LEVEL
LEVEL OF
OF OUTPUT
OUTPUT THAN
THAN EQUILIBRIUM
EQUILIBRIUM
•• Demand
Demand would
would exceed
exceed total
total output
output
•• Firms
Firms find
find that
that demand
demand for for consumption
consumption and and
investment
investment goods
goods is is greater
greater thatthat their
their current
current
production
production
•• Inventories
Inventories disappear
disappear and and firms
firms face
face increasing
increasing
backlogs
backlogs
•• Firms
Firms respond
respond byby stepping
stepping upup production
production
•• The
The economy
economy rapidly
rapidly adjusts
adjusts to
to reach
reach the
the equilibrium
equilibrium
level
level of
of output
output
 EQUILIBRIUM OUTPUT

450
Demand

E1

}
excess
E production
C+I
C+I Demand

0 Output, y
y2 y* y1
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall. If output were lower (y2),
 EQUILIBRIUM OUTPUT

450
Demand

E1

}
excess
E production
C+I
C+I
insufficient
production { E2
Demand

0 Output, y
y2 y* y1
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall. If output were lower (y2),
it would fall short of demand and production would rise.
 THE
THE CONSUMPTION
CONSUMPTION FUNCTION
FUNCTION
•• Describes
Describes the
the relationship
relationship between
between consumer
consumer spending
spending
and
and income
income
C
C == C
Caa ++ by
by
•• Consumption
Consumption spending,
spending, C,
C, has
has twotwo parts:
parts:
–– CCaa == autonomous
autonomous consumption
consumption is is the
the part
part of
of total
total consumption
consumption
which
which is is unaffected
unaffected byby the
the level
level of
of income,
income, i.e.
i.e. itit is
is constant
constant at
at all
all
levels
levels ofof income.
income.
–– byby == the
the product
product of
of aa fraction,
fraction, b,
b, called
called the
the marginal
marginal propensity
propensity
to
to consume
consume (MPC)
(MPC) and
and the
the level
level of
of income,
income, yy
•• The
The consumption
consumption function
function is is aa line
line that
that intersects
intersects the
the
vertical
vertical axis
axis at
at C
Caa.. ItIt has
has aa slope
slope equal
equal to
to b.
b.
 THE CONSUMPTION FUNCTION

Consumption
function (Ca + by)
Demand

0 Output, y

The consumption function relates consumer spending to

the level of income.
 THE CONSUMPTION FUNCTION

Consumption
Demand function (Ca + by)

Ca

0 Output, y

The consumption function relates consumer spending to

the level of income.
 THE CONSUMPTION FUNCTION

Consumption
function (Ca + by)
Demand

Ca
autonomous
consumption { Output, y
0
The consumption function relates consumer spending to
the level of income.
 THE CONSUMPTION FUNCTION

Consumption
function (Ca + by)
Demand

slope b

Ca
autonomous
consumption { Output, y
0
The consumption function relates consumer spending to
the level of income.
 THE
THE CONSUMPTION
CONSUMPTION FUNCTION
FUNCTION
• Although
Although output
output isis on
on the
the horizontal
horizontal axis,
axis,
output
output and
and income
income in in this
this simple
simple economy
economy
are
are identical
identical
• Output
Output generates
generates income
income that
that is
is all
all received
received
by
by households
households
• As
As output
output rises
rises by
by $1,
$1, consumption
consumption
increases
increases byby the
the marginal
marginal propensity
propensity to to
consume
consume (b)(b) times
times $1$1
 MARGINAL
MARGINAL PROPENSITY
PROPENSITY TO
TO CONSUME
CONSUME
(MPC)
(MPC)
•• Is
Is always
always less
less than
than 11
•• If
If aa consumer
consumer receives
receives aa dollar
dollar ofof income,
income,
consumer
consumer will will spend
spend some
some of
of it
it and
and save
save the
the rest
rest
•• The
The fraction
fraction that
that the
the consumer
consumer spends
spends isis
determined
determined by by the
the MPC
MPC
•• The
The fraction
fraction of
of income
income that
that the
the consumer
consumer saves
saves is
is
determined
determined by by the
the marginal
marginal propensity
propensity to to save
save
(MPS)
(MPS)
•• The
The sumsum ofof the
the MPC
MPC and
and MPS
MPS is is always
always 11
$$ $$
 CHANGES
CHANGES IN
IN THE
THE CONSUMPTION
CONSUMPTION
FUNCTION
FUNCTION

