Aggregate demand, the multiplier and fiscal policy Flashcards
What affects GDP growth through the multiplier process?
Fluctuations in aggregate demand, because households face limits in saving, borrowing, and risk-sharing
How can governments stabilize the economy?
By changing taxes or government spending, but bad policy can destabilize it.
Why might saving by all households not increase total wealth?
Because without additional spending by the government or firms, aggregate income falls, reducing savings.
Why does investment spending tend to occur in clusters?
Firms adopt new technology simultaneously.
Firms share similar beliefs about future demand.
How do credit-constrained households react to higher income?
They increase consumption spending, unlike households that can smooth temporary income bumps.
What is the multiplier effect?
When changes in income influence spending, amplifying the initial shock to aggregate demand.
If GDP increases exactly by the initial spending increase, what is the multiplier?
1 (multiplier = 1).
What happens if GDP rises more than the initial investment spending?
The multiplier is greater than 1.
What are the two types of expenditure in the multiplier model?
Consumption
Investment
(Government and foreign trade ignored)
What are the two parts of aggregate consumption?
Autonomous consumption (C₀): Fixed spending independent of income.
Income-dependent consumption: Varies with current income.
What is the consumption function equation?
C = C₀ + C₁Y
(C₀ = autonomous consumption, C₁ = marginal propensity to consume, Y = income)
What does the marginal propensity to consume (C₁) represent?
The fraction of additional income spent on consumption (0 < C₁ < 1).
What does a steeper consumption line indicate?
A larger consumption response to income changes (less smoothing).
What does a flatter consumption line indicate?
Households are smoothing consumption (less variation with income changes).
If the MPC (c₁) = 0.6, how much does consumption rise when income increases by €1?
€0.60 (60 cents).
Why does the average MPC hide variation across households?
Wealthy households: MPC ≈ 0 (income changes barely affect spending).
Low-wealth/credit-constrained households: MPC ≈ 0.8 (spending closely tracks income).
How do credit-constrained households behave when income falls?
They cannot smooth consumption—spending drops sharply (MPC near 0.8).
What factors are included in autonomous consumption (c₀)?
Future income expectations.
Wealth levels.
Credit access.
What does the slope of the consumption function represent?
The MPC (c₁)—how much consumption changes with income.
What is the equation for aggregate demand (AD) in this model?
AD = C + I = c₀ + c₁Y + I
(c₀ = autonomous consumption, c₁ = MPC, Y = income, I = investment)
What does the 45-degree line represent?
All points where output (Y) = aggregate demand (AD) (goods market equilibrium).
Why is the aggregate demand line flatter than the 45-degree line?
Because the MPC (c₁) < 1, so AD rises less steeply than income (slope = c₁ vs. 1).
What is the intercept of the aggregate demand line?
c₀ + I
(Sum of autonomous consumption and investment)
when is there goods market equilibrium?
where AD = Y and the economy stabilizes.
How does investment (I) affect the aggregate demand line?
It shifts the consumption line upward (parallel shift by amount I).
What assumption is made about firms’ production in this model?
Firms supply any amount demanded (no full capacity constraints).
If MPC = 0.6 and investment rises by €10, how much does AD increase at equilibrium?
Use the multiplier: ΔY = (1/(1 - MPC)) × ΔI = (1/0.4) × 10 = €25.
multiplier process of a £1.5 billion decrease in investment
Lower demand → reduced production/income (€1.5 bn).
Lower income → reduced consumption (MPC × income drop).
Repeat until new equilibrium (total output falls by €3.75 bn).
What is the multiplier formula, and what does it depend on?
k= 1 / (1−c1)
Depends on the marginal propensity to consume (MPC, c1).
(If MPC = 0.6,
k =2.5).
Why does output fall by €3.75 billion after a €1.5 billion investment drop?
The multiplier (k = 2.5) amplifies the initial shock:
ΔY = k × ΔI = 2.5 × 1.5 = 3.75 bn.
How does MPC affect the multiplier?
Higher MPC → larger multiplier (more spending per income change).
(MPC = 0.6 → k = 2.5; MPC = 0.8 → k = 5).
What happens if the economy lacks spare capacity?
The multiplier shrinks because higher demand raises prices/wages instead of output.
What is the equilibrium output equation in the multiplier model?
Y=[1 / (1−c1)] × (c0+I)
(Derived from Y=AD=c0+c1Y+I).
How is the total output change calculated after infinite rounds of the multiplier process?
