CHAPTER 22 The ISLM Model 583 If government spending is set at $400 billion, the aggregate demand function shifts upward to Y ad C I G 900 0.5Y The economy moves to point 2, and aggregate output rises by $800 billion to $1800 billion Figure 22-5 indicates that aggregate output is positively related to government spending and that a change in government spending leads to a multiplied change in aggregate output, equal to the expenditure multiplier, 1/(1 mpc) 1/(1 0.5) Therefore, declines in planned investment spending that produce high unemployment (as occurred during the Great Depression) can be offset by raising government spending What happens if the government decides that it must collect taxes of $400 billion to balance the budget? Before taxes are raised, the economy is in equilibrium at the same point found in Figure 22-5 Our discussion of the consumption function (which allows for taxes) indicates that taxes T reduce consumer expenditure by mpc T because there is T less income now available for spending In our example, mpc 0.5, so consumer expenditure and the aggregate demand function shift downward by $200 billion ( 0.5 400); at the new equilibrium, point 3, the level of output has declined by twice this amount (the expenditure multiplier) to $1400 billion Although you can see that aggregate output is negatively related to the level of taxes, it is important to recognize that the change in aggregate output from the $400 billion) is smaller than the change in aggre$400 billion increase in taxes ( Y gate output from the $400 billion increase in government spending ( Y $800 billion) If both taxes and government spending are raised equally, by $400 billion, as occurs in going from point to point in Figure 22-5, aggregate output will rise The Keynesian framework indicates that the government can play an important role in determining aggregate output by changing the level of government spending or taxes If the economy enters a deep recession, in which output drops severely and unemployment climbs, the analysis we have just developed provides a prescription for restoring the economy to health The government might raise aggregate output by increasing government spending, or it could lower taxes and reverse the process described in Figure 22-5 (that is, a tax cut makes more income available for spending at any level of output, shifting the aggregate demand function upward and causing the equilibrium level of output to rise) Role of International Trade International trade also plays a role in determining aggregate output because net exports (exports minus imports) are a component of aggregate demand To analyze the effect of net exports in the Keynesian cross diagram of Figure 22-6, suppose that initially net exports are equal to zero (NX1 0) so that the economy is at point 1, where the aggregate demand function Y 1ad C I G NX1 500 0.5Y crosses the 45 line Y Y 1ad Equilibrium output is again at $1000 billion Now foreigners suddenly get an urge to buy more Canadian products so that net exports rise to $100 billion (NX2 100) The $100 billion increase in net exports adds directly to aggregate demand and shifts the aggregate demand function upward to Y 2ad C I G NX2 600 0.5Y The economy moves to point 2, and aggregate output rises by $200 billion to $1200 billion (Y2) Figure 22-6 indicates that just as we found for planned investment spending and government spending, a rise in net exports leads to a multiplied rise in aggregate output, equal to the expenditure multiplier, 1/(1 mpc) 1/(1 0.5) Therefore, changes in net exports can be another important factor affecting fluctuations in aggregate output