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Systematic ups and downs in GDP Expansions, recessions Peaks, Troughs Overall the trend is growth of Real GDP Carried out by the National Government Started with the ideas of John Maynard Keynes Help the US administration with his ideas of how to stop the Great Depression from getting worse He believed in fixing problems now, by increasing and decreasing spending (GDP) There are two tools of fiscal Policy o Taxes and Government Spending Government spending is the most direct form Economy in recession and need a boost? o Lower taxes o Raise government spending Economy overheated and need to slow down? o Raise taxes (Mondale) o Lower government spending The problem with this policy is it often leads to unseen or increased spending Can lead to a “Budget Deficit” o Spending more than you make (have to borrow) Contractionary fiscal policy can lead to “Budget Surplus” o More income than expenditures (can pay debt) Whenever you spend money that amount becomes income for someone else Example: You buy a new TV from Best Buy, they take a portion of this money and invest in new computer terminals…. So there are only two things we (C,G,I,Xn) can do with our Money o Spend o Save Using aggregate data from income, GDP, savings The propensity to spend additional income is known as Marginal Propensity to Consume (MPC) The propensity to save additional income is known as Marginal Propensity to Save (MPS) These are given in percentages Since we can either save or consume, MPS + MPC = 1 o MPC and MPS are percentages o So if you spend 90% of your income then MPC is .9 o And your MPS has to be .1 (MPS + MPC = 1) o Can you have a negative savings percentage? Joe makes $10,000 a month He gets a raise of $900 from his company per month After this raise his savings account increases by $450 per month, while his spending increases by $450 What is Joe’s MPC and MPS? MPC and MPS help us get two types of multipliers Both are related to Fiscal Policy Expenditure Multiplier: Related to changes is spending Tax Multiplier: Related to changes in taxes Shows how much a change in spending (C, G, Ig, Xn) will affect GDP Me = 1/MPS With a consumer MPC of .9, an increase in consumer spending of $10m could change GDP by how much? o Me = 1/.1 (or 10) o So 10 multiplied by $10m o Could change GDP by $100m The MPC of the average American is estimated to be .75 (75%) If the government wishes to boost GDP and decides to do so by spending on public works projects what would the multiplier (Me) be? If they wanted to boost spending by $400m then how much would they need to spend on these projects? o 1/.25 = 4 Me= 4 o Desired boost = $400 o Increase spending by $100 $400/4= $100 A Change in taxes (T) will change disposable income (DI) and thus change consumption An increase in taxes would potentially lower consumption while a decrease could increase consumption This one tells us how much GDP will change as a result of a change in taxes Mt = MPC/MPS So change in taxes (can be negative) and their effect on GDP is shown as: o T x Mt = Change in GDP Consumers MPC is .9 (90%) So MPS is .1 Mt = .9(MPC)/.1(MPS) o Mt = 9 So the government increases taxes by $100m (-T) Change in GDP = -$100m x Mt (9) o Potential decrease in GDP of $900m Example #1: Increase taxes and decrease government spending Budget Surplus Example #2: Increase government spending while taxes stay the same Budget Deficit Example #3: Decrease taxes and decrease government spending or Increase in both ??????? Mb = Me – Mt = 1 Why? Remember MPC and MPS (not all income is spent) So…. Equal increases in government spending and taxes will increase equilibrium GDP by an amount equal to the increase in government spending Decreases will have the opposite effect Consider the following data: o A countries MPC is .9 so MPS is .1 o Therefore the Me is 10 (1/MPS) o And the Mt is 9 (MPC/MPS) Government wants to increase GDP by $10m without causing inflation….so….. The government decides to increase spending by $10m and increase taxes by $10m So Me of Government spending is 10 x 10 or $100m increase in G after the multiplier Mt of increase in taxes is 9 x -$10m or a potential loss of $90m in C spending after tax increase So potentially GDP can increase by $10m without creating a budget deficit or inflationary pressure Additional income may be spent on imports In recent decades, new income may be used on old debt Inflation can affect the effect (affect/effect?) Changes in the “Animal Spirits” Remember these are not absolutes, but we need somewhere to start