I. Introduction
A. Objectives
1. Understand why changes in investment (I) and net exports (NX) have multiplier effects
2. Learn how to calculate the value of the multiplier
3. Understand why government expenditures on goods and services (G) has a multiplier effect.
4. Understand why changes in taxes (T) and transfer payments (TR) have multiplier effects.
5. Know why governments use fiscal policy to try to stabilize aggregate expenditure (AE).
6. To understand the relationship between aggregate expenditure (AE) and aggregate demand (AD).
B. Context
1. In last lecture we learned how the equilibrium aggregate expenditure (AE) is determined.
2. We also learned that the equilibrium is stable.
a. When an economy is out of equilibrium firms will take actions which will push the economy back into equilibrium.
4. Objective now is to see how the equilibrium changes when there is a change in one of the components of aggregate planned expenditure (APE),
a. Investment (I)
b. exports (X)
c. government purchases of goods and services (G)
C. Lecture Outline
1. The determination of private expenditure multipliers
2. The determination of government fiscal policy multipliers
3. The linkages between real GDP, inflation and the multipliers.
II. Autonomous and induced expenditures
A. Aggregate planned expenditure (APE) is equal to the sum of:
1. autonomous expenditure (A) and
2. induced (or endogenous) expenditures (N)
a. which are related to the level of real GDP (Y).
B. Autonomous expenditure (A) is the part of aggregate planned expenditure (APE) that is not influenced by real GDP (Y).
1. Autonomous expenditure (A) includes:
a. investment (I),
b. government purchases (G),
c. exports (X), and
d. autonomous consumption, (CA).
A = I + G + X + CA
C. Autonomous expenditure (A) is the level of aggregate planned expenditure (APE) that would be planned even if real GDP (Y) were zero.
1. Graphically, autonomous expenditure (A) corresponds to the intercept of the aggregate planned expenditure (APE) function.
D. Induced planned expenditure (N) is that part of aggregate planned expenditure (APE) that varies with real GDP (Y).
1. Induced planned expenditure (N) includes:
a. Induced consumption (CN) minus
b. all of imports (Z), which also varies with real GDP (Y).
N = CN - Z
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A. Total aggregate planned expenditure (APE) equals autonomous expenditure (A) plus induced expenditure (N).
APE = A + N
B. As real GDP (Y) rises:
1. Induced consumption (CN) rises
2. Imports (Z) rise
3. Normally the increase in consumption spending exceeds the increase in spending on imports (Z) hence,
a. Aggregate planned expenditure (APE) rises.
C. The slope of the aggregate expenditure curve (APE) equals:
1. The increase in aggregate planned expenditure (DELTA APE) divided by the increase in real GDP (Y)
Slope of APE = DELTA APE / DELTA Y
2. The increase in APE is equal to the increase in induced consumption (CN) less the increase in imports (Z).
DELTA APE = DELTA CN - DELTA Z
3. If We divide by the change in real GDP, we get:
Slope of APE = DELTA APE = DELTA CN - DELTA Z
DELTA Y DELTA Y DELTA Y
a. We will use the letter "g" to stand for the slope of the APE curve
g = DELTA APE = MPC' - MPZ
DELTA Y
4. Recall the definition of (MPC'), the marginal propensity to consume out of GDP (Y).
a. The marginal propensity to consume out of real GDP (MPC') is:
i. the fraction of an additional unit of real GDP (Y)
ii. spent on consumption (C).
MPC' = DELTA CN/ DELTA Y
5. And Define the Marginal Propensity to Import (MPZ)
a. The marginal propensity to import (MPZ) is:
i. the fraction of the last unit of real GDP (Y)
ii. spent on imports (Z).
MPZ = DELTA Z / DELTA Y
4. Hence the slope of the APE curve is equal to:
a. the marginal propensity to consume out of real GDP (MPC') minus
b. the marginal propensity to import (MPZ).
Slope of APE = g = MPC' - MPZ
e.g. g = .8 - .2 = .6
5. The slope of the APE curve (g) is less than the MPC' because of the subtraction of the marginal propensity to import (MPZ).
1. The MPZ makes spending plans less responsive to changes in real GDP (Y).
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A. An increase in autonomous expenditure (A)
1. Shifts the autonomous expenditure curve upward and
2. Increases the equilibrium real GDP (Y).
B. A shift in the A curve can occur because of :
1. A change in investment (I) due to
a. A change in interest rates,
b. A wave of innovations
2. A change in exports (X) due to
a. An economic boom in the rest of the world
3. A change in autonomous consumption (CA) due to
a. A change in peoples desire to save
C. A decrease in autonomous expenditure (A) lowers the equilibrium real GDP (Y).
D. One possible source of a decrease in autonomous expenditure is a decrease in autonomous consumption (CA).
1. Thus, an increase in people's desire to save (SA),
a. which causes a decrease in their consumption expenditure, (CA) and
b. lowers the equilibrium level of real GDP (Y).
