Prepared by: Jamal Husein C H A P T E R 14 © 2006 Prentice Hall Business PublishingSurvey of...

© 2006 Prentice Hall Business Publishing© 2006 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Prepared by: Jamal Husein

C H A P T E R

1414

Aggregate Demand and Fiscal Policy

© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

Why do governments cut taxes to increase economic output?

Why is the U.S. economy more stable than it was prior to World war II?

If consumers become more confident about the future of the economy, can that confidence lead to faster economic growth?

If a government increases spending by $10 billion, could total GDP increases by more than $10 billion?


Behind the AD Curve: A short Run Behind the AD Curve: A short Run AnalysisAnalysisBehind the AD Curve: A short Run Behind the AD Curve: A short Run AnalysisAnalysis

The demand for goods and services determines output, or the level of GDP, at least in the short run.

The short run is a period of time during which prices do not change, or change very little.

In the short run, producers supply all of the output that is demanded.

In the short run, the economy rapidly adjusts to reach the equilibrium level of output, where total demand equals production, i.e., AD equals AS.


Shifts in Aggregate DemandShifts in Aggregate DemandShifts in Aggregate DemandShifts in Aggregate Demand

Output, y

Price,P

SRAS

y0

A shift in AD curve from AD0 to AD1 increases output from

y0 to y1.

A shift in AD curve from AD0 to AD1 increases output from

y0 to y1.

AD1

y1

AD0


Shifts in Aggregate DemandShifts in Aggregate DemandShifts in Aggregate DemandShifts in Aggregate Demand

Output, y

Price,P

y0

An increase of government spending of $10 billion will initially shift original AD by $10 billion (from A to B). Total AD will increase by more than $10 billion after a

period of time due to the multiplier effect.

An increase of government spending of $10 billion will initially shift original AD by $10 billion (from A to B). Total AD will increase by more than $10 billion after a

period of time due to the multiplier effect.

Initial shift

y1

Original AD

y2

Final AD

A B C


The Consumption Function & the The Consumption Function & the MultiplierMultiplierThe Consumption Function & the The Consumption Function & the MultiplierMultiplier The relationship between consumer spending

and income is called the consumption function:

Ca= autonomous consumption spending, or the amount of consumption spending that does not depend on the level of income.

by = induced consumption, or the amount of consumption induced by higher income.

b= marginal propensity to consume (MPC). y= level of income in the economy.

C = C bya


Consumption FunctionConsumption FunctionConsumption FunctionConsumption Function

The consumption function is a line that intersects the vertical axis at Ca. the value of autonomous consumption spending.

When income equals zero, the value of total consumption (C) equals Ca. It corresponds to the amount of consumption that does not depend on the level of income.


The MPC & the MPSThe MPC & the MPSThe MPC & the MPSThe MPC & the MPS The slope of the consumption function is the marginal

propensity to consume (MPC), or the value of b in the linear equation.

For each additional dollar of income received, a consumer will spend part of it and save the rest.

The fraction that the consumer spends is given by his or her MPC or the slope of the consumption function b.

The MPC is always less than one

0 1 b <


The MPC & the MPSThe MPC & the MPSThe MPC & the MPSThe MPC & the MPS

The fraction that the consumer saves is determined by his or her marginal propensity to save (MPS).

For example, if b (MPC) = 0.6, then 60 cents of each additional dollar are consumed and 40 cents (MPS = .4) are saved.

The sum of the MPC and the MPS is always equal to one

MPC + MPS = 1


Changes in the Consumption FunctionChanges in the Consumption FunctionChanges in the Consumption FunctionChanges in the Consumption Function

The consumption function can change for two reasons:

A change in autonomous consumption A change in the marginal propensity to

consume

Factors that cause autonomous consumption to change are:

Consumer wealth, or the value of stocks, bonds, and consumer durables held by the public (Franco Modigliani).

Consumer confidence.



Factors that cause the marginal propensity to consume to change are:

Consumers’ perceptions of changes in income. Studies show that consumers tend to save a higher proportion of a temporary increase in income, and spend a higher proportion of income if the increase in income is perceived to be permanent.

Changes in taxes, as we will see later in this chapter.



Impact of a change in autonomous consumption

Impact of a change in the marginal propensity to consume


Determining Aggregate DemandDetermining Aggregate DemandDetermining Aggregate DemandDetermining Aggregate Demand

We stack up the amount of investment on top of consumption function.

At any level of output (income), total demand for goods and services can be read of the C + I line.

In an economy without government or the international sector, AD will be determined by consumption (C) and investment spending (I).


Determining Aggregate DemandDetermining Aggregate DemandDetermining Aggregate DemandDetermining Aggregate Demand

Equilibrium output, where y = C+I, is found where the 450 line intersects the demand line (C+I).

