Download Document

Chapter 3 Income
and Spending
Aggregate demand and equilibrium
output

The accounting identity:
 Y=C+I+G+NX;
 All

variables represent actual quantities.
The aggregate demand:
 AD=C+I+G+NX;
 All

variables represent desired quantities.
What if they mismatch?
 AD>Y:
unintended inventory reduction;
 AD<Y: unplanned additions to inventory.
Aggregate demand and equilibrium
output

Unplanned additions to inventory:
 IU=Y-AD;
 IU>0:
Firms respond by reducing output;
 IU<0: Firms respond by increasing output.

Goods market equilibrium:
 Y=AD;
 Unintended
changes to inventory is zero at
equilibrium;
 Output is determined by aggregate demand.
Aggregate demand and equilibrium
output

Equilibrium with constant aggregate demand.
The consumption function and
aggregate demand

Assuming two-sector economy:
 Y=C+I;
 YD=Y.

The Keynesian consumption function:
C  C  cY
 c:
C  0 0  c 1
marginal propensity to consume;
 Should use disposable personal income generally;
 All variables are in real terms.
The consumption function and
aggregate demand

Empirical consumption function.
DPI: Disposable Personal Income
PCE: Personal Consumption Expenditures
U.S., 1960.Q1 to 2001.Q3: Federal Reserve Economic Data
The consumption function and
aggregate demand

Empirical consumption function.
Regression line: PCE = - 71.23 + 0.93 DPI
The consumption function and
aggregate demand

Consumption and saving:
 S=Y-C;
saving function: S  C  (1  c)Y
 1-c: marginal propensity to save.
 The

Planned investment and aggregate demand:
 Assume
for now that planned investment is
constant;
AD  C  I  C  I  cY  A  cY
The consumption function and
aggregate demand

Equilibrium income and output.
Y  AD  A  cY
1
Y0 
A
1 c
The consumption function and
aggregate demand

Saving and investment:
Y  C  AD  C
SI
The multiplier

The adjustment process:
 Initial

increase in autonomous spending: A
Output increase:
 Secondary

A
increase in induced spending: cA
Output increase: cA
 Tertiary
increase in induced spending: c 2 A
2
c
A
 Output increase:
 
 Total
increase in output:
Y0  A(1  c  c 
2
1
)
A
1 c
The multiplier

The adjustment process.
The government sector

Assuming constant government expenditures
and proportional tax:
G  G TR  TR TA  tY

The consumption function:
C  C  cYD  C  c(Y  TR  TA)

The aggregate demand:
AD  C  I  G  C  c(Y  TR  tY )  I  G
 (C  cTR  I  G)  c(1  t )Y
 A  c(1  t )Y
The government sector

Equilibrium income:
Y  AD  A  c(1  t )Y
A
C  cTR  I  G
Y0 

1  c(1  t )
1  c(1  t )

Income taxes as automatic stabilizers:
 The
presence of income taxes lowers the multiplier;
 Fluctuations in output is usually caused by shifts in
autonomous spending;
 A smaller multiplier reduces fluctuations in output.
The government sector

Effects of a change in government purchases.
1
Y0 
G   G G
1  c(1  t )
The government sector

Effects of an income tax change
t   t  G  G Y0  Y0
The government sector

Effects of increased transfer payments:
 An
increase in transfer payments increases
autonomous spending and output;
 The multiplier of transfer payments is smaller than
that of government purchase.
The budget
The budget surplus depends on income:
BS  TA  G  TR  tY  G  TR
 The effects of government purchases and tax
changes on the budget surplus:

 An
increase in government purchase reduces
budget surplus;
BS  TA  G  t G G  G  
 An
(1  c)(1  t )
G
1  c(1  t )
increase in tax rate increases budget surplus.
BS  TA  t Y  tY0 
1 c
Y0t
1  c(1  t )
The full-employment budget surplus
Budget surplus can be used to measure the
nature of fiscal policy;
 Actual budget surplus hinges on actual income;
 Full employment surplus:

 Budget
surplus at the full-employment level of
income; BS *  tY *  G  TR
BS  BS  t (Y  Y )
*
 The
cyclical component of budget: BS*-BS
Recession: surplus;
 Booms: deficit.

*