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(B 21-8)
A. The paradox of thrift refers to the fact that:
1. increased savings for an individual raises his or her income but
2. lowers income for the economy as a whole.
B. The paradox of thrift also refers to the fact that:
1. a change in the amount that households wish to save at each level of income leads to
2. a change in the equilibrium level of income (Y).
3. There is no change in the equilibrium level of savings, (S) which must still equal planned investment (I).
S = I
C. Thrift can lead to increased household savings in some households, but not to increased national savings (S).
1. Savings (S) must equal investment (I) and
S = I
2. Investment is autonomous,
3. Only an increase in investment (I) can produce an increase in savings (S).
DELTA S = DELTA I
D. In the long run, an increase in thrift (SA) could lead to an increase in investment (I).
1. If it did, then it would lead to the same amount of increased savings (S).
2. Japan has a high average propensity to save (APS) and also high investment (I) and savings (S).
E. Keynes believed that an increase in thrift (SA) was a major cause of the Great Depression of the 1930s.
III. The Multiplier Effect
(B 21-6, and 21-7)
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A. The multiplier effect refers to the fact that an increase in GDP (Y) resulting from an increase in autonomous expenditure (A)
1. will be larger than the initial change in autonomous expenditure (A).
DELTA Y > DELTA A
B. Similarly a decrease in autonomous spending (A) will result in a decrease in the equilibrium GDP (Y)
1. which is larger than the original decrease in autonomous expenditure. (A)
C. The multiplier effect occurs because:
1. a change in autonomous expenditure (A) causes
2. an additional change in induced expenditure (N).
3. The total effect is equal to the change in autonomous expenditure (A) plus the change in induced expenditures (N)
DELTA Y = DELTA A + DELTA N
D. The autonomous expenditure multiplier, (MULTA) equals:
1. the change in equilibrium real GDP (Y) divided by
2. the change in autonomous expenditure (A).
MULTA = DELTA Y/ DELTA A
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A. The autonomous expenditure multiplier (MULTA) equals:
1. 1 / (1 - g)
2. where g is the slope of the aggregate planned expenditure (APE) curve.
Slope of APE = g = MPC' - MPZ
3. PROOF
APE = A + N
DELTA APE = DELTA A + DELTA N
BY DEFINITION
g = DELTA N / DELTA Y
DELTA N = g * DELTA Y
SUBSTITUTING FOR DELTA N
DELTA APE = DELTA A + g * DELTA Y
IN EQUILIBRIUM
DELTA APE = DELTA Y
SUBSTITUTING
DELTA Y = DELTA A + g * DELTA Y
DELTA Y - (g * DELTA Y) = DELTA A
FACTOR OUT DELTA Y
DELTA Y (1-g) = DELTA A
DIVIDE BY DELTA A
DELTA Y * (1-g) = 1
DELTA A
DIVIDE BY (1-g)
DELTA Y = 1
DELTA A (1 - g)
MULTA = DELTA Y / DELTA A = 1 / (1 - g)
Note a. g is a fraction between 0 and 1
b Therefore (1 - g) is a fraction between 0 and 1
c. Therefore 1 / (1 - g) is greater than one.
d. Hence the autonomous expenditure multiplier (MULTA) is greater than one.
MULTA = 1 / (1 - g) > 1
B. The multiplier process can be thought of as a series of rounds of spending.
1st round DELTA APE = DELTA A
2nd round DELTA APE = g * DELTA A
3rd round DELTA APE = g * (g * DELTA A) = g2 * DELTA A
n rounds DELTA APE = 1/ (1- g) DELTA A
A Numerical Example
DELTA A = 128
g = 1/2
1st round DELTA APE = DELTA A = 128
2nd round DELTA APE = g * DELTA A = 1/2 * 128 = 64
3rd round DELTA APE = g2 * DELTA A = 1/2 ( 1/2 *128)
= 1/2 (64) = 32
4th round DELTA APE = 1/2 (32) = 16
5th round DELTA APE = 1/2 (16) = 8
6th round DELTA APE = 1/2 (8) = 4
7th round DELTA APE = 1/2 (4) = 2
8th round DELTA APE = 1/2 (2) = 1
9th round DELTA APE = 1/2 (1) = 1/2
10th round DELTA APE = 1/2 (1/2) = 1/4
The total Effect is equal to DELTA A plus DELTA N
128+64+32+16+8+4+2+1+1/2+1/4 etc.
