582 PA R T V I I Monetary Theory demand Taxes, however, not affect aggregate demand directly, as government spending does Instead, taxes lower the amount of income that consumers have available for spending and affect aggregate demand by influencing consumer expenditure; that is, when there are taxes, disposable income YD does not equal aggregate output; it equals aggregate output Y minus taxes T: YD Y T The consumption function C a mpc YD can be rewritten as follows: C a mpc (Y T) a mpc Y mpc T (6) This consumption function looks similar to the one used in the absence of taxes, but mpc T on the right side This term indicates that if it has the additional term taxes increase by $100, consumer expenditure declines by mpc times this amount; if mpc 0.5, consumer expenditure declines by $50 This occurs because consumers view $100 of taxes as equivalent to a $100 reduction in income and reduce their expenditure by the marginal propensity to consume times this amount To see how the inclusion of government spending and taxes modifies our analysis, first we will observe the effect of a positive level of government spending on aggregate output in the Keynesian cross diagram of Figure 22-5 Let s say that in the absence of government spending or taxes, the economy is at point 1, where the aggreC I 500 0.5Y crosses the 45 line Y Y ad Here gate demand function Y ad equilibrium output is at $1000 billion Suppose, however, that the economy reaches full employment at an aggregate output level of $1800 billion How can government spending be used to restore the economy to full employment at $1800 billion of aggregate output? Aggregate Demand, Yad ($ billions) 1800 Y = Y ad ad Y2 = C + I + G = 900 + 0.5Y ad Y3 = C + I + G = 700 + 0.5Y 1600 1400 mpc T = 200 ad Y1 = C + I = 500 + 0.5Y 1200 G = 400 1000 900 800 700 600 500 400 200 200 FIGURE 22-5 600 1000 1400 1800 Y1 Y3 Y2 Aggregate Output, Y ($ billions) Response of Aggregate Output to Government Spending and Taxes With no government spending or taxes, the aggregate demand function is Y 1ad, and equilibrium output is Y1 1000 With government spending of $400 billion, the aggregate demand function shifts upward to Y 2ad, and aggregate output rises by $800 billion to Y2 $1800 billion Taxes of $400 billion lower consumer expenditure and the aggregate demand function by $200 billion from Y 2ad to Y 3ad, and aggregate output falls by $400 billion to Y3 $1400 billion