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CHAPTER
10
Income and Spending
Learning objectives




Understand that in the most basic model of aggregate
demand, spending determines output and income, but
output and income also determine spending. In particular,
consumption depends on income, but increased
consumption increases aggregate demand, and therefore,
output.
Understand that increases in autonomous spending
increases output more than one for one. In other words,
there is a multiplier effect.
Understand that the size of the multiplier depends on the
marginal propensity to consume and on tax rates.
Understand that increases in government spending
increase aggregate demand, and, therefore tax collections.
However, tax collections rise by less than the increase in
government spending, so increased government spending
increases the budget deficit.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
AD and Equilibrium Income
o

YD  Y T A T R
(1)
C  C  cYD
(2)
Chapter 10: Income and Spending
o Consumption Function: Describes the
relationship between consumption
spending and disposable income.
Marginal Propensity to Consume: The
increase in consumption per unit increase
in income.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 2
AD and Equilibrium Income
The consumption
function shows
the level of
consumption
spending at each
level of
disposable
income.
Consumption
C  C  cYD
C

The slope of the
consumption
function is given
by the marginal
propensity to
consume.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Y
Chapter 10: Income and Spending
Figure 10-1: The Consumption Function
Slide 3

AD and Equilibrium Income
o The Consumption Function and Aggregate
Demand:
AD  C  I G  NX
 C  cYD  I G  NX
 C  cT R T A  I  G  N X  cY
 A0  cY
(3)

Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 4
BOX
The Consumption-Income Relationship
10-1
C = 0.28 + 0.89YD
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Slide 5
AD and Equilibrium Income
o Equilibrium Income:
AD  A0  cY
Y  AD
Y  A0  cY
1
Y0 
A0
1 c
1
Y0 
A0
1 c
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(3)
(4)
(5)
(6)
(7)
Slide 6
AD and Equilibrium Income
Aggregate demand
Figure 10-2: The Consumption Function, AD and Equilibrium Output
AD  Y
C  cC  cT R T A  cY
E



A0
The vertical
distance between
AD and C is
given by I + G +
NX
C  cT R T A 
Y0
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AD  A  cY
Y
At E, supply
equals demand.
Slide 7
BOX
C, S, I, and Equilibrium: Why is Chap. 3 different
from Chap.10?
10-2

Y  C  I G  NX
Y  C  S T A T R
I  NX  S  T A G T R 

In Chapter 3: In the long run the AS curve is vertical and that
level
of output is determined by amount of capital and labour

through the production function.
In Chapter 10: In the very short run the AS curve is horizontal
and that level of output is determined by aggregate demand.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 8
o Multiplier: The amount by which
equilibrium output changes when
autonomous aggregate demand increases
by one unit.
AD  A  cA  c A  c A ...
2
3
(8)
 A  1 c c  c ...
2
3
o For c < 1…
AD 1 1 cA  Y0
 1 1 c
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending

The Multiplier
(9)
(10)
Slide 9
The Multiplier
Table 10-1
The Multiplier
Round
1
2
3




4
…
…
Increase in
Demand
Increase in
Production
Total Increase
A
cA
c 2A
3

c A
…
 …
A
cA
c 2A

c 3A
A
1 cA
2
1 c  c A
2
3
1
c
c

c

A

Copyright 2005 © McGraw-Hill Ryerson Ltd.

…
…


…
1 1 cA
Slide 10
Fiscal Policy in the Very Short Run
TA  tY
C  C  cYD
 C  cY T R tY 
 C  cT R  c1t Y
(11)
Chapter 10: Income and Spending
o Fiscal Policy: The policy of the government
toward the level of government spending, the
level of transfers, or the level of taxes.
(12)
o By adding the other components…
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Slide 11
Fiscal Policy in the Very Short Run
 C  cYD  I G  NX
 C  cY T R tY  I G  NX
 C  cT R  I G  NX  c1t Y
 A1  c1t Y
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
AD  C  I G  NX
(13)
Slide 12
Fiscal Policy in the Very Short Run
(14)
1
Y
A1
1 c1 t 
(15)
o Automatic Stabilizer: Any mechanism in the
economy that automatically reduces the amount
by which output changes in response to a change
in autonomous spending.
o Discretionary Fiscal Policy : When the
government changes a variable under its control
(e.g., government spending) in response to a
change in the economy.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
Y  A1  c1t Y
Slide 13
Fiscal Policy in the Very Short Run
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(16)
(17)
Chapter 10: Income and Spending
1
Y 
G   G G
1 c1 t 
1
G 
1 c1 t 
Slide 14
Fiscal Policy in the Very Short Run
Aggregate demand
Figure 10-3: Endogenous Taxes and Aggregate Demand
AD  A0  cY

A1
A0
AD’ has a higher
intercept but a
flatter slope.