128 + 127 3/4 = almost 256 = 128 * 2
C. The effect of the multiplier process is to amplify changes in autonomous spending (A).
D. An alternative way to find the multiplier is to determine the equilibrium level of APE
Y = APE
APE = CA + MPC'* Y + I + G + X - MPZ * Y
Y = (CA + I + G + X) * MPC' * Y - MPZ * Y
Y = A + (MPC' -MPZ) * Y
Y = A + g * Y
Y - g * Y = A
Y * (1 - g) = A
Y = A * 1 / (1 - g)
DELTA Y = DELTA A * 1/ (1 - g)
DELTA Y / DELTA A = 1 / (1 - g) = MULTA
E. An example
1. DETERMINE THE EQUILIBRIUM LEVEL OF APE (AND Y)
Let C = 10 + .7Y
I = 50
G = 100
X = 200
Z = .2Y
Calculate autonomous spending (A)
A = CA + I + G + X
A = 10 + 50 + 100 + 200 = 260
Calculate the slope of the APE curve (g)
g = MPC' -MPZ = .7 - .2 = .5
Calculate the autonomous spending multiplier (MULTA)
MULTA = 1 / (1 - g) = 1 / .5 = 2
Calculate the equilibrium level of income (Y)
Y = A * MULTA = 260 * 2 = 520
This is sometimes called "The Keynesian equation"
a. It is not a behavioral equation
b. It is a reduced form equation
i. Simpler to use
2. Does not show the causal mechanisms
2. INCREASE INVESTMENT BY 10
A' = 270
Y' = 270 * 2 = 540
DELTA Y = (Y - Y') = 20
DELTA Y/ DELTA A = 20/10 = 2 = MULTA
IV. Fiscal Policy Multipliers
(B 22)
A. Fiscal policy (or stabilization policy) is the government's attempt to smooth the business cycle by changing:
1. The amount of its purchases of goods and services (G),
2. its transfer payments, (TR) and\or
3. its taxes (T).
B. In order to conduct fiscal policy, government must know the numerical value of the relevant multipliers.
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A. The government purchases multiplier (MULTG) is the ratio of:
1. the change in real GDP (Y) to
2. the change in government purchases of goods and services (G).
MULTG = DELTA Y / DELTA G
B. Since government spending on goods and services (G) is not determined by the current level of real GDP(Y),
1. it is part of autonomous spending (A)
2. Hence, the Government spending multiplier (MULTG) equals the autonomous spending multiplier
MULTG = MULTA = 1 / (1 - g).
3. Since Investment spending and export demand are also autonomous, the Government spending multiplier (MULTG) is the same as:
a. the multiplier for investment (MULTI) and
b. the multiplier for exports (MULTX).
MULTG = MULTI = MULTX = MULTA = 1 / (1- g)
C. In theory, government could change its purchases to exactly offset changes in investment (I) or exports (X).
1. Because the government spending multiplier (MULTG) is the same size as:
a. the investment multiplier (MULTI) and
b. the export multiplier (MULTX)
2. In practice, it is hard to vary government purchases of goods and services (G) rapidly
a. since these decisions are made in a political process.
b. Decisions are generally made for reasons other than macroeconomic policy:
i. Military needs
ii. Infrastructure
iii. natural disasters
c. Could be used in a serious, long lasting situation like Great Depression of 1930s.
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A. The tax and transfer payment multipliers refer to that part of taxes and transfer payments that are autonomous.
1. Autonomous taxes (TA) do not vary with the level of real GDP (Y).
a. Example is the property tax
2. Autonomous transfer payments (TRA) do not vary with the level of real GDP (Y).
b. Example is military pensions
B. Assume that the net tax rate (t) is equal to zero.
t = 0
1. It follows that:
a. The MPC out of GDP (MPC') = MPC out of disposable income (MPC = b)
MPC' = MPC * (1 - t) = MPC = b
C. The autonomous transfer payment multiplier (MULTTRA) is equal to:
1. the change in real GDP (Y) divided by
2. the change in autonomous government transfer payments (TRA).
MULTTRA = DELTA Y / DELTA TRA
C. A change in autonomous transfer payments (TRA) changes aggregate planned expenditure (APE) by:
1. changing disposable income (YD), which leads to
a. a change in autonomous consumption expenditure (CA).
2. The initial change in aggregate planned expenditure (APE) is equal to:
a. the autonomous transfer payment (TRA)
b. or the change in disposable income (YD)
times
c. the MPC out of disposable income (b).
i. First round DELTA APE = TRA * MPC
3. After that, the multiplier process is the same as in any change in spending
a. It changes imports (Z) as well as induced consumption (CN)
3. Therefore the autonomous transfer payment multiplier (MULTTRA) is equal to:
a. the MPC (b) times
b. the expenditure multiplier [ 1 / (1 - g)].
MULTTRA = MPC * MULTA
4. The autonomous transfer payment multiplier (MULTTRA) equals
a. b / (1 - g)
b. where b is the marginal propensity to consume out of Disposable Income (YD).
5. Since the MPC (b) is less than 1,
a. the transfer multiplier (MULTTRA) is less than the government expenditure multiplier (MULTG).
