Chapter 7 Income and Spending Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Develop the Keynesian model of income determination Consider the role of consumption, savings and investment as determinants of aggregate demand Explain the concept of the multiplier Analyse the impact of the government sector on the multiplier process Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.1 AD and Equilibrium Output Aggregate demand The total amount of goods demanded in the economy The AD function represents demand in the four sectors of the economy. AD = C + I + G + NX (7.1) The AD function AD consists of autonomous spending as well as induced spending. Autonomous spending is independent of income. Induced spending changes as income changes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

AD and Equilibrium Output Equilibrium output is when the quantity of output supplied is equal to the quantity demanded: Y = AD = C + I + G + NX (7.2) When AD is not equal to output there are unplanned changes in inventories: IU = Y – AD (7.3) IU > 0 (unplanned inventory accumulation) IU < 0 (unplanned inventory run down) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.2 The Consumption Function and AD The consumption function describes the relationship between consumption, C and income, Y: The intercept represents the autonomous consumption, which is independent of Y c is the marginal propensity to consume (mpc). This is the increase in consumption per one unit increase in income. (7.4) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Consumption Function and Savings Consumption and saving Income must either be spent or saved. Hence, the savings function is (7.6) Equation (7.6) shows that savings is a positive function of the level of income The marginal propensity to save (s) is 1 – c Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Consumption, AD and Autonomous Spending We now refine our model of aggregate demand further to include the other sectors of the economy. We now add investment (I), government spending (G), transfers (TR), taxes (TA) and the overseas sector (NX). For the moment, each of the components is assumed to be autonomous. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Consumption, AD and Autonomous Spending The addition of the government sector includes taxes and transfer payments. Taxes and transfer payments impact on income and through this consumption. Consumption now depends on disposable income: _ _ _ C = C + c(Y – TA+TR) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Equilibrium Income and Output Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Equilibrium Income and Output From Figure 7.2, the 45° line shows points at which AD and output are equal. Only at E does AD equal output. At any income below Yo firms find: AD exceeds output and inventories are declining Therefore, they increase production. Conversely, for output above Yo firms find: Inventories piling up and therefore they cut production. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Formula for Equilibrium Output The equilibrium condition (7.10) is: (7.10) The position of the AD curve is characterised by its: Slope (marginal propensity to consume) c Intercept (autonomous spending). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.3 The Multiplier The multiplier is the amount by which equilibrium income changes when autonomous AD increases by 1 unit. How much will income increase by if we increase autonomous spending by $1? Initially, output would increase by $1 to match the increase. The increase in income Y would, in turn, induce further spending. This increased spending further increases income and output, inducing more spending. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Multiplier The closed economy, no government sector multiplier is: (7.15) The size of the multiplier depends on the size of the mpc, c. The larger the mpc, the larger the multiplier. That is, the larger the induced increase in spending in each round. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Multiplier The multiplier helps us to understand economic fluctuations. It shows how income and output change by a greater proportion than the original change in autonomous spending. A graphical representation of the multiplier is given in Figure 7.3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Multiplier Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.4 The Government Sector Governments affect equilibrium income in two separate ways: First, through government purchases of goods and services (G) Second, taxes (TA) and transfers (TR) affect the disposable income of households. Assume government spending (G) and transfer payments (TR) are autonomous. Taxes (TA) are induced because of a proportional income tax (TA = tY). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Government Sector (7.17) The new consumption function shows: Transfers raise autonomous consumption by the mpc out of disposable income, times the amount of transfers Income taxes lower disposable income and consumption at each level of income The marginal propensity to consume out of income is now c(1 – t). (7.17) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Government Sector AD with the government sector is now: Graphically, the introduction of the government sector can be seen in Figure 7.4. (7.18) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Government Sector Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Government Sector The effects of the government sector are: The new AD curve has a higher intercept due to greater autonomous spending The AD curve has a flatter slope because households pay taxes leaving (1– t) of income. The equilibrium condition is Y = AD (7.19) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Government Sector The multiplier becomes: (7.21) The size of the multiplier has decreased because of the increased tax leakage (1– t). (7.21) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Income Taxes as Automatic Stabilisers An automatic stabiliser reduces the change in output caused by shocks. An example is proportional income taxes which reduce the size of the multiplier. Unemployment benefits are also automatic stabilisers. AD falls less when someone becomes unemployed and receives benefits. This makes output more stable. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Effects of a Change in Fiscal Policy An increase in government purchases: Increases autonomous spending Shifts the AD curve up At initial output, demand exceeds output and firms increase production. How much does equilibrium Y increase by? Depends on the size of the multiplier which is a function of taxes Higher taxes means a smaller multiplier and income increases by a smaller amount. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.5 The Budget The budget surplus is the excess of the government’s revenues over its total expenditures. A negative budget surplus: Is an excess of expenditures over revenues This is called a budget deficit. (7.22) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Budget Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Budget At low levels of income, the budget is in deficit Because government expenditure exceeds income tax collection. At high levels of income, the budget is in surplus Because income tax collection exceeds government expenditure. The budget therefore depends not only on policy choices but also on the level of income. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 7.1 Aggregate Demand and Equilibrium Output 7.2 The Consumption Function and Aggregate Demand 7.3 The Multiplier 7.4 The Government Sector 7.5 The Budget 7.6 The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

7.6 The Full-Employment Budget Surplus The budget surplus (deficit) is flawed as a measure of the direction of fiscal policy. The budget position is influenced by both a discretionary and a cyclical component. So, an increase in the budget deficit (surplus) does not necessarily imply a change in fiscal policy. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Full-Employment Budget Surplus The full-employment budget surplus is used to measure the policy stance independent of the business cycle. The full-employment budget surplus measures the surplus at the full-employment level of income. It is given as: BS* – BS = (Y* – Y) (7.25) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Full-Employment Budget Surplus The FEBS measures the difference between actual and full-employment budgets: If Y is above (below) full-employment Y*, the full-employment surplus BS* is less than (exceeds) the actual surplus BS. The difference between BS* and BS is the cyclical component of the budget. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Full-Employment Budget Surplus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.