•• The
The level
level of
of autonomous
autonomous consumption
consumption and
and the
the
MPC
MPC can can change
change causing
causing movements
movements inin the
the
consumption
consumption function
function
•• If
If the
the level
level of of autonomous
autonomous consumption
consumption isis
higher,
higher, itit will
will shift
shift the
the entire
entire consumption
consumption
function.
function.
•• Changes
Changes in in the
the marginal
marginal propensity
propensity to
to consume
consume
will
will change
change the the slope
slope ofof the
the consumption
consumption
function.
function.
 AUTONOMOUS
AUTONOMOUS CONSUMPTION
CONSUMPTION
CHANGES
CHANGES
• Increases
Increases in
in consumer
consumer wealth
wealth will
will cause
cause an
an
increase
increase in
in autonomous
autonomous consumption
consumption
Consumer
Consumer wealth
wealth consists
consists of
of the
the value
value ofof
stocks,
stocks, bonds
bonds and
and consumer
consumer durables
durables
• Increases
Increases in
in consumer
consumer confidence
confidence will
will
increase
increase autonomous
autonomous consumption
consumption
MOVEMENTS OF THE CONSUMPTION FUNCTION

Demand

Ca0
Output, y
 MOVEMENTS OF THE CONSUMPTION FUNCTION

Demand

Ca1
Ca0
Output, y

An increase in autonomous consumption from

Ca0 to Ca1 shifts the entire consumption function.
 MARGINAL
MARGINAL PROPENSITY
PROPENSITY TO
TO
CONSUME
CONSUME CHANGES
CHANGES
• Consumers’
Consumers’ perceptions
perceptions of of changes
changes inin their
their
income
income affect
affect their
their MPC
MPC
• IfIf consumers
consumers believe
believe that
that an
an increase
increase in
in
their
their income
income isis permanent,
permanent, they
they will
will
consume
consume aa higher
higher fraction
fraction of
of the
the increased
increased
income
income thanthan ifif the
the increase
increase were
were believed
believed to
to
be
be temporary
temporary
$$
MOVEMENTS OF THE CONSUMPTION FUNCTION

Demand

Slope b

Output, y
 MOVEMENTS OF THE CONSUMPTION FUNCTION

Slope b1
Demand

Slope b

Output, y

An increase in MPC from b to b1 increases the slope

of the consumption function.
 DETERMINING
DETERMINING GDP
GDP
•• Plot
Plot the
the consumption
consumption function function
•• Investment
Investment is is constant
constant at at all
all levels
levels of
of income
income
•• Add
Add thethe level
level ofof desired
desired investment
investment vertically
vertically to to the
the
consumption
consumption functionfunction
•• The
The C C ++ II line
line is
is the
the total
total spending
spending in in the
the economy
economy
•• At
At any
any level
level ofof income,
income, total total spending
spending is is C
C ++ II
•• The
The level
level of of equilibrium
equilibrium income,income, y*,
y*, occurs
occurs where
where thethe
total
total spending
spending (( C C ++ II )) line
line crosses
crosses thethe 45
4500 line
line
•• At
At this
this level
level ofof output,
output, totaltotal spending
spending equals
equals output
output
 DETERMINING GDP
Demand