MULTTRA < MULTG
[b / (1-g)] < [1 / (1-g)]
6. Derivation
Y = AE = CA + MPC * (Y + TRA) + I + G + X - MPZ * Y
Y = (CA + I + G + X) + MPC * Y + MPC * TRA - MPZ * Y
Y = A + (MPC * Y - MPZ * Y) + MPC * TRA
We have assumed that MPC' = MPC
Y = (A + MPC * TRA) + Y * (MPC' - MPZ)
Y = (A + MPC * TRA) + Y * g
Y - Y * g = (A + MPC * TRA)
Y (1-g) = A + MPC * TRA
Y = A * (1 / 1-g) + TRA * (MPC / 1-g)
Y = A * (1 / 1-g) + TRA * (b / 1-g)
DELTA Y = DELTA A * (1 / 1-g) + DELTA TRA * (b / 1-g)
MULTTRA = DELTA Y / DELTA TRA = b / 1-g
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A. The autonomous tax multiplier (MULTTA) is:
1. the ratio of the change in real GDP (Y) to
2. the change in autonomous taxes (TA).
B. An increase in autonomous taxes (TA) changes aggregate planned expenditure (APE) by:
1. reducing disposable income (YD), which leads to
b. a reduction in autonomous consumption expenditure (CA).
C. The initial reduction in aggregate planned expenditure (APE) is equal to:
1. The autonomous tax payment (TA) times the MPC out of disposable income (MPC = b).
3. Therefore the autonomous tax multiplier (MULTTA) is equal to the negative of:
a. the MPC out of disposable income (MPC = b) times
b. the expenditure multiplier [ 1 / (1 - g)].
4. The autonomous tax multiplier (MULTTA) equals
MULTTA = -b / (1 - g)
where b is the marginal propensity to consume out of disposable income (MPC).
5. Since the MPC (b) is less than 1, the autonomous tax multiplier (MULTTA) is:
a. less than the expenditure multiplier
b. and of the opposite sign.
In absolute value [ -b / (1-g)] < [1 / (1-g)]
6. The autonomous tax multiplier (MULTTA) is negative because
a. an increase in autonomous taxes (TA) leads to a decrease in real GDP (Y).
7. Derivation
Y = AE = CA + MPC * (Y - TA) + I + G + X - MPZ * Y
Y = (CA + I + G + X) + MPC * Y - MPC * TA - MPZ * Y
Y = A + (MPC * Y - MPZ * Y) - MPC * TA
Y = (A - MPC * TA) + Y * (MPC - MPZ)
We have assumed that MPC' = MPC = b
Y = (A - b * TA) + Y * g
Y - Y * g = (A - b * TA)
Y (1-g) = A - b * TA
Y = A * (1 / 1-g) - TA * (b / 1-g)
Hence DELTA Y / DELTA TA = b / (1-g)
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A. A balanced budget change in fiscal policy refers to:
1. a change in government expenditure (G) balanced by
2. An equal change in autonomous taxes (TA).
DELTA G = DELTA TA
B. The balanced budget multiplier (MULTB) is:
1. the amount by which a change in government purchases of goods and services (G) is multiplied to determine
2. the change in the expenditure equilibrium (Y) when:
3. autonomous taxes (TA) are increased by the same amount that goods and services (G) are increased.
C. The balanced budget multiplier (MULTB) equals:
1. the change in real GDP (Y) divided by
2. the change in government expenditure (G) (which is the same as the change in autonomous taxes (TA)).
MULTB = DELTA Y / (DELTA G which equals DELTA TA)
D. The balanced budget multiplier (MULTB) is found by adding:
1. the Government spending multiplier (MULTG) to
2. the autonomous tax multiplier (MULTTA)
MULTB = MULTG + MULTTA
3. If we substitute into this equation, we get:
MULTB = [1 / (1 - g)] + [ -b / (1 - g)]
= [1 / (1 - g)] - [ b / (1 - g)]
Putting over a common denominator
= (1 - b) / (1 - g)
3. The balanced budget multiplier (MULTB) is equal to
MULTB = (1 - b) / (1 - g).
4. The MPC, (b), is larger than the slope of the aggregate planned expenditure (APE) function, (g),
a. (1 - b) is less than (1 - g)
b. so the balanced budget multiplier (MULTB) is less than one.
MULTB < 1
c. The balanced budget multiplier is small but positive.
MULTB > 0
C. The balanced budget multiplier (MULTB) shows that:
1. an increase in government spending (G) accompanied by
2. an equal increase in autonomous taxes (TA)
3. results in an increase in output (Y).
D. The balanced budget multiplier (MULTB) means that government could engage in fiscal policy, even if it were required to run a balanced budget.
1. But it would require large changes in government spending to offset changes in private spending because
2. the balanced budget multiplier is very small.
