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Topic 3: Fiscal Policy

Topic 3: Fiscal Policy. Circular Flow Investment Taxes and Government Spending. AE (with no Govt). AE = C + I AE = Planned Aggregate Expenditure C = Consumption I = Investment. In equilibrium (with no Govt). Y = AE = C + I Y = National Income or Aggregate Output

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Topic 3: Fiscal Policy

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  1. Topic 3: Fiscal Policy Circular Flow Investment Taxes and Government Spending

  2. AE (with no Govt) AE = C + I • AE = Planned Aggregate Expenditure • C = Consumption • I = Investment

  3. In equilibrium (with no Govt) Y = AE = C + I • Y = National Income or Aggregate Output • In equilibrium, output equals planned expenditures • Why? • If people buy too little: companies are overproducing, inventories will rise, then firms slow down production • If people buy too much: companies don’t produce enough, inventories fall, then firms increase production

  4. Types of Investment • Inventories are important: • If people buy too little: companies are overproducing, inventories will rise, then firms slow down production • If people buy too much: companies don’t produce enough, inventories fall, then firms increase production • e.g., end of 2008

  5. What is consumption? • C usually depends on income Y C = minC+ mpc * Y • minC = spending even when there is no income (must eat to survive) • mpc = how much each additional dollar of income increases consumption. mpc = “Marginal Propensity to Consume” • mpc = 1-mps, where mps = “marginal propensity to save”

  6. Solving for Equilibrium Y • Suppose C = 100 + 0.8 Y and I = 1000. • What is the equilibrium level of output (income)? • What happens when consumers become pessimistic and spend less of their income? Suppose the mpc falls to 0.75. • What is the new equilibrium output?

  7. Solving for Equilibrium Y • Starting with C = 100 + 0.8 Y and I = 1000. • Now, suppose firms decrease investment by 200. • What is the new equilibrium output? ΔY = Δ I [ 1 / (1- mpc) ] • Illustrate this change using circular flow. • Initial impact versus long run impact on Y

  8. AE with Government AE = C + I + G • AE = Planned Aggregate Expenditure • C = Consumption • I = Investment • G = Government Spending

  9. In equilibrium Y = AE = C + I + G • Y = National Income or Aggregate Output • In equilibrium, output equals planned expenditures • Why? • If people buy too little: companies are overproducing, inventories will rise, then firms slow down production • If people buy too much: companies don’t produce enough, inventories fall, then firms increase production

  10. What is consumption? • C now can depend on income and taxes C = minC + mpc ( Y – Tx) • Y – Tx is “Disposable Income” or income after taxes • In Equilibrium: Y = AE = minC+ mpc ( Y - Tx) + I + G

  11. Solving for Equilibrium Y • Suppose C = 100 + 0.8 Y , I = 1000, G = 500 = Tx.What is the equilibrium level of output? • Suppose that the government increases spending by 200, but does not change taxes. • Illustrate this increase in spending using circular flow • What is the new equilibrium output? ΔY = Δ G [ 1/ (1- mpc) ]

  12. Solving for Equilibrium Y • Start with C = 100 + 0.8 Y , I = 1000, G = 500 = Tx. • Suppose the government decreases taxes by 200. • Illustrate this change using circular flow. • What is the new equilibrium output? ΔY = Δ I [ - mpc / (1- mpc) ] • Suppose investment increases by 100. • Illustrate this change using circular flow. • What is the new equilibrium output? ΔY = Δ I [ 1 / (1- mpc) ]

  13. Keynesian Multipliers • Tells us how much changes in G, Tx, and I influence output • G: [1/ (1-mpc)] • I: [1 / (1-mpc)] • Tx: [-mpc / (1-mpc)] • Solve a problem without any numbers plugged in…

  14. The role of inventories • Initial increase in I or G causes inventories to initially fall • Planned inventories are greater than actual inventories • Firms produce more, which causes Y to increase • The increase in Y results in an increase in C • The increase in C causes inventories to again fall below planned level (but not as much as before), which causes the process to repeat

  15. Other Examples and Problems • …..

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