Sum of geometric series:
ΔY = ΔI ×(1+c1+c1^2+…)= ΔI x [1 / (1−c1)]
What is the economic interpretation of the multiplier?
It shows how initial spending changes ripple through the economy via income → consumption → more income.
What is the largest component of GDP, and why is it critical for understanding economic fluctuations?
Consumption. Changes in spending behavior shift the aggregate demand curve, affecting output and employment.
How do household target wealth and collateral influence consumption?
If actual wealth < target wealth: Households save more (↓ consumption).
If actual wealth > target wealth: Households save less (↑ consumption).
(Example: Falling home prices → precautionary saving.)
What two mechanisms exacerbated the Great Depression’s consumption collapse?
Credit-constrained households: Cut spending as income fell (A → B).
Non-constrained households: Reduced spending due to pessimism (B → C), shifting the consumption function down.
Why did output fall beyond the multiplier effect during the Great Depression?
Autonomous consumption dropped due to:
Uncertainty
Banking crises (↓ credit)
Rising precautionary saving (target wealth adjustment).
What is human capital, and how does it relate to household wealth?
The present value of expected future earnings.
Declines during downturns → households feel poorer → ↑ saving to rebuild wealth.
How did the banking crisis deepen the Great Depression?
Collapsed credit → constrained households couldn’t borrow.
Reduced confidence → even employed households cut spending.
What does the shift from B to C in the multiplier diagram represent?
A downward shift in the consumption function due to:
Pessimism about permanence of the crisis.
Efforts to rebuild target wealth.
How do household balance sheets affect aggregate demand?
Falling asset prices (e.g., homes) → ↓ wealth → ↑ saving → ↓ consumption → ↓ AD.
Debt burdens amplify the effect (e.g., mortgages).
Why did non-credit-constrained households reduce spending in the 1930s?
Revised expectations: Downturn was not temporary.
Target wealth > actual wealth → saved to rebuild assets.
What is precautionary saving, and when does it occur?
Saving more due to economic uncertainty or wealth shocks (e.g., housing busts).
Shifts the consumption function downward.
What is the relationship between target wealth and consumption?
Wealth > target: Spend more (↓ saving).
Wealth < target: Spend less (↑ saving).
How do rising home prices affect non-credit-constrained households?
Increases net worth
Wealth rises above target
Reduces precautionary saving
→ Higher consumption
What is the key difference between how constrained vs. unconstrained households respond to wealth changes?
Unconstrained: Adjust based on wealth vs. target
Constrained: Adjust based on borrowing capacity
What two factors make up a household’s “broad wealth”?
Financial + physical assets (e.g., home value)
Human capital (expected future earnings)
Minus any debts
How does the target wealth model explain consumption booms?
When asset appreciation makes:
Actual wealth > Target wealth
→ Households feel “rich enough”
→ Reduce saving, increase spending
What are the four options firms have for using accumulated profits?
Pay dividends (to owners/employees)
Save (buy financial assets or pay off debt)
Invest abroad (build capacity overseas)
Invest domestically (build home capacity)
How does an owner decide between consuming now vs. later?
By comparing:
Discount rate (ρ): Preference for current consumption
Interest rate (r): Return from saving
Profit rate (Π): Return from investing
What positive supply shocks increase investment?
Lower production costs
Tax cuts
Stronger property rights (↓ expropriation risk)
Why might investment be insensitive to interest rates empirically?
Long project horizons: Profit expectations dominate.
Credit constraints: Firms rely on retained earnings.
Uncertainty: Overrides rate changes.
What shifts the aggregate investment curve outward?
Higher expected profitability due to:
Demand surges (↑ product prices)
Supply improvements (e.g., tax cuts)
(Moves from C to D at same interest rate.)
What components are added to aggregate demand (AD) in the expanded multiplier model?
AD = C + I + G + (X - M)
How does disposable income differ from total income in this model?
Disposable income = (1 - t)Y
(Income after proportional taxes, where t = tax rate)
What is the modified consumption function with taxes?
C = c₀ + c₁(1 - t)Y
(c₀: autonomous consumption; c₁: MPC; t: tax rate)
Why does government spending (G) shift the AD curve?
G is exogenous (independent of income) → Directly increases aggregate demand.
How are net exports (X - M) calculated?
X - mY
(X: exogenous exports; m: marginal propensity to import; mY: imports)
What are the two “leakages” that reduce the multiplier effect?