III. Automatic Stabilizers
A. Now we will relax the assumption that taxes and transfer payments are entirely autonomous.
1. We will no longer assume that the net tax rate is zero.
B. An automatic stabilizer is a mechanism that:
1. decreases the fluctuations in aggregate planned expenditure (APE) resulting from
2. fluctuations in autonomous expenditures (A).
C. An automatic stabilizer reduces the size of the multiplier.
D. Taxes (TN) and transfer payments (TRN) that depend on the level of real GDP (Y) are automatic stabilizers,
1. They make the fluctuations in real GDP (Y) less than what would occur in their absence.
3. They act like economic shock absorbers.
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A. If the net tax rate (t) is changed, that will change the multiplier.
1. An increase in the net tax rate (t) will reduce the multiplier.
MULTA = 1 / (1 - g) and
g = MPC' - MPZ hence,
MULTA = 1 / [ 1 - (MPC' - MPZ)] and
MPC' = MPC (1 - t)
MULTA = 1 / { 1 - [ MPC (1 - t) - MPZ]}
MULTA = 1 / [ 1 - (MPC - MPC * t - MPZ)]
MULTA = 1 / 1 - MPC + MPC * t + MPZ
2. The net tax rate (t) has a positive sign in the denominator of the multiplier.
a. An increase in the net tax rate (t) will reduce the multiplier.
b. Income related taxes are "built-in stabilizers" because:
i. they reduce the effects of changes in autonomous spending (A)
B. In an economy with no income-induced taxes (TN) or income- induced transfer payments (TN),
1. the gap between GDP and YD would not depend on income.
C. Because people must pay more taxes to the government as GDP (Y) rises, a unit of real GDP (Y) translates into a smaller amount of disposable income (YD).
1. Thus, an increase in GDP (Y) has a smaller impact on consumption expenditure (C) when net taxes (NT) depend on income (Y).
2. This reduces the autonomous spending multiplier (MULTA).
3. The higher the net tax rate (t), the smaller are the fluctuations in real GDP (Y) resulting from changes in autonomous spending (A).
D. The new multiplier
Y = AE = A + CN - Z
Y = A + (MPC * YD) - MPZ * Y
Y = A + [MPC * (Y - TN + TRN) - MPZ * Y
NT = TN - TRN = t * Y
Y = A + MPC * ( Y - t * Y) - MPZ * Y
Y = A + MPC * (1-t) * Y - MPZ * Y
Y = A + MPC' * Y - MPZ * Y
Y = A + (MPC' - MPZ) * Y
Y = A + g * Y
Y - g * Y = A
Y * (1 - g) = A
Y = A * (1 / 1 - g)
D. Since MPC' = MPC * (1 -t)
1. The larger the net tax rate (t), the smaller is (1 - t) hence the smaller is MPC'
2. The smaller is MPC', the smaller is g since
g = MPC' - MPZ
D. Since g has a minus sign, the smaller is g the larger is the denominator (1 - g) of the multiplier
1. The larger the denominator (1 - g), the smaller the multiplier (MULTA) or 1 / (1 - g).
V. US Experience with the multiplier
A. In the US the multiplier (MULTA) has varied over the business cycle.
1. Varied from 0.27 (1974-1975) to 2.14 (1982-1983)
2. The MPC' in the US varied due to changing expectations.
B. In the US, the multiplier has declined because of the increasing Marginal Propensity to Import (MPZ)
1. Increasing MPZ due to increasing international specialization.
2. The higher the MPZ,
a. the lower the slope of the APE curve (g) and
b. the smaller the multiplier.
C. An increase in the Marginal Propensity to Import (MPZ) will reduce the multiplier.
Proof
MULTA = 1 / (1 - g) and
g = MPC' - MPZ hence,
MULTA = 1 / [ 1 - (MPC' - MPZ)] and
MULTA = 1 / 1 - MPC' + MPZ
D. The Marginal Propensity to import (MPZ) also appears in the denominator of the autonomous spending multiplier (MULTA)
1. and so it is also a built in stabilizer.
2. Imports are called leakages
3. They soften the impact of fiscal policy
4. Policy makers must be concerned about the effects of fiscal policy on the trade deficit.
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A. There is a particular level of real GDP (Y) where the trade deficit (TD) = (Z - X) is zero.