Consumption Function
C

Ca

Output, y
 DETERMINING GDP
Demand

C+I

Consumption Function
C
Ca + I

Ca

Output, y
 DETERMINING GDP

450
Demand

C+I

Consumption Function
C
Ca + I

Ca

Output, y
 DETERMINING GDP

450
Demand

C+I

Consumption Function
C
Ca + I

Ca

Output, y
y*

GDP is determined where the C + I line intersects the 450 line. At that
level of output, y * , desired spending equals output.
 EQUILIBRIUM
EQUILIBRIUM INCOME
INCOME
== autonomous
autonomous consumption
consumption // (1 (1 -- MPC)
MPC)
Y
Y ** == (C
(Caa ++ I)I) // (1
(1 -- b)
b)
•• Suppose
Suppose :: C C == 100
100 ++ 0.6
0.6
Ca
Ca == 100100
bb == 0.6
0.6
II == 40
40
•• Using
Using the
the formula
formula for for equilibrium
equilibrium income: income:
Y
Y ** == (100
(100 ++ 40)40) // (1(1 -- 0.6)
0.6)
Y
Y ** == 140
140 // 0.40.4
yy ** == 350
350
•• In
In equilibrium,
equilibrium, saving
saving == investment
investment
 THE
THE MULTIPLIER
MULTIPLIER
The
The increase
increase in
in output
output divided
divided by by an
an increase
increase investment
investment
•• An
An increase
increase in
in investment
investment spending
spending shifts
shifts up
up the
the C C ++ II
curve
curve by
by II
•• The
The intersection
intersection with
with the
the 45
4500 line
line shifts
shifts from
from E E00 to
to E
E11
•• GDP
GDP increases
increases by by yy from
from yy00 to
to yy11
•• The
The increase
increase in in GDP
GDP ((yy)) is
is greater
greater than
than the
the increase
increase in in
investment
investment ((II))
•• Since
Since output
output increases
increases moremore thanthan the
the initial
initial increase
increase in in
investment,
investment, the
the multiplier
multiplier is is greater
greater than
than 11
 THE MULTIPLIER
450
Demand

C+I0
y0
E0 Consumption Function
C
Ca + I 0
}I 0

Ca

Output, y
y0
 THE MULTIPLIER
450

C+I1
Demand

I C+I0
y0

}
E0 Consumption Function
I1 C
Ca + I 0
} I0
Ca

Output, y
y0
 THE MULTIPLIER
450

y1 C+I1

y
Demand

I C+I0
y0
E0 Consumption Function
C
Ca + I 0
}I 0

Ca y

Output, y
y0 y1

When investment increases by I from I0 to I1, equilibrium output

increases by y. The change in output (y) is greater than the change
in investment (I).
KEYNESIAN
KEYNESIAN FISCAL
FISCAL POLICY
POLICY

Using
Using taxes
taxes and
and spending
spending toto
influence
influence the
the level
level of
of GDP
GDP in
in
the
the short
short run
run GDP

Taxes
&
Spending
 GOVERNMENT
GOVERNMENT SPENDING
SPENDING
•• Government
Government purchasespurchases of of goods
goods and
and services
services (( G G ))
is
is aa component
component of of spending
spending
•• Total
Total spending
spending is is C
C ++ II ++ GG
•• Increases
Increases of of government
government purchases
purchases (( G
G )) shift
shift up
up
the
the C C ++ II ++ G
G line
line just
just as
as increases
increases of
of investment
investment
spending
spending or or autonomous
autonomous consumption
consumption spending
spending do do
•• The
The multiplier
multiplier for for government
government spending
spending isis also
also the
the
same
same as as forfor changes
changes in in investment
investment or
or autonomous
autonomous
consumption
consumption
 GOVERNMENT
GOVERNMENT SPENDING
SPENDING

