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Topic 3: Fiscal Policy. Circular Flow Keynesian Economics Taxes and Government Spending. Economic Output Equation. Y = GDP = C + I + G + X – M Y = National Income C = Consumption I = Investment G = Government Spending X – M = Net Exports. Focus on National Income.

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topic 3 fiscal policy
Topic 3: Fiscal Policy

Circular Flow

Keynesian Economics

Taxes and Government Spending

economic output equation
Economic Output Equation

Y = GDP = C + I + G + X – M

  • Y = National Income
  • C = Consumption
  • I = Investment
  • G = Government Spending
  • X – M = Net Exports
focus on national income
Focus on National Income

Y = C + I + G + X – M

  • In “equilibrium” total national expenditures equal total national income. Both are measures of “Output”
focus on national income1
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
what is consumption
What is consumption?
  • The amount people (e.g., households) spend on newly produced goods and services
      • Cars
      • Books
      • Accountants
      • Food
      • Clothes
      • Beer
      • Pets
      • Tuition
      • Nanny
      • Garbage bags
      • Everything
how much do people consume
How much do people consume?
  • 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 equation
Consumption Equation
  • A 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)
marginal propensity to consume
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”
consumption functions
Consumption Functions
  • If 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 )

what is investment
What is Investment?

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

what is investment1
What is Investment?
  • Plant & Equipment
what is investment2
What is Investment?
  • New Residential Construction
inventories
Inventories
  • 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 investment4
What is Investment?

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

  • Plant & Equipment
  • New Residential Construction
  • Inventories
calculating output
Calculating Output

Y = C + I + G

C = Cmin+ MPC ( Y – Tx)

Y = [Cmin+ MPC ( Y – Tx)] + I + G

solving for equilibrium y
Solving for Equilibrium Y
  • Suppose
    • C = 100 + 0.75 (Y-Tx)
    • I = 1000
    • G = Tx = 500 (i.e., there is a balanced budget)
  • What is National Income?
    • Y = 4900
solving for equilibrium y1
Solving for Equilibrium Y
  • Now, 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.
  • What is National Income?
    • Y = 6000
solving for equilibrium y2
Solving for Equilibrium Y
  • Assume again that MPC = 0.8.
  • Now the government increases spending by 200 (G increases to 700) while keeping taxes unchanged at 500.
  • What is National Income?
    • Y = 7000
  • Illustrate this change on the circular flow diagram
solving for equilibrium y3
Solving for Equilibrium Y
  • Assume again that MPC = 0.8.
  • G = 700
  • Now the government cuts taxes by 200 from 500 to 300.
  • What is National Income?
    • Y = 7800
  • Illustrate this change on the circular flow diagram
solving for equilibrium y4
Solving for Equilibrium Y
  • Now, MPC = 0.8, G = 700, Tx = 300.
  • Investment increases from 1000 to 1200
  • What is National Income?
    • Y = 8800
  • Illustrate this change on the circular flow diagram
what have we shown
What have we shown?
  • National Income increases when:
    • MPC increases
    • Government spending increases
    • Taxes decrease
    • Investment increases
converse is also true
Converse is also true
  • National Income decreases when:
    • MPC decreases
    • Government spending decreases
    • Taxes increase
    • Investment decreases
keynesian multipliers
Keynesian Multipliers
  • 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)

keynesian multipliers1
Keynesian Multipliers
  • For Investment
  • For Government Spending
  • For Taxes
example
Example
  • If the MPC is 0.8, and G increases by 200:
  • Then Y increases by:
example1
Example
  • If the MPC is 0.8, and Tx decreases by 200:
  • Then Y increases by:
using fiscal policy
Using Fiscal Policy
  • 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
Using Expansionary Fiscal Policy

Expansionary Fiscal Policy

    • Policy designed to “speed up” the economy, encourage more output
    • Increasing G
    • Decreasing Tx
  • Expansionary policy increases Y
    • If 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
Using Contractionary Fiscal Policy

Contractionary Fiscal Policy

    • Policy designed to “slow down” the economy
    • Decreasing G
    • Increasing Tx
  • Contractionary policy decreases Y
    • Slowing down the economy can decrease inflation
    • But, it also will increase the unemployment
full employment level of income
Full Employment Level of Income
  • 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 1
Fiscal Policy Example 1
  • Suppose
    • C = 100 + 0.75 (Y-Tx)
    • I = 400
    • G = Tx = 200
  • What is National Income?
    • Y = 2200
fiscal policy example 11
Fiscal Policy Example 1
  • If 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?
fiscal policy example 12
Fiscal Policy Example 1
  • If 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?
fiscal policy example 2
Fiscal Policy Example 2
  • Suppose
    • C = 200 + 0.5 (Y-Tx)
    • I = 500
    • G = Tx = 300
  • What is National Income?
    • Y = 1700
fiscal policy example 21
Fiscal Policy Example 2
  • If 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?
fiscal policy example 22
Fiscal Policy Example 2
  • The 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?
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