1. Imports (Z) are equal to exports (X)
B. Derivation
1. TD = Z - X
2. TD = MPZ * Y - X
3. Can be graphed as a straight line
a. -X is the ordinal intercept
b. MPZ is the slope
c. It will cross the x-axis as real income grows
d. As income grows, so does the trade deficit (TD)
C. If the country is in international equilibrium, the trade deficit is equal to zero
TD = 0
1. TD = Z - X
2. 0 = MPZ * Y - X
3. X = MPZ * Y
4. X / Y = MPZ
D. Equilibrium will occur (Z = X) where:
1. the proportion of real GDP (X) made up of exports (X) just equals
2. the marginal propensity to import (MPZ)
X / Y = MPZ
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(B 22-3)
A. The government's budget deficit (GBD) is equal to:
1. its purchases of goods and services (G) less
2. net taxes (NT)
GBD = G - NT
GBD = G - (T - TR)
GBD = G - T + TR
B. Government purchases (G) are independent of real GDP (Y).
C. Because taxes (T) and transfers (TR) change with the business cycle,:
1. Net taxes (NT) change over the business cycle
2. Therefore, the government's budget deficit (GBD) also varies with the business cycle.
D. In a downturn,
1. Taxes (T) fall and transfers (TR) rise so that
2. Net taxes (NT) fall and
2. the government budget deficit (GBD) rises;
E. In an upturn,
1. Taxes (T) rise and transfers (TR) fall so that
2. Net taxes (NT) rise and
3. The government's budget deficit (GBD) shrinks.
F. There is a particular level of real GDP (Y) where the government budget is balanced.
1. The government budget deficit (GBD) is zero.
2. Government purchases of goods and services (G) is equal to net taxes (NT)
3. The proportion of real GDP (Y) going to government (G / Y) just equals the net tax rate (t).
G. Derivation
1. GBD = G - NT
2. GBD = G - t * Y
3. Can be graphed as a straight line
a. G is the ordinal intercept
b. -t is the slope
c. It will cross the x-axis as real income grows
4. If GBD = 0
a. 0 = G - t * Y
b G = t * Y
c. G / Y = t
H. The government will run a balanced budget (GBD = 0) when:
1. The proportion of real GDP (Y) going to government spending (G) just equals the tax rate (t)
G / Y = t
I. Hence an increase in GDP (Y) will have opposite effects on
1. The trade deficit and
2. the government budget deficit
J. An increase in GDP (Y) will
1. Increase the country's trade deficit (TD)
2. Reduce the country's government budget deficit (GBD)
IV Difficulties With Implementing Fiscal Policy
A. It is very difficult for governments to carry out fiscal policy because:
1. They do not know the precise values of the marginal propensities (MPC') or (MPZ).
a. Therefore they don't know the precise value of the multipliers
2. They do not know the economy's potential income level (YP)
3. Government lacks flexibility in changing spending (G) and taxes (T) and transfer payments (TR).
4. Financing the government budget deficit (GBD) will have offsetting effects.
5. Fiscal policy may conflict with other government goals.
B. Predicting the multiplier (MULTA) and future autonomous spending (A) is difficult because of:
1. Data collection problems and
2. weaknesses of forecasting models
C. Knowing the potential level of income (YP)
1. In U.S. estimates of natural rates of unemployment (U*) vary from 4% to 8%
2. Those who think unemployment can be 4% lower feel that:
a. potential real GDP (YP) can be 8% larger assuming that
b. 1% unemployment costs 2% of GDP (Y).
c. That is according to Okun's Law.
3. Range of estimates of the natural level of unemployment (U*)is so large that:
a. some economists in US are calling for contractionary fiscal policy
b. while others are calling for expansionary policy
D. Government lacks flexibility
1. Congress will not raise taxes (T) or cut spending (G) in an election year
a. US has congressional elections every two years.
E. Financing the government deficit will have offsetting effects.
1. When government borrows it sells bonds
2. This lowers the price of bonds and raises interest rates (r)
3. the increase in interest rates (r) tends to reduce private investment () or crowding out.
F. Fiscal policy may conflict with other goals
1. An expansionary fiscal policy will worsen the trade deficit.
IV. Aggregate Expenditure and Aggregate Demand
(review B 26-1)
A. The previous analysis of aggregate planned expenditure (APE) assumed constant price level (P).
1. All adjustments to unplanned inventory accumulation (UIA) were assumed to be in the form of
a. changing the level of GDP (Y).
2. In real world firms can also raise and lower prices.
B. To study the effect of price level changes (P),
1. we need to return to the aggregate supply and aggregate demand model (AS-AD).
C. The aggregate expenditure (AE) model is related to the aggregate supply and demand model (AS-AD).
1. The aggregate planned expenditure (APE) curve shows how:
a. aggregate planned expenditures (APE) vary with real GDP (Y),
b. holding all other things constant (including prices ((P)).
2. The aggregate demand, (AD), curve shows:
a. how the equilibrium level of aggregate planned expenditure (APE) depends on the price level (P),
b. holding everything else except interest rates (r and rn) constant.
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A. At any particular price level (P), there is a given equilibrium level of aggregate planned expenditure (APE) and real GDP (Y).
1. If the price level (P) changes, so will aggregate planned expenditure (APE).
2. The reasons why a change in the price level (P) will cause a change in APE are:
a. the real money balances effect,
b. the interest effect, and
c. the international effect.