• Changes
Changes in in government
government purchases
purchases have
have
exactly
exactly the
the same
same effects
effects as
as changes
changes inin
investment
investment spending
spending or or autonomous
autonomous
consumption
consumption spending
spending
• The
The multiplier
multiplier for
for government
government spending
spending is is
also
also the
the same
same asas for
for changes
changes inin investment
investment
or
or autonomous
autonomous consumption
consumption
Multiplier
Multiplier for
for government
government spending
spending == 11 // (1-
(1-
MPC)
MPC)
 DISPOSABLE
DISPOSABLE PERSONAL
PERSONAL
INCOME
INCOME
The
The income
income that
that ultimately
ultimately flows
flows back
back to
to
households
households andand consumers,
consumers, afterafter subtracting
subtracting
any
any taxes
taxes that
that are
are paid
paid and
and after
after adding
adding any
any
transfer
transfer payments
payments received
received by by households
households
(such
(such as
as social
social security,
security, unemployment
unemployment
insurance
insurance and
and welfare)
welfare)
disposable
disposable Personal
Personal income
income == (y-T)
(y-T)
where
where TT is
is net
net taxes
taxes ---- taxes
taxes minus
minus transfer
transfer
payments
payments
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
Demand AND TAXES

450

C + I + G0

y0 Output, y
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
Demand AND TAXES

After Spending Increase

450

C + I + G1

C + I + G0

y0 Output, y
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
Demand AND TAXES

After Spending Increase

450

C + I + G1

C + I + G0

y0 y1 Output, y
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
Demand AND TAXES

After Spending Increase

450

C + I + G1

C + I + G0

y0 y1 Output, y
An increase in government
spending leads to an increase
in output.
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
Demand AND TAXES

Demand
After Spending Increase After Tax Increase

450 450

C + I + G1 C+I+G
C+I+G
C + I + G0

y0 y1 Output, y y1 y0 Output, y
An increase in government
spending leads to an increase
in output.
 CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
Demand

Demand
After Spending Increase After Tax Increase

450 450

C + I + G1 C+I+G

C + I + G0 C+I+G

y0 y1 Output, y y1 y0 Output, y
An increase in government An increase in taxes leads to an
spending leads to an increase decrease in output.
in output.
 TAX
TAX MULTIPLIER
MULTIPLIER
•• Is
Is negative
negative because
because increases
increases in in taxes
taxes decrease
decrease
disposable
disposable income
income and and lead
lead toto reduction
reduction in
in
consumption
consumption spending
spending
•• Is
Is smaller
smaller (in
(in absolute
absolute value) value) than
than the
the government
government
spending
spending multiplier,
multiplier, because
because an an increase
increase in
in taxes
taxes
first
first reduces
reduces the
the disposable
disposable incomeincome of of households
households
by
by the
the amount
amount of of the
the tax
tax
•• tax
tax multiplier
multiplier == -- b
b // (1
(1 -- b)
b)
== -- MPC
MPC // (( 11 -- MPC
MPC ))
 BALANCED-BUDGET
BALANCED-BUDGET
MULTIPLIER
MULTIPLIER
• The
The multiplier
multiplier for
for equal
equal increases
increases
in
in government
government spending
spending and
and taxes
taxes
• Equal
Equal increases
increases inin spending
spending and
and
taxes
taxes will
will not
not unbalance
unbalance the
the
budget
budget
• Is
Is always
always equal
equal to
to “1”
“1”
 EXPANSIONARY
EXPANSIONARY POLICIES
POLICIES
Government
Government policies
policies that
that increase
increase
total
total demand
demand and
and GDP.
GDP.
• Tax
Tax cuts
cuts and
and spending
spending increases
increases
are
are examples
examples of of expansionary
expansionary
policies
policies
 CONTRACTIONARY
CONTRACTIONARY
POLICIES
POLICIES
Government
Government policies
policies that
that decrease
decrease
total
total demand
demand and
and GDP.
GDP.
• Tax
Tax increases
increases and
and spending
spending cuts
cuts
are
are examples
examples ofof contractionary
contractionary
policies.
policies.
 BUDGET
BUDGET DEFICIT
DEFICIT
Increases
Increases when
when government
government
increases
increases spending
spending or
or cuts
cuts
taxes
taxes to
to stimulate
stimulate the
the
economy.
economy.
 PERMANENT
PERMANENT INCOME
INCOME
Consumers
Consumers often
often base
base
their
their spending
spending onon an
an
estimate
estimate of
of their
their long-run
long-run
average
average income.
income.
 AUTOMATIC
AUTOMATIC STABILIZERS
STABILIZERS
Taxes
Taxes and
and transfers
transfers which
which act
act
as
as economic
economic institutions
institutions that
that
automatically
automatically reduce
reduce economic
economic
fluctuations.
fluctuations.
 HOW
HOW AUTOMATIC
AUTOMATIC STABILIZERS
STABILIZERS
WORK
WORK
•• When
When income
income isis high:
high:
--
-- government
government collects
collects more
more taxes
taxes and
and pays
pays out
out less
less
transfer
transfer payments
payments
--
-- since
since government
government is is taking
taking funds
funds from
from
consumers,
consumers, this this tends
tends to
to reduce
reduce consumer
consumer spending
spending
•• When
When income
income isis low
low (i.e.,
(i.e., during
during recessions):
recessions):
--
-- government
government collects
collects less
less taxes
taxes and
and pays
pays out
out
more
more transfer
transfer payments
payments
--
-- tends
tends to
to increase
increase consumer
consumer spending,
spending, since
since the
the
government
government is is putting
putting funds
funds into
into the
the hands
hands of
of
consumers
consumers
 AFTER
AFTER A
A TAX
TAX INCREASE
INCREASE
•• Consumption
Consumption function
function depends
depends on on after-tax
after-tax
income:
income:
CC == C
Caa ++ bb (( 11 -- tt )) yy
•• Marginal
Marginal propensity
propensity to to consume
consume is is now
now
adjusted
adjusted for
for taxes
taxes and
and becomes
becomes
bb (( 11 -- tt ))
•• Raising
Raising the
the tax
tax rate
rate therefore
therefore lowers lowers thethe MPC
MPC
adjusted
adjusted for
for taxes
taxes
 AN INCREASE IN TAX RATES
450