Taxes (t): Diverts income from consumption
Imports (m): Diverts spending abroad
What is the multiplier formula with government and trade?
k = 1 / [1 - c₁(1 - t) + m]
If c₁ = 0.6, t = 0.2, and m = 0.1, what is the multiplier?
k = 1 / [1 - 0.6(0.8) + 0.1] = 1 / 0.62 ≈ 1.6
(Originally 2.5 without taxes/imports)
How does a higher tax rate (t) affect the multiplier?
Reduces k (flattens AD curve) by decreasing disposable income → less consumption.
What happens to the multiplier if the marginal propensity to import (m) falls?
k increases (more spending stays in domestic economy).
k increases (more spending stays in domestic economy).
Each income increase has a smaller indirect effect due to leakages (taxes/imports).
What shifts the AD curve upward in this model?
↑ Autonomous C₀, I, G, or X
What is the key takeaway about stabilization policy in this model?
Governments can stabilize shocks via:
G (spending changes)
t (tax adjustments)
Central bank influencing r (interest rates)
How does the government naturally stabilize the economy without active intervention?
Size of government: Stable spending (e.g., health/education) smooths demand.
Unemployment benefits: Maintain consumption during job losses.
Automatic tax stabilizers: Progressive taxes reduce multiplier effects.
Why can’t private markets provide effective unemployment insurance?
Correlated risk: Mass layoffs bankrupt insurers.
Hidden actions: Workers might slack (moral hazard).
Hidden attributes: Only high-risk workers buy insurance (adverse selection).
Why is collective saving during a recession self-defeating?
(paradox of thrift)
Individual saving → ↓ consumption → ↓ others’ income → ↑ unemployment → deeper recession.
How does fiscal stimulus counteract a downturn?
↑ Government spending (G): Directly boosts AD via multiplier.
Tax cuts: Encourage private spending (if targeted to high-MPC groups).
How do taxes/imports shrink the multiplier?
k = 1 / 1−c1(1−t)+m
Leakages: Taxes (t) and imports (m) reduce disposable income/spending.
Example: If c1=0.6, t=0.2, m=0.1, then k=1.6
What happens if governments don’t act in a downturn?
vicious cycle
↓ AD → ↓ Production → ↑ Unemployment → Further ↓ AD…
Why does unemployment insurance create moral hazard?
Workers might ↓ effort (if benefits are too generous).
Solution: Time limits/work requirements.
How does a fall in consumer confidence (↓c₀) affect the AD curve?
Shifts AD downward (from A to B).
Formula: AD = c₀’ + c₁(1-t)Y + I(r) + G + X - mY.
How does increasing government spending (G→G’) counteract a consumption shock?
Shifts AD upward (from B to C).
New AD: c₀’ + c₁(1-t)Y + I(r) + G’ + X - mY.
Define budget balance, deficit, and surplus.
Balance: G = T
Deficit: G > T
Surplus: G < T
How do automatic stabilizers affect the budget during a recession?
↑ Transfers (e.g., unemployment benefits).
↓ Tax revenue → larger deficit.
How do rising house prices affect consumption?
↑ Collateral value → Wealth > target → ↓ Saving, ↑ Consumption.
What qualifies as a destabilizing policy mistake?
Limiting automatic stabilizers (e.g., austerity).
Running deficits in booms/surpluses in recessions.
Why does austerity deepen recessions?
↓ G reduces AD → ↓ Income → ↓ Consumption (via multiplier).
What do the intercepts (c₀ + I(r) + G + X) represent?
Autonomous demand (independent of income).
Write the full AD equation with all components.
AD = c₀ + c₁(1-t)Y + I(r) + G + X - mY.
What is crowding out in fiscal policy?
When increased government spending reduces private spending, especially in full-employment economies or when fiscal expansion raises interest rates.
How does the multiplier differ between recession vs. full-employment conditions?
Recession: Multiplier > 1 (idle resources available)
Full employment: Multiplier ≈ 0 (crowding out dominates)
How can expectations weaken fiscal stimulus?
Households anticipating future tax hikes may save more (↓ consumption).
Firms confident in stabilization may need less stimulus.
What are the main sources of government revenue?
Income taxes
Consumption taxes (VAT/sales tax)
Product taxes (alcohol, tobacco)
Wealth taxes (inheritance)
Define primary deficit and how it differs from total deficit.
Primary deficit: G - T (excluding interest payments).
Total deficit: Includes interest on existing debt.
How does government borrowing work?
Issues bonds bought by households/firms/foreigners.
Adds to debt stock (rolled over at maturity).
What triggers a sovereign debt crisis?
When bond markets perceive high default risk, forcing austerity