B. A higher price level (P) lowers aggregate planned expenditure (APE)
1. (all other things held constant)
2. Real balance effect -
a. people want to restore the real value of their money balances (M) and so they try to save more.
b. There is
i. An increase in autonomous saving (SA) and
ii. A decline in autonomous consumption (CA)
iii. This reduces autonomous spending (A) and
iv. This reduces the equilibrium level of GDP (Y).
3. Interest rate effect -
a. Due to reduced real balances, the interest rate rises (r) and people postpone spending.
b. There is
i. An increase in autonomous saving (SA) and
ii. A decline in autonomous consumption (CA)
iii. A decline in investment spending (I)
iv. This reduces autonomous spending (A) and
iv. This reduces the equilibrium level of GDP (Y).
4. International effect -
a. higher prices make domestic goods less attractive and foreign goods more attractive.
b. There is
i. An increase in the propensity to import (MPZ) and
g = MPC + MPZ
ii. A reduction in the autonomous spending multiplier (MULTA)
MULTA = 1 / 1 - g
iii. A decline in autonomous consumption (CA)
iv. A decline in export sales (X)
iv. This reduces autonomous spending (A) and
iv. Both the reduction in autonomous spending (A) and the autonomous spending multiplier (MULTA) reduce the equilibrium level of GDP (Y).
C. Similarly a lower price level would increase AE and real GDP (Y)
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A. When the price level (P) changes, other things (except the interest rate) held constant,
1. the aggregate planned expenditure curve (APE) shifts and
2. a new expenditure equilibrium (Y) arises.
B. Each point on the aggregate demand curve (AD)
1. corresponds to an equilibrium level of aggregate planned expenditure. (APE)
C. The relationship between the price level (P) and aggregate planned expenditure curve (APE) is used to derive the aggregate demand curve (AD).
E. A higher price level (P) lowers the aggregate planned expenditure curve (APE).
1. The fall in the aggregate planned expenditure curve (APE) results in a lower equilibrium level of real GDP (Y).
F. An increase in price level (P) from P to P' shifts the AE curve down and
1. lowers the equilibrium level of real GDP (Y) from Y to Y'.
G. The aggregate demand (AD) curve graphs the relationship between the price level (P) and real GDP (Y).
H. An increase in the price level (P):
1. shifts the aggregate expenditure curve (AE) and
2. results in a movement along the aggregate demand curve (AD).
VII Changes in autonomous expenditure
A. An increase in autonomous expenditure (A)
1. (which is not a result of a change in the price level (P))
2. shifts the aggregate demand curve (AD) to the right.
B. The distance the AD curve shifts is determined by
1. the size of the change in autonomous spending (A) and
2. The size of the multiplier (MULTA).
DELTA Y = DELTA A * MULTA
2. The greater the autonomous spending multiplier (MULTA), the greater the shift in the AD curve.
B. Fiscal policy is directed at shifting the APE curve.
1. It will also shift the AD curve.
C. The effect of a change in the price level (P) runs
a. from a movement along the AD curve to
b. A change in autonomous spending (A) to
c. A shift in the APE curve.
D. The effect of a change in autonomous spending (A) runs from
a. a shift of the APE curve to
b. a shift in the AD curve.
VI. Equilibrium GDP and the Equilibrium Price Level
(B 26-4)
A. The effect of a change in autonomous spending (A) on real GDP (Y) and the Price level (P) will depend on the slope of the aggregate supply curve. (AS)
B. The slope of the aggregate supply curve (AS) will depend on the time period.
1. The short run aggregate supply curve (SAS) is likely to be positively sloped
2. The long run aggregate supply curve (LAS) is likely to be vertical.
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(B 26-6)
A. In the short run, it is assumed that output prices can change but
1. input prices (e.g. wage rates) are fixed due to:
a. contracts or
b. legislation or
c. custom.
B. If an increase in autonomous expenditure (A) shifts the aggregate demand (AD) curve to the right.
1. The economy moves along its short-run aggregate supply curve (SAS).
2. In the intermediate range, the level of real GDP (Y) rises (from Y to Y') and the price level (P) increases (from P to P').
a. The price level (P) rises due to increasing marginal costs due to diminishing returns.
b. The rising price level (P) is not due to increasing input costs (e.g. wages)
3. If the price level (P) had not risen, the increase in real GDP (Y) would have been greater.
4. The increased price level (P) has reduced autonomous spending (A) and thus lowered the APE curve and the equilibrium GDP (Y).
a. The reduction in autonomous spending (A) was due to:
i. the real balances effect,
ii. the interest rate effect and
iii. the international effect.
B. In the short run, fiscal policy will shift the APE curve and the AD curve and thus effect
1. the price level (P)
2. and real GDP (Y).