C+I+G
Demand

y0 Output, y
 AN INCREASE IN TAX RATES
450

C+I+G
Demand

C+I+G
after tax- rate increase

y0 Output, y
 AN INCREASE IN TAX RATES
450

C+I+G
Demand

C+I+G
after tax- rate increase

y1 y0 Output, y
 AN INCREASE IN TAX RATES
450

C+I+G
Demand

C+I+G
after tax- rate increase

y1 y0 Output, y

An increase in tax rates decreases the slope of the C + I + G

line. This lowers output and reduces the multiplier.
 OTHER
OTHER FACTORS
FACTORS CONTRIBUTING
CONTRIBUTING TO
TO
STABILITY
STABILITY OF
OF ECONOMY
ECONOMY
•• IfIf households
households base
base their
their consumption
consumption decisions
decisions
partly
partly onon their
their permanent
permanent or or long-run
long-run income,
income,
they
they will
will not
not be
be very
very sensitive
sensitive to to changes
changes inin
current
current income.
income.
•• IfIf consumption
consumption doesn’t
doesn’t change
change muchmuch withwith
current
current income,
income, thethe marginal
marginal propensity
propensity to to
consume
consume out out of
of current
current income
income willwill be
be small,
small,
which
which will
will make
make the
the multiplier
multiplier small.
small.
•• When
When consumers
consumers basebase their
their decisions
decisions onon long-
long-
run
run factors,
factors, not
not just
just on
on their
their current
current level
level of
of
income,
income, thethe economy
economy tends
tends toto be
be stabilized.
stabilized.
MODIFYING
MODIFYING THE
THE MODEL
MODEL FOR
FOR EXPORTS
EXPORTS
AND
AND IMPORTS
IMPORTS
•• Add
Add exports,
exports, X,
X, as
as another
another source
source of of demand
demand for
for US
US
goods
goods and
and services
services
•• Subtract
Subtract imports,
imports, M,
M, from
from the
the total
total spending
spending byby US
US
residents
residents
•• Consumers
Consumers willwill import
import more
more goods
goods as as income
income rises:
rises:
imports
imports == M M == m
m**yy
•• m
m is
is the
the fraction
fraction known
known as as the
the marginal
marginal propensity
propensity to
to
import
import
•• Subtract
Subtract this
this fraction
fraction from
from the
the overall
overall marginal
marginal
propensity
propensity toto consume
consume (( bb )) to
to obtain
obtain the
the MPC
MPC for
for
spending
spending on on domestic
domestic goods
goods
 DETERMINING OUTPUT IN AN OPEN ECONOMY

