Topic 3: Fiscal Policy Circular Flow Keynesian Economics Taxes and Government Spending 1.

Topic 3: Fiscal PolicyCircular FlowKeynesian EconomicsTaxes and Government Spending

1

Economic Output Equation

Y = GDP = C + I + G + X – M

Y = National IncomeC = ConsumptionI = InvestmentG = Government SpendingX – M = Net Exports

2

Focus on National Income

Y = C + I + G + X – M

In “equilibrium” total national expenditures equal total national income. Both are measures of “Output”

3

Focus on National Income

Y = C + I + G

For now, we will also assume that net exports are zero. This is the case when X = M, or if the economy is closed (i.e., it doesn’t trade with others)

We will allow for trade later in the course

4

Let’s go through these one at a time

5

Y = C + I + G

What is consumption?

6

The amount people (e.g., households) spend on newly produced goods and services

CarsBooksAccountantsFoodClothesBeerPetsTuitionNannyGarbage bagsEverything

How much do people consume?

7

Depends on people’s income

C is increasing in “disposable” (after-tax) income

Represent this using an equation. For example:

C = 100 + 0.9 ( Y – Tx )

(This means that people consume 100, plus 90% of disposable income)

Consumption EquationA general form of the equation:

C = Cmin + MPC ( Y – Tx )

Cmin = spending even when there is no income (must eat to survive)

mpc = “Marginal Propensity to Consume”Y – Tx = disposable income (Tx is taxes and Y

is income)

8

Marginal Propensity to Consume

C = Cmin + MPC ( Y – Tx )

Income can be spent on consumption, saved, or used to pay taxes.

MPC is the portion of disposable income that households spend on consumption

1 – MPC is therefore the portion of disposable income households save. It is called the “marginal propensity to save”

9

Consumption FunctionsIf households always spend $750, plus 80%

of their disposable income, then

C = 750 + 0.8 ( Y – Tx )

If households always spend $1000, plus 75% of their disposable income, then

C = 1000 + 0.75 ( Y – Tx )

10

What is Investment?

11

Spending by investors (whom may be businesses, financial institutions, governments or households) on:

What is Investment?

12

1. Plant & Equipment

What is Investment?

13

2. New Residential Construction

What is Investment?

14

3. Inventories

Inventories

15

Intermediate goods to be used in future production

Final good not yet sold

Inventories are important:If people buy too little: companies are

overproducing, inventories will rise, then firms slow down production

If people buy too much: companies don’t produce enough, inventories fall, then firms increase production

What is Investment?

16

Spending by investors (whom may be businesses, financial institutions, governments or households) on:

1. Plant & Equipment2. New Residential Construction3. Inventories

Calculating Output

17

Y = C + I + GC = Cmin+ MPC ( Y – Tx)

Y = [Cmin+ MPC ( Y – Tx)] + I + G

Solving for Equilibrium YSuppose C = 100 + 0.75 (Y-Tx) I = 1000G = Tx = 500 (i.e., there is a balanced budget)

What is National Income? Y = 4900

18

Solving for Equilibrium YNow, consumers become more optimistic

about future income, and in response, they spend an extra 5% of their disposable income. Therefore, MPC goes from 0.75 to 0.8.


19

Solving for Equilibrium YAssume again that MPC = 0.8. Now the government increases spending

by 200 (G increases to 700) while keeping taxes unchanged at 500.


Illustrate this change on the circular flow diagram

20

Solving for Equilibrium YAssume again that MPC = 0.8. G = 700Now the government cuts taxes by 200

from 500 to 300.



21

Solving for Equilibrium YNow, MPC = 0.8, G = 700, Tx = 300. Investment increases from 1000 to 1200



22

What have we shown?

