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: 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 = DPI

The consumption function and aggregate demand Consumption and saving:  S=Y-C;  The saving function:  1-c: marginal propensity to save. Planned investment and aggregate demand:  Assume for now that planned investment is constant;

The consumption function and aggregate demand Equilibrium income and output.

The consumption function and aggregate demand Saving and investment:

The multiplier The adjustment process:  Initial increase in autonomous spending: Output increase:  Secondary increase in induced spending: Output increase:  Tertiary increase in induced spending: Output increase:    Total increase in output:

The multiplier The adjustment process.

The government sector Assuming constant government expenditures and proportional tax: The consumption function: The aggregate demand:

The government sector Equilibrium income: 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.

The government sector Effects of an income tax change

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: The effects of government purchases and tax changes on the budget surplus:  An increase in government purchase reduces budget surplus;  An increase in tax rate increases budget surplus.

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;  The cyclical component of budget: BS*-BS Recession: surplus; Booms: deficit.