450
Demand

Demand
- m )
o p e (b
sl
C a+ I + X

y0 Output, y

Output is determined where demand for domestic goods

equals output.
Demand INCREASE IN EXPORTS AND IMPORTS

Demand
450
450

Ca + I + X
Ca + I + X

y0 Output, y y0 Output, y
Demand INCREASE IN EXPORTS AND IMPORTS

Demand
450
450

Ca + I + X
X
Ca + I + X

y0 Output, y y0 Output, y
Demand INCREASE IN EXPORTS AND IMPORTS

Demand
450
450
After the
increase
in exports
Increase in the

Ca + I + X
Marginal
X
Ca + I + X

Propensity to
Import

y0 y1 Output, y y1 y0 Output, y
Demand INCREASE IN EXPORTS AND IMPORTS

Demand
450
450
After the
increase
in exports
Increase in the

Ca + I + X
Marginal
X
Ca + I + X

Propensity to
Import

y0 y1 Output, y y1 y0 Output, y
An increase in exports will increase An increase in taxes leads to an
the level of GDP decrease in output.
 ACTUAL
ACTUAL VERSUS
VERSUS PLANNED
PLANNED -- 11
•• A
A firm
firm may
may not
not always
always invest
invest the
the exact
exact amount
amount that
that
it
it planned
planned to.
to.
•• Why?
Why?
•• Firms
Firms do do not
not have
have complete
complete control
control over
over their
their
investment
investment decisions.
decisions.
•• This
This isis not
not true
true of
of consumption,
consumption, as as households
households
have
have complete
complete control
control over
over their
their consumption.
consumption.
Planned
Planned consumption
consumption is is always
always equal
equal to
to actual
actual
consumption.
consumption.
 ACTUAL
ACTUAL VERSUS
VERSUS PLANNED
PLANNED -- 22
•• Firms
Firms can
can generally
generally chose
chose howhow much
much new new plant
plant and
and
equipment
equipment they
they wish
wish to
to purchase
purchase in in any
any given
given period
period
(e.g.
(e.g. McDonald’s
McDonald’s buys
buys anan extra
extra french-fry
french-fry machines,
machines,
etc).
etc).
•• However,
However, firms
firms have
have less
less control
control over
over inventory
inventory
investment.
investment.
•• Remember,
Remember, inventories
inventories are
are part
part of
of the
the capital
capital stock.
stock.
Manufacturing
Manufacturing firms
firms have
have two
two kind
kind of
of inventories:
inventories:
–– Inputs
Inputs (e.g.
(e.g. tyres,
tyres, rolled
rolled steel,
steel, engine
engine blocks,
blocks, etc)
etc)
–– Final
Final production
production (finished
(finished automobiles
automobiles awaiting
awaiting shipment)
shipment)
 ACTUAL
ACTUAL VERSUS
VERSUS PLANNED
PLANNED -- 33

