Aggregate Expenditure, Equilibrium GDP and The Fiscal policy

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Aggregate Expenditure, Equilibrium GDP and The
Fiscal policy
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The Simple Economy Case

• We assume here that we have a simple economy
  where G 0 ( no government effect on the
  economy) and X 0, M 0, and hence X-M 0 (no
  foreign trade).
• In such a case the national spending becomes C
  I.
• Let us start with the consumption spending
  (expenditure)

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Consumer Spending and Income

• The relationship between the level of income and
  consumption spending is called the consumption
  function

C Ca by
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Consumer Spending and Income
C Ca by

• Ca autonomous consumption, or the amount of
  consumption spending that does not depend on the
  level of income.

• by the part of consumption that is dependent on
  income, where

• b marginal propensity to consume (MPC), or the
  fraction of additional income that is spent.

• y level of income in the economy.

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The Consumption Function

• The consumption function relates desired consumer
  spending to the level of income.

• The consumption function intersects the vertical
  axis at Ca, the value of autonomous consumption.

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The Consumption Function

• When income equals zero, the value of total
  consumption (C) equals Ca. It corresponds to the
  amount of consumption that does not depend on the
  level of income.

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The Consumption Function

• The slope of the consumption function is the
  marginal propensity to consume (MPC), or the
  value of b in the linear equation.

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Consumer Spending and Income

• The fraction that the consumers spend on
  consumption is given by their MPC.

• The fraction that the consumer s save is
  determined by their marginal propensity to save
  (MPS).

• The sum of the marginal propensity to consume and
  the marginal propensity to save is always equal
  to one. MPC MPS 1.

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Changes in the Consumption Function

• The consumption function can change for two
  reasons

• A change in autonomous consumption.

• A change in the marginal propensity to consume.

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Changes in the Consumption Function

• Factors that cause autonomous consumption to
  change are

• Consumer wealth, or the value of stocks, bonds,
  and consumer durables held by the public (i.e.
  the consumers). More wealth gt higher
  consumption spending.

• Consumer confidence. More confidence gt higher
  consumption spending.

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Changes in the Consumption Function

• An increase in autonomous consumption from C0a to
  C1a shifts up the entire consumption function.

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Changes in the Consumption Function

• An increase in the MPC from b to b increases the
  slope of the consumption function.

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Changes in the Consumption Function

• The consumption function is determined by the
  level of autonomous consumption and by the MPC.

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Changes in the Consumption Function

• Factors that cause the marginal propensity to
  consume to change are

• Perception of changes in income. Studies show
  that consumers tend to save a higher proportion
  of a temporary increase in income, and spend a
  higher proportion if the increase is perceived to
  be permanent.

• Changes in taxes.

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Determining GDP

• GDP is determined where the C I line intersects
  the 45 line.

• At that level of output, y, desired spending
  equals output.

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Savings and Investment

• Savings equals output minus consumption.

• Output is determined by demand, C I, or

• Subtracting consumption from both sides of the
  equation results in

• The left side shows that y C equals savings, S,
  therefore

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Savings and Investment

• Equilibrium output is determined at the level of
  income where savings equals investment

• The level of savings in the economy is not fixed,
  and how it changes depends on the real GDP.

• The savings function is the relationship between
  the level of income and the level of savings.

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The Multiplier

• The multiplier is the ratio of the change in
  equilibrium output to the change in spending. It
  measures the degree to which changes in spending
  are multiplied into changes in output.

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The Multiplier

• An increase in investment shifts the C I line
  upward.

• When investment increases by ?I from I0 to I1,
  equilibrium output rises by ? y from y0 to y1.

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The Multiplier

• The change in equilibrium output (?y) is greater
  than the change in investment (?I).
• The value of the multiplier 1/(1-b)
• 1/(1-b) gt 1. Why?

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The Multiplier in Action (if b 0.8)
Round of Spending Increase in CI Increase in GDP and Income Increase in Consumption
1 10 10 8
2 8 8 6.4
3 6.4 6.4 5.12
4 5.12 5.12 4.096
5 4.096 4.096 3.277

Total 50 million 50 million 40 million
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The Multiplier in Action (if b 0.8)

• In this numerical example notice that
• The value of the multiplier 1 / (1-b)
• 1
  / (1-0.8)
• 1
  / 0.2
• 5
• And ? y ? I the multiplier
• 10 5
• 50

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The Multiplier in Action

• In general
• The final change in equilibrium output or income
  the initial change in spending
• the multiplier.
• The change could be an increase or a decrease.
• The source of the change in spending could be
  from consumption or investment or any other
  source of expenditure.

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The Fiscal Policy

• More realistically, we should include in our
  model the two other items of spending
  (expenditure) that we assumed out before.
• Therefore, AE C I G (X M)
• AE will change when one or more of its components
  (on the right hand side) change.
• An intentional government action to change AE is
  called government economic policy or
  government policy for short.

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The Fiscal Policy

• The fiscal policy refers to one type of the
  government policy actions to change the level of
  GDP through changing the government expenditure
  or taxes.
• Recall that AE C I G (X M), and
  therefore if the government changes its
  expenditure while all other things remain
  constant we will have
• ? AE ? G.
• Increasing (decreasing) G by 1 billion SR leads
  to an equal increase (decrease) in AE.

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The Fiscal Policy

• If the government knows that the value of
  expenditure multiplier 5 and it increases its
  expenditure by 1 billion SR, it should expect an
  increase in GDP by 5 billion SR. We refer here to
  the formula on slide no. 24 before.
• If reducing taxes leads to an increase in C by 1
  billion SR, we expect the same effect.
• Notice that the final increase in GDP will take
  some time to appear. This time length varies
  from one economy to another.

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Test yourself

1. Why do we say MPC MPS 1? Is it possible to be
   greater than 1? Why or why not?
2. If MPC 0.75 and the government raised G by 40
   million SR, what do you expect to happen to GDP?
3. Give a definition of MPC, MPS and the multiplier.
4. The value of the expenditure multiplier can not
   be less than 1. Why is this true?
5. If MPC 0.8 and we need GDP to increase by 10
   billion SR, what can the fiscal policy do in
   order to achieve this goal?