Topic 3: Fiscal PolicyCircular FlowInvestmentTaxes and Government Spending

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AE (with no Govt)

AE = C + I

AE = Planned Aggregate ExpenditureC = ConsumptionI = Investment

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In equilibrium (with no Govt)Y = AE = C + I

Y = National Income or Aggregate OutputIn equilibrium, output equals planned expenditures

Why?If people buy too little: companies are overproducing,

inventories will rise, then firms slow down productionIf people buy too much: companies don’t produce

enough, inventories fall, then firms increase production

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Types of Investment

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1. 2. 3.

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

e.g., end of 2008

What is consumption?C usually depends on income Y

C = minC+ mpc * Y

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

mpc = how much each additional dollar of income increases consumption. mpc = “Marginal Propensity to Consume”

mpc = 1-mps, where mps = “marginal propensity to save”

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Solving for Equilibrium YSuppose C = 100 + 0.8 Y and I = 1000.

What is the equilibrium level of output (income)?

What happens when consumers become pessimistic and spend less of their income? Suppose the mpc falls to 0.75. What is the new equilibrium output?

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Solving for Equilibrium YStarting with C = 100 + 0.8 Y and I =

1000.

Now, suppose firms decrease investment by 200. What is the new equilibrium output?

ΔY = Δ I [ 1 / (1- mpc) ]Illustrate this change using circular flow.Initial impact versus long run impact on Y

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AE with Government

AE = C + I + G

AE = Planned Aggregate ExpenditureC = ConsumptionI = InvestmentG = Government Spending

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In equilibriumY = AE = C + I + G

Y = National Income or Aggregate OutputIn equilibrium, output equals planned expenditures

Why?If people buy too little: companies are overproducing,

inventories will rise, then firms slow down productionIf people buy too much: companies don’t produce

enough, inventories fall, then firms increase production

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What is consumption?C now can depend on income and taxes

C = minC + mpc ( Y – Tx)

Y – Tx is “Disposable Income” or income after taxes

In Equilibrium:

Y = AE = minC+ mpc ( Y - Tx) + I + G

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Solving for Equilibrium YSuppose C = 100 + 0.8 Y , I = 1000, G =

500 = Tx.What is the equilibrium level of output?

Suppose that the government increases spending by 200, but does not change taxes. Illustrate this increase in spending using

circular flowWhat is the new equilibrium output?

ΔY = Δ G [ 1/ (1- mpc) ]

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Solving for Equilibrium YStart with C = 100 + 0.8 Y , I = 1000, G = 500

= Tx.

Suppose the government decreases taxes by 200. Illustrate this change using circular flow.What is the new equilibrium output?

ΔY = Δ I [ - mpc / (1- mpc) ]

Suppose investment increases by 100. Illustrate this change using circular flow.What is the new equilibrium output?

ΔY = Δ I [ 1 / (1- mpc) ]

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Keynesian Multipliers

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Tells us how much changes in G, Tx, and I influence output

G: [1/ (1-mpc)]I: [1 / (1-mpc)]Tx: [-mpc / (1-mpc)]

Solve a problem without any numbers plugged in…

The role of inventoriesInitial increase in I or G causes inventories

to initially fallPlanned inventories are greater than actual

inventoriesFirms produce more, which causes Y to

increaseThe increase in Y results in an increase in CThe increase in C causes inventories to

again fall below planned level (but not as much as before), which causes the process to repeat

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Other Examples and Problems

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