C. The size of the effects of fiscal policy will depend on:
1. The size of the change in autonomous spending (A)
2. The size of the relevant multipliers
3. The slope of the short run aggregate supply curve (SAS)
D. If there is an increase in autonomous government spending (G):
1. The APE curve will shift up
2. The equilibrium GDP (Y) will increase by a multiple of the change in G.
3. The AD curve will shift rightward by the change in equilibrium GDP (Y).
4. The economy will move along the short run aggregate supply curve (SAS)
5. The Price level (P) will rise.
6. Autonomous spending (A) will fall somewhat
7. The equilibrium GDP (Y) will fall back somewhat.
8. The net effect will be:
a. a higher level of real GDP (Y) and
b. a higher level of prices (P).
9. However the increase in GDP (Y) will be smaller than if there had been no increase in prices (P).
E. Prices act like built in stabilizers,
1. Price adjustments reduce the multiplier effect.
2. Price movements reduce the potential shifts in real GDP (Y) and employment.
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A. In the long run, it is assumed that all markets are in equilibrium,
1. input prices (including wage rates) are assumed to adjust to changes in:
a. output prices and
b. other factors.
B. In the long run it is assumed that the economy is at full employment equilibrium.
1. Real GDP (Y) is equal to potential GDP (YP).
Y = YP
1. Input prices (e.g. wages) rise as output prices (P) rise.
a. This shifts upward the short run supply curves of individual firms
b. Who must then raise prices or cut back on production.
D. If there is an increase in autonomous spending (A):
1. The APE curve will shift up
2. The equilibrium GDP (Y) will increase by a multiple of the change in A.
a. The equilibrium GDP (Y) will be greater than the full employment GDP (YP).
Y > YP
3. The AD curve will shift rightward by the change in equilibrium GDP (Y).
4. The equilibrium will shift up along a short run aggregate supply curve (SAS).
4. The price level (P) will rise.
a. Autonomous spending (A) will fall somewhat
b. Equilibrium real GDP (Y) will fall somewhat
c. But equilibrium real GDP (Y) will still be above potential real GDP (YP)
Y > YP
5. Prices of inputs (e.g. wages) will rise
b. The short run aggregate supply curve (SAS') shifts to the left
c. (it rises because input costs are rising)
6. The equilibrium point moves along the new aggregate demand curve (AD').
6. This will push up the price level (P) more
a. Autonomous spending (A) will fall more
b. Equilibrium real GDP (Y) will fall more
c. As long as equilibrium real GDP (Y) is above potential real GDP (YP) wages will continue to rise
d As long as wages rise, the SAS curve will shift up.
6. The equilibrium GDP (Y) will continue to fall until
a. it reaches the full employment level (YP) on the long run aggregate supply curve. (LAS)
7. As a result of the increase in autonomous spending (A):
a. The price level (P) will be higher but
b. There will be no change in real GDP (YP)
E. In the long run,
1. The economy returns to its full employment level of output (YP).
Y = YP
2. If Y' is an above full-employment level of real GDP (YP),
a. eventually the level of real GDP (Y) falls back to its full employment level (YP) and
b. the price level (P) rises to a higher level.
F. This means that fiscal policy will have no effect on long run real GDP (Y),
1. In the long run actual GDP (Y) will always equal potential GDP (YP).
2. The long run may take a very long time.
3. Keynes said "In the long run we are all dead."
X. Summary of the lecture
Key concepts
1. Automatic stabilizers (Nhung cong cu tu on dinh)
2. Autonomous expenditure (A)
3. Autonomous expenditure
multiplier (MULTA)
4. Autonomous tax multiplier (MULTTA)
5. Autonomous transfer payments
multiplier (MULTTRA)
6. Balanced budget multiplier (MULTB) (Thua so cua ngan sach can bang)
7. Countercyclical fiscal policy
8. Crowding out
9. Endogenous
10. Government purchases
multiplier (MULTG)
11. Induced expenditure (N)
12. Marginal propensity to import (MPZ) (Thien huong nhap khau bien)
13. Net tax rate (t)
14. Multiplier (MULT) (Thua so)
15. Paradox of thrift (Nghich ly tiet kiem)
16. Stabilization policy (Chinh sach on dinh)
17. Trade balance (Can can thuong mai)
Review Questions
1. To which components of aggregate planned expenditure (APE) does the autonomous expenditure multiplier (MULTA) apply?
2. What is the relationship between the autonomous expenditure multiplier (MULTA) and the slope of the APE curve (g) ?
3. Why is the autonomous expenditure multiplier (MULTA) greater than 1?
4. Why is the autonomous tax multiplier (MULTTA) smaller than the autonomous expenditure multiplier (MULTA)? Why does it have the opposite sign?
5. Why is the absolute value of the autonomous tax multiplier (MULTTA) equal to the autonomous transfer payment multiplier (MULTTRA)? Why does it have the opposite sign?
6. Why is the balanced budget multiplier (MULTB) less than 1?
7. How do income taxes and transfer payment act as automatic stabilizers.
8. What will happen to the APE curve as you move down the AD curve?
9. What will happen to the AD curve if the APE curve shifts upward?