37 fiscal policy Macroeconomic

Context 37 Aggregate Demand and Fiscal Policy • The previous chapter introduced the model of aggregate demand and aggregate supply • Long run • prices flexible • output determined by factors of production & technology • unemployment equals its natural rate • Short run • prices fixed • output determined by aggregate demand • unemployment is negatively related to output Bài gi ng c a TS Ph m Th Anh pham.theanh@yahoo.com Copyright © 2004 South-Western Copyright © 2004 South-Western Context The Keynesian Cross • A simple closed economy model in which income is determined by expenditure • This chapter develops the Keynesian Cross model, the theory that focus on the role of government in influencing output and employment (due to J.M Keynes) • Notation: • We focus on the short run and assume the price level is fixed I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure • Difference between actual & planned expenditure: unplanned inventory investment Copyright © 2004 South-Western Elements of the Keynesian Cross = Copyright © 2004 South-Western Graphing planned expenditure − = planned expenditure = = = − + + = = MPC income, output, Copyright © 2004 South-Western Copyright © 2004 South-Western Graphing the equilibrium condition The equilibrium value of income planned expenditure planned expenditure 45º income, output, income, output, Equilibrium income Copyright © 2004 South-Western Copyright © 2004 South-Western Solving for ∆Y An increase in government purchases = At , there is now an unplanned drop in inventory… ∆ + = ∆ = + +∆ ∆ +∆ + ∆ = ! "× ∆ ∆ " …so firms increase output, and income rises toward a new equilibrium % ∆ # − ! "$ ×∆ % + ∆ %∆ % ∆ ∆ & ∆ =∆ = −!" Copyright © 2004 South-Western The government purchases multiplier = = ∆ −!" − () ∆ = ì Copyright â 2004 South-Western The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G In this model, the G multiplier equals Example: MPC = 0.8 ∆ ! "∆ ( ∆ ∆ ∆ = '∆ The increase in G causes income to increase by times as much! Copyright © 2004 South-Western = −!" In the example with MPC = 0.8, ∆ ∆ = − (* ) = ' Copyright © 2004 South-Western Why the multiplier is greater than • Initially, the increase in G causes an equal increase in Y: ∆Y = ∆G • But ↑Y ↑C further ↑Y further ↑C further ↑Y • So the final impact on income is much bigger than the initial ∆G An increase in taxes Initially, the tax increase reduces consumption, and therefore E: ∆ At , there is now an unplanned inventory buildup… −! "∆ …so firms reduce output, and income falls toward a new equilibrium ∆ Copyright © 2004 South-Western Copyright © 2004 South-Western Solving for ∆Y ∆ = ∆ +∆ The Tax Multiplier def: the change in income resulting from a $1 increase in T : + % +∆ = ∆ = ! "× ( ∆ , & ∆ −∆ ∆ ∆ ) # − ! "$ ×∆ ∆ = = − ! "× ∆ −!" ×∆ −!" = −! " −!" If MPC = 0.8, then the tax multiplier equals ∆ ∆ = − () − () = = −− () ( Copyright © 2004 South-Western The Tax Multiplier Copyright © 2004 South-Western The Tax Multiplier …is negative: A tax hike reduces consumer spending, which reduces income …is greater than one (in absolute value): A change in taxes has a multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G Copyright © 2004 South-Western …is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income …is greater than one (in absolute value): A change in taxes has a multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G Copyright © 2004 South-Western K t lu n Exercise: • Use a graph of the Keynesian Cross to show the impact of an increase in investment on the equilibrium level of income/output Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income Copyright © 2004 South-Western Copyright © 2004 South-Western ... income/output Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income Copyright © 2004 South-Western