The y* level of output means that firms are producing precisely the level of output necessary to meet the consumption and investment demands by households and firms.

Dem

and

Output, y

C

C+I

450

y*

Ca

Ca + I

E


The MultiplierThe MultiplierThe MultiplierThe Multiplier

The model of AD can be used to explain what happens to equilibrium output (employment) if there is a change in investment spending (an autonomous expenditure);

An increase in investment, i.e., from I0 to I1 (called ∆I) will shift the initial C+I0 curve upward by ∆I to C+I1;

The intersection of C+I1 curve with the 45 degree line shifts equilibrium from E0 to E1;

As a result AD increases from Y0 to Y1;


The MultiplierThe MultiplierThe MultiplierThe Multiplier The change in AD (∆y) is greater than the increase

in I, which is the general result that the increase in output always exceeds the increase in investment;

This explains the multiplier or why the final shift in AD is greater than the initial shift in AD;

The Multiplier is a number that shows by how much equilibrium output will change as a result of a change in the value of autonomous expenditures.

For example, if b = 0.75, then the multiplier equals 4. A one-dollar increase in autonomous consumption or in investment, will increase equilibrium income by 4 dollars.


The MultiplierThe MultiplierThe MultiplierThe MultiplierD

eman

d

Output, y

C

C+I0

450

y0

CA

I0

E0

y1

E1 C+I1

I1

y0

y1

∆y

∆I


The Multiplier in Action (millions $)The Multiplier in Action (millions $)The Multiplier in Action (millions $)The Multiplier in Action (millions $)

Round of Spending

Increase in Demand

Increase in GDP and Income

Increase in Consumption

1 $10 $10 $8

2 8 8 6.4

3 6.4 6.4 5.12

4 5.12 5.12 4.096

5 4.096 4.096 3.277

… … … …

Total 50 million 50 million 40 million

11 MultiplierMultiplier == (1 – MPC)


Government Spending and TaxationGovernment Spending and TaxationGovernment Spending and TaxationGovernment Spending and Taxation

Both the level of government spending and the level of taxation, through their influence on the demand for goods and services, affect the level of GDP in the short run.

Using taxes and spending to influence the level of GDP (shift the AD curve) in the short run is known as Fiscal Policy.

Government purchases of goods and services are a component of total spending;

Total Spending including government = C + I + G


Government SpendingGovernment SpendingGovernment SpendingGovernment Spending Increases (decreases) in government spending

shifts the C+I+G curve upward (downward), just as changes in investment;

Dem

and

Output, y

C+I+G0

450

y1

Dem

and

Output, y

C+I+G0

450

y0y0

C+I+G1

C+I+G1

y1


The Impact of TaxesThe Impact of TaxesThe Impact of TaxesThe Impact of Taxes

The consumption function becomes:

After taxes and transfers are taken into account, national income becomes personal disposable income:

C = C b ya d C = C b (y T )a

Yd = y - T

or For example, if taxes increase by $1, after-

tax income will decline by $1. Since the MPC is b, this means that consumption (C) will fall by b×$1 and the C+I+G curve will shift downward by b×$1 ;


The Impact of TaxesThe Impact of TaxesThe Impact of TaxesThe Impact of Taxes Increases (decreases) in taxes shifts the

C+I+G curve downward (upward) and impact total demand and equilibrium output.

Dem

and

Output, y

C+I+G

450

y1

Dem

and

Output, y

C+I+G

450

y0y0

C+I+G

C+I+G

y1


The Impact of TaxesThe Impact of TaxesThe Impact of TaxesThe Impact of Taxes

The multiplier for taxes is less than that for government spending;

Decreasing government spending (G) by $1, will shift the C+I+G curve downward by $1;

However, increasing taxes by $1, consumers will cut back their consumption by a fraction of $1 (b×$1), thus the C+I+G curve will shift downward by less than $1, or exactly by b×$1;



We use a special terminology to describe fiscal policy;

Government policies directed towards increasing AD and GDP are called expansionary policies such as tax cuts and increases in government spending;

Government policies directed towards decreasing AD and GDP are called contractionary policies such as tax increases and government spending cuts



Budget deficit, the difference between government spending and its revenue, will be impacted by government policies;

An increase in government spending or a reduction in taxes (expansionary policies) will increase the government's budget deficit;

A decrease in government spending or an increase in taxes (contractionary policies) will decrease the government's budget deficit


Fiscal Policy in ActionFiscal Policy in ActionFiscal Policy in ActionFiscal Policy in Action

According to Keynesian economics, expansionary fiscal policy—tax cuts and increased government spending—could pull the economy out of a recession or depression.

