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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 SI The multiplier The adjustment process: Initial increase in autonomous spending: A Output increase: Secondary A increase in induced spending: cA Output increase: cA 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 Y0t 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. *