Income and Spending

1. Income and Spending Chapter #10

2. AD and Equilibrium Output • The Keynesian model (flat AS curve) develops the theory of AD: ↑ in autonomous spending causes additional ↑ in AD (feed back) • Total amount of goods demanded in economy is AD = C + I + G + NX • Equilibrium output when: output produced = quantity demanded or Y = AD • If AD ≠ Y => unplanned inventory (IU = Y – AD) signals firms to change Y • Consumption, the largest component of AD, increases w/ income • Consumption function: (assumes TR = TA or Y = YD) • Intercept is consumption when income is zero (> 0 for subsistence consumption) • Slope is marginal propensity to consume 1 > c > 0. • Since Y is spent or saved  consumption theory also explains saving • Substitute consumption function into budget constraints for savings function: • Also increases w/ income since marginal propensity to save s = 1 – c > 0 • Add all AD components : G, I, taxes & foreign trade (assume autonomous) • Since consumption now depends on disposable income YD = Y + TR – TA, consumption function becomes • Finally:

3. Equilibrium Income and Output • Basic model of macro equilibrium assumingconstant price and interest rates • Equilibrium where Y=AD (45° line)  point E • Arrows show how the equilibrium is reachedthrough signals from unplanned inventory • For Y < Y0, inventories ↓ & firms ↑ production • For Y > Y0, inventories ↑ & firms ↓ production • Solving equilibrium condition for equilibrium output, shows output as a function of MPC & A: • To find how change in autonomous spending affects output use: • Ex: If the MPC = 0.9, then 1/(1-c) = 10  $1B ↑ in G causes Y to ↑ by $10BRecipients of higher G increase their spending, recipients of that spending increase their own spending & so on

4. Saving and Investment • For closed econ w/o government, in equilibrium, planned investment = savings • Vertical distance between AD & C = I (constant) • Vertical distance between C & 45° line = S • at Y0 two vertical distances are equal & I = S • National income accounting also gives S = I • Income is either spent or saved: Y = C + S • Without G or trade: AD = Y = C + I • Putting two together: C + S = C + I => I = S • For open econ w/ government: • Income is either spent, saved, or paid in taxes:Y = C + S + TA - TR • Complete AD = Y = C + I + G + NX • Putting two together:C + S + TA – TR = C + I + G + NXI = S + (TA – TR – G) - NX

5. The Expenditure Multiplier • By how much does $1 in autonomous spending raise equilibrium level of income? • Of additional $1 in income, $c is consumed • Output ↑ to meet ↑ expenditure by (1+c) • Output & income expansion cause further ↑ • Successive rounds of increased spending, starting w/ initial autonomous demand ↑, give: (15) • This geometric series simplifies to: • General definition of multiplier is • Effect of autonomous spending ↑ on equilib Y: • Initial equilibrium income Y0 is at E • Autonomous spending ↑ shifts AD up by • New equilibrium income Y0’ is at E’

6. The Government Sector • The government affects the level of equilibrium output in two ways: • Government expenditures (component of AD) • Taxes and transfers • Fiscal policy is government policy with regards to G, TR, and TA • Assume G and TR are constant, and that there is a proportional income tax (t) • The consumption function becomes: • Combining with • Using equilibrium condition Y=AD, equilibrium output is: • Government sector flattens AD curve & reduces multiplier to • Automatic stabilizer is any mechanism that automatically (w/o government intervention) ↓ output change in response to ↑ in autonomous demand • Business cycle is caused by shifts in autonomous demand, especially investment • Investment affects Y less w/ automatic stabilizers (ex. Proportional income tax) • Unemployment benefits are another example of an automatic stabilizer  enables unemployed to continue consuming even though they do not have a job

7. Effects of a Change in Fiscal Policy • Suppose government expenditures G increase • Changes in autonomous spending shift ADschedule upward by the amount of change • At the initial level of output, Y0, the demand forgoods > output, and firms increase productionuntil reach new equilibrium (E’) • The change in equilibrium income is: • $1 ↑ in G => ↑ in income > $1 • If c = 0.80 and t = 0.25, multiplier αG = 2.5 • $1 ↑ in G => ↑ in equilibrium income = $2.50 • Suppose government increases TR instead • Autonomous spending ↑ by only cTR, so output would increase by GcTR • The multiplier for transfer payments is smaller than that for G by a factor of c • Part of any increase in TR is saved (since considered income) • If government increases marginal tax rates, two things happen: • Direct effect is that AD is reduced since disposable income decreases, and thus consumption falls • The multiplier is smaller, and the shock will have a smaller effect on AD

8. The Budget • Government budget deficits have been the norm in the U.S. since the 1960s • Is there a reason for concern over a budget deficit? • Fear: government’s borrowing makes it difficult for firms to borrow & invest  slows economic growth • Budget surplus = tax revenues TA, above initial expenditures (purchases of goods and services and TR): • Negative BS = budget deficit • If TA = tY, • Figure of BS as a function of income for given G, TR, and t • At low income budget is in deficit (gov.spends more than it receives in income) • At high income budget is in surplus (gov. receives more than it spends) • Budget deficit depends on gov’spolicy choices (G, t, and TR) & anything else that shifts the level of income • Example: ↑ I => ↑ Y  Budget deficit ↓ as tax revenues ↑

9. Effects of Government Purchases and Tax Changes on the BS • How does fiscal policy affect the budget? OR Must an increase in G reduce the BS? • ↑ in G reduces the surplus, but also increases income& thus tax revenues • Possibility that increased tax collections > increase in G • The change in income due to increased G is equal to , a fraction of which is collected in taxes • Tax revenues increases by • The change in BS is