AD'  A1  c1t Y
The slope is
smaller because
the marginal
propensity to
consume out of
total income is
now c(1 -t), which
is smaller than c.
The intercept is
larger because
the term cTA is
no longer in the
intercept.
Y
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Slide 15
Fiscal Policy in the Very Short Run
Figure 10-4: The Effects of an increase in government purchases
Aggregate demand
AD  Y
E’



A '1

E
A1
Y0
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Y1
AD'  A '1 c1t Y
AD  A1  c1t Y
G
The increase in
government
spending shifts
the AD curve up
and income rises.
Y
Slide 16
The Government Budget in the Very Short Run
BS  TA G TR
TA  tY
BS  tY G TR
Copyright 2005 © McGraw-Hill Ryerson Ltd.
(18)
Chapter 10: Income and Spending
o Budget Surplus: The excess of the government’s
revenues, taxes, over its total expenditures,
consisting of purchases of goods and services
and transfer payments.
o Budget Deficit: An excess of expenditures over
revenues.
(19)
Slide 17
The Government Budget in the Very Short Run
Figure 10-5: The Budget Surplus
Budget surplus
BS  tY G TR
The higher the level
of income, the
higher are tax
receipts and the
higher the budget
surplus.

0
G T R 
Income, Output
Y
The lower the level
of income, the
lower are tax
receipts and the
higher the budget
deficit.
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Slide 18
The Government Budget in the Very Short Run
BS  TA  G
  G G  G
 t

 
1G
1 c1 t  
1 c1 t 


G
1 c1 t 
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
How do changes in fiscal policy affect the
budget? OR Does an increase in government
purchases reduce the budget surplus?
(20)
Slide 19
The Government Budget in the Very Short Run
BS*  tY *G TR
(21)
BS * BS  t Y * Y 
(22)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
o Balanced Budget Multiplier: Increase in
output that results from equal increases in
taxes and government purchases.
o Full Employment Budget Surplus: The
budget surplus at the full employment
level of income or at potential output.
Slide 20
The Government Budget in the Very Short Run
Figure 10-6: Actual and Cyclical Adjusted Budget Deficit, 1970-2002
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Slide 21
The Foreign Sector
AD  C  I G  NX
NX  X  Q
Q  Q  mY
(23)
o Marginal Propensity to Import: The
increase in the demand for imports that
results from a one-unit increase in
domestic import.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
o Taking foreign trade into account….
Slide 22
The Foreign Sector
Y  C  cT R  I G  X Q  c1t  mY
Y  A2  c1t  mY
In equilibrium…..
1
Y0 
A2
1 c1 t  m
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Chapter 10: Income and Spending
Y  C  cT R  c1t Y  I G  X Q  mY
(24)
Slide 23
Chapter Summary
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
• Output is at its equilibrium when the aggregate
demand for goods is equal to the level of
output.
• Aggregate demand consists of planned
spending by households on consumption, by
firms on investment goods, and by
government on its purchases of goods and
services and also includes net exports.
• When output is at its equilibrium level, there
are no unintended changes in inventories and
all economic units are making precisely the
purchases they had planned to make.
Slide 24
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 10: Income and Spending
• The level of aggregate demand is itself affected
by the level of output (equal to the level of
income).
• The consumption function relates consumption
spending to income.
• The multiplier is the amount by which a $1.00
change in autonomous spending changes the
equilibrium level of output.
• Government purchases and and government
transfer payments act like increases in
autonomous spending I their effects on the
equilibrium level of income.
Slide 25
Chapter Summary (cont’d)
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Chapter 10: Income and Spending
• The budget surplus is the excess of government
receipts over expenditures.
• The actual budget surplus is also affected by
changes in tax collection and transfers resulting
from movements in the level of income that occur
because of changes in private autonomous
spending.
• When foreign trade is taken into account, exports
add to and imports subtract from autonomous
spending.
Slide 26
The End
Chapter 10: Income and Spending
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 27