23

National Income increases when:MPC increasesGovernment spending increasesTaxes decreaseInvestment increases

Converse is also true

24

National Income decreases when:MPC decreasesGovernment spending decreases Taxes increaseInvestment decreases

Keynesian Multipliers

25

Tell us how much Y changes given a change in I, or G, or Tx

Technically, they equal to:

(But, you if you are not comfortable with calculus, don’t worry about these expressions)

€

∂Y∂I

€

∂Y∂G

€

∂Y∂Tx

Calculating Keynesian Multipliers

26

€

Y =Cmin +MPC(Y −Tx) + I +G

€

Y −Y × MPC =Cmin −MPC × Tx + I +G

€

Y (1−MPC) =Cmin −MPC × Tx + I +G

€

Y =1

(1−MPC)Cmin −

MPC

(1−MPC)Tx +

1

(1−MPC)I +

1

(1−MPC)G


27

For Investment

For Government Spending

For Taxes

€

1

1−MPC

€

1

1−MPC

€

−MPC

1−MPC


28

€

ΔY = ΔI1

1−MPC

€

ΔY = ΔG1

1−MPC

€

ΔY = ΔTx−MPC

1−MPC

Example

29

If the MPC is 0.8, and G increases by 200:

Then Y increases by:€

1

1−MPC=

1

1−0.8=1

0.2=10

2= 5

€

ΔY = ΔG1

1−MPC= 200 × 5 =1000

Example

30

If the MPC is 0.8, and Tx decreases by 200:

Then Y increases by:€

−MPC1−MPC

= −0.8

1−0.8= −0.8

0.2= −8

2= −4

€

ΔY = ΔTx−MPC

1−MPC= −200 × (−4) = 800

Using Fiscal Policy

31

Fiscal policy: government’s attempt to influence national income by adjusting government spending and taxation

G and Tx are determined by government (congress)

Fiscal policy provides tools for the government to “slow down” or “speed up” the economy

Using Expansionary Fiscal Policy

32

Expansionary Fiscal Policy Policy designed to “speed up” the economy,

encourage more outputIncreasing G Decreasing Tx

Expansionary policy increases YIf there are unemployed/underutilized resources

in the economy, then these resources can be used to increase production… unemployment decreases

If the economy is near full employment, then there is no unemployment to decrease… get inflation

Using Contractionary Fiscal Policy

33

Contractionary Fiscal Policy Policy designed to “slow down” the economyDecreasing G Increasing Tx

Contractionary policy decreases YSlowing down the economy can decrease

inflationBut, it also will increase the unemployment

Full Employment Level of Income

34

At the “full employment” level of national income, the economy is at full employment, and there isn’t too much inflation

If national income exceeds the full employment level, there is too much inflation

If national income is below the full employment level, there is too much unemployment

Fiscal Policy Example 1Suppose C = 100 + 0.75 (Y-Tx) I = 400G = Tx = 200


35

Fiscal Policy Example 1If the full employment level of

National Income is 2600, then is expansionary or contractionary policy appropriate?

If the government wants to achieve the full employment level by increasing government spending, then by how much must G increase?

36

Fiscal Policy Example 1If the government wants to

achieve the full employment level of 2600 by decreasing taxes, then by how much must Tx decrease?

If the government cuts taxes by more than this amount, then what happens to inflation?

37

Fiscal Policy Example 2Suppose C = 200 + 0.5 (Y-Tx) I = 500G = Tx = 300


38

Fiscal Policy Example 2If the economy is currently

experiences high inflation and low unemployment, then is expansionary or contractionary policy appropriate?

The government wants to use fiscal policy to achieve the full employment income of 1500 without changing taxes. What should it do?

39

Fiscal Policy Example 2The government wants to use fiscal

policy to achieve the full employment income of 1500 without changing government spending. What should it do?

The government wants to use fiscal policy to achieve the full employment income of 1500 while maintaining a balanced budget. What should it do?

40

Topic 3: Fiscal Policy Circular Flow Keynesian Economics Taxes and Government Spending 1.

Documents

Transcript of Topic 3: Fiscal Policy Circular Flow Keynesian Economics Taxes and Government Spending 1.