•• Consequently,
Consequently, one one component
component of of investment
investment --
inventory
inventory change
change -- isis partly
partly determined
determined by by how
how
much
much households
households decide
decide to to buy,
buy, which
which isis not
not
under
under complete
complete control
control of
of firms.
firms.
•• If
If households
households do do not
not buy
buy asas much
much as
as firms
firms expect
expect
them
them to,
to, inventories
inventories will
will be
be higher
higher than
than expected,
expected,
and
and firms
firms will
will have
have made
made an an inventory
inventory investment
investment
that
that they
they did
did not
not plan
plan to
to make.
make.
 ACTUAL
ACTUAL VERSUS
VERSUS PLANNED
PLANNED -- 44
•• Because
Because involuntary
involuntary inventory
inventory adjustments
adjustments areare neither
neither
desired
desired nor
nor planned,
planned, we
we need
need toto distinguish
distinguish between
between
actual
actual investment
investment and
and desired
desired ,, or
or planned
planned investment.
investment.
•• When
When we we have
have been
been discussing
discussing II inin this
this lecture,
lecture, we
we
have
have used
used II to
to refer
refer to
to desired
desired oror planned
planned investment
investment
only.
only.
•• So,
So, we
we could
could have
have written:
written:
Planned
Planned aggregate
aggregate expenditure
expenditure Consumption
Consumption ++ Planned
Planned investment
investment

AE
AE C
C ++ II
 EQUILBIRUM
EQUILBIRUM AGGREGATE
AGGREGATE
OUTPUT
OUTPUT (INCOME)
(INCOME) -- 11
•• In
In microeconomics
microeconomics we we said
said that
that equilibrium
equilibrium is is
said
said to
to exist
exist in
in aa particular
particular market
market (e.g.
(e.g. the
the market
market
for
for bananas)
bananas) at at the
the price
price for
for which
which the
the quantity
quantity
demanded
demanded is is equal
equal to
to the
the quantity
quantity supplied.
supplied.
•• In
In macroeconomics,
macroeconomics, we we define
define equilibrium
equilibrium in
in the
the
goods
goods market
market as as that
that point
point atat which
which planned
planned
aggregate
aggregate expenditure
expenditure is is equal
equal toto aggregate
aggregate
output.
output.
 EQUILBIRUM
EQUILBIRUM AGGREGATE
AGGREGATE
OUTPUT
OUTPUT (INCOME)
(INCOME) -- 22
Aggregate
Aggregate output
output Y
Y
Planned
Planned aggregate
aggregate expenditure
expenditure AE
AE C C ++ II
Equilibrium:
Equilibrium: YY == AE,
AE, or
or Y
Y == C
C ++ II
•• This
This definition
definition of
of equilibrium
equilibrium cancan hold
hold if,if, and
and only
only if,
if,
planned
planned investment
investment andand actual
actual investment
investment are are equal.
equal. To To
understand
understand why,
why, consider
consider Y Y no
no equal
equal to
to AE.
AE. First
First let
let us
us
suppose
suppose aggregate
aggregate output
output is is greater
greater than than planned
planned
aggregate
aggregate expenditure:
expenditure:
Y>C
Y>C ++ II
Aggregate
Aggregate output>
output> Planned
Planned aggregate
aggregate expenditure
expenditure
 EQUILBIRUM
EQUILBIRUM AGGREGATE
AGGREGATE
OUTPUT
OUTPUT (INCOME)
(INCOME) -- 33
•• When
When output
output is is greater
greater than than planned
planned spending,
spending,
there
there is
is unplanned
unplanned inventory
inventory investment.
investment. Firms
Firms
planned
planned toto sell
sell more
more of
of their
their goods
goods than
than they
they sold,
sold,
and
and the
the difference
difference shows
shows up up as
as unplanned
unplanned increase
increase
in
in inventories.
inventories.
•• Suppose
Suppose nownow that
that planned
planned aggregate
aggregate expenditure
expenditure
is
is greater
greater than
than aggregate
aggregate output:
output:
C
C ++ II >> Y
Y
Planned
Planned aggregate
aggregate expenditure
expenditure >> Aggregate
Aggregate output
output
 EQUILBIRUM
EQUILBIRUM AGGREGATE
AGGREGATE
OUTPUT
OUTPUT (INCOME)
(INCOME) -- 44
•• When
When planned
planned spending
spending exceeds
exceeds output,
output, firms
firms have
have
sold
sold more
more than
than they
they planned
planned to.
to. Inventory
Inventory investment
investment isis
smaller
smaller than
than planned.
planned.
•• Planned
Planned and
and actual
actual investment
investment are
are not
not equal.
equal. Only
Only when
when
output
output is
is exactly
exactly matched
matched by by planned
planned spending
spending will
will
there
there be
be no
no unplanned
unplanned inventory
inventory investment.
investment.
•• Equilibrium
Equilibrium inin the
the goods
goods market
market isis achieved
achieved only
only when
when
aggregate
aggregate output
output (Y) (Y) and
and planned
planned aggregate
aggregate
expenditure
expenditure (C+I)
(C+I) are
are equal,
equal, or
or when
when actual
actual and
and planned
planned
investment
investment are
are equal.
equal.
 SAVINGS
SAVINGS AND
AND INVESMENT
INVESMENT
APPROACH
APPROACH -- 11
•• Because
Because aggregate
aggregate income
income must must either
either be
be saved
saved or
or spent,
spent,
by
by definition:
definition:
YYCC ++ S
S
THIS
THIS IS
IS ANAN IDENTITY
IDENTITY
•• The
The equilibrium
equilibrium condition
condition is:is:
YY == C
C ++ II
BUT
BUT THIS
THIS IS
IS NOT
NOT AN
AN IDENTITY,
IDENTITY, BECAUSEBECAUSE IT IT DOES
DOES NOT
NOT
HOLD
HOLD WHEN
WHEN WEWE ARE
ARE OUT
OUT OF OF EQUILIBRIUM.
EQUILIBRIUM. IT IT WOULD
WOULD
BE
BE AN
AN IDENTITY
IDENTITY IF
IF II WERE
WERE ACTUAL
ACTUAL INVESTMENT
INVESTMENT
RATHER
RATHER THAN
THAN PLANNED
PLANNED INVESTMENT
INVESTMENT
 SAVINGS
SAVINGS AND
AND INVESMENT
INVESMENT
APPROACH
APPROACH -- 22
•• Substituting
Substituting C
C ++ S
S for
for Y
Y in
in the
the equilibrium
equilibrium condition,
condition, we
we can
can
write:
write:

