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Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 0 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 cT 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 Copyright 2005 © McGraw-Hill Ryerson Ltd. 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 cC cT R T A cY E A0 The vertical distance between AD and C is given by I + G + NX C cT R T A Y0 Copyright 2005 © McGraw-Hill Ryerson Ltd. 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 cA c A c A ... 2 3 (8) A 1 c c c ... 2 3 o For c < 1… AD 1 1 cA 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 cA c 2A 3 c A … … A cA c 2A c 3A A 1 cA 2 1 c c A 2 3 1 c c c A Copyright 2005 © McGraw-Hill Ryerson Ltd. … … … 1 1 cA Slide 10 Fiscal Policy in the Very Short Run TA tY C C cYD C cY T R tY C cT R c1t 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… Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 11 Fiscal Policy in the Very Short Run C cYD I G NX C cY T R tY I G NX C cT R I G NX c1t Y A1 c1t 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 c1 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 c1t 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 c1 t 1 G 1 c1 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 c1t 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 Copyright 2005 © McGraw-Hill Ryerson Ltd. 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 c1t Y AD A1 c1t 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. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 18 The Government Budget in the Very Short Run BS TA G G G G t 1G 1 c1 t 1 c1 t G 1 c1 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 Copyright 2005 © McGraw-Hill Ryerson Ltd. 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 c1t mY Y A2 c1t mY In equilibrium….. 1 Y0 A2 1 c1 t m Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 10: Income and Spending Y C cT R c1t 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) Copyright 2005 © McGraw-Hill Ryerson Ltd. 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