During the 1930s, however, politicians did not believe in Keynesian fiscal policy, largely because they feared the consequences of budget deficits.

Although government spending increased during the 1930s, so did taxes, resulting in no net fiscal expansion.


Fiscal Policy in ActionFiscal Policy in ActionFiscal Policy in ActionFiscal Policy in Action It was not until the early 1960s, during the

Kennedy administration, that modern fiscal policy came to be accepted. Tax cuts were used to try to reduce unemployment.

Estimating the actual effects the tax cuts had is difficult, but from 1963 to 1966, both real GDP and consumption grew at rapid rates. This rapid growth suggests that the tax cuts had the effect, predicted by Keynesian theory, of stimulating economic growth.



From 1966 to 1969, the unemployment rate fell below 4%, and fiscal policy was used in economic policy again.

A temporary surcharge tax, enacted in 1968, raised the taxes of households by 10%.

But since the tax was temporary, it did not have a major effect on permanent income, and the decrease in demand was smaller than economists had anticipated. Households simply saved less during that period.


Fiscal Policy in ActionFiscal Policy in ActionFiscal Policy in ActionFiscal Policy in Action During the 1970s there was no net change

in fiscal policy. Mild changes in taxes were enacted in 1975, after the economy went into a recession in 1973.

Significant tax cuts were enacted in 1981, but these tax cuts were justified on the basis of their impact on supply, not demand.

A major tax increase was passed under President Clinton that successfully brought the budget into balance.



By year 2000, the federal budget began to show surpluses that set the stage for tax cuts that were passed by President George W. Bush.

Post September 11, 2001, the president and the Congress became less concerned with balancing the budget and authorized new spending programs to provide relief to victims and to stimulate the economy


Automatic StabilizersAutomatic StabilizersAutomatic StabilizersAutomatic Stabilizers

Certain taxes and transfers act as automatic stabilizers for the economy.

When income is high, the government collects more taxes and pays out less transfer payments, thereby reducing spending.

When output is low, the government collects less taxes and pays out more in transfer payments, putting more funds into the hands of consumers.


Automatic StabilizersAutomatic StabilizersAutomatic StabilizersAutomatic Stabilizers

As such automatic stabilizers prevent consumption from falling as much in bad times and from rising as much in good times.

Other factors contributing to the stability of the economy is that consumers base their spending decisions on permanent income and not just their current level of income.


Growth Rate of U.S. GDP, 1871-2000Growth Rate of U.S. GDP, 1871-2000Growth Rate of U.S. GDP, 1871-2000Growth Rate of U.S. GDP, 1871-2000


Exports and ImportsExports and ImportsExports and ImportsExports and Imports

Exports (X) and imports (M) affect AD through their influence on how foreigners demand goods and services produced in the U.S.

An increase in exports means an increase in demand for U.S. goods and services, while an increase in imports means an increase in demand for foreign goods and services by U.S. residents.


Exports and ImportsExports and ImportsExports and ImportsExports and Imports To recognize the impacts of exports and

imports on AD and GDP, we take two steps and ignore government spending and taxes for the moment:

Add exports, X, which we assume to be autonomous because they depend on foreign income, to other sources of spending; and

subtract imports, M, which depends on the level of domestic income, from total spending by U.S. residents

y = C + I + (X – M)


Exports and ImportsExports and ImportsExports and ImportsExports and Imports

Consumers will buy more foreign goods and services (M) as income rises;

imports = M = my Additional spending on U.S. goods and

services out of additional income can be obtained by subtracting m or the (marginal propensity to import) from b or the MPC.

MPC for domestic spending = b – mMPC for domestic spending = b – m


Exports and ImportsExports and ImportsExports and ImportsExports and Imports For example, if b = 0.8 and m = 0.2, then

MPC for domestic spending = b – m = 0.8 – 0.2 = 0.6MPC for domestic spending = b – m = 0.8 – 0.2 = 0.6

Dem

and

Output, yy*

Ca+I+X

450

Demand

Slope = (b – m)

In an open economy, the level of equilibrium income is determined

by the intersection of total demand for U.S. goods and

services with the 45 degree line.


Exports and ImportsExports and ImportsExports and ImportsExports and ImportsD

eman

d

Output, y

450

y1

Dem

and

Output, y

450

y0y0

Ca+I+X

y1

Ca+I+X

An increase in exportsWill increase the levelof Aggregate Demand.

An increase in marginalpropensity to import willdecrease the level of AD.

∆X

Prepared by: Jamal Husein C H A P T E R 14 © 2006 Prentice Hall Business PublishingSurvey of...

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Transcript of Prepared by: Jamal Husein C H A P T E R 14 © 2006 Prentice Hall Business PublishingSurvey of...