Saving/investment
Saving/investment approach
approach toto equilibrium:
equilibrium: C C ++ S
S == C
C ++ II
Because
Because we
we can
can subtract
subtract C
C from
from both
both sides
sides of of this
this equation,
equation, we we areare left
left
with
with S
S == I.I.
Thus,
Thus, only
only when
when planned
planned investment
investment equals
equals saving
saving will
will there
there be be
equilibrium.
equilibrium.

•• Remember,
Remember, saving
saving is
is income
income that
that is
is not
not spent.
spent. Because
Because itit is
is
not
not spent,
spent, saving
saving is
is like
like aa leakage
leakage out
out of
of the
the spending
spending stream.
stream.
 SAVINGS
SAVINGS AND
AND INVESMENT
INVESMENT
APPROACH
APPROACH -- 33
•• Only
Only ifif that
that leakage
leakage is is counterbalanced
counterbalanced byby some
some other
other
component
component of of planned
planned spending
spending can
can the
the resulting
resulting
planned
planned aggregate
aggregate expenditure
expenditure equal
equal aggregate
aggregate output.
output.
This
This other
other component
component is is planned
planned investment
investment (I).
(I).
•• The
The leakage
leakage out out of
of the
the spending
spending stream
stream -- saving
saving -- isis
matched
matched by by anan equal
equal injection
injection of
of planned
planned investment
investment
spending
spending into
into the
the spending
spending stream.
stream.
•• For
For this
this reason,
reason, thethe saving/investment
saving/investment approach
approach to to
equilibrium
equilibrium is is also
also called
called the
the leakages/
leakages/ injections
injections
approach
approach to to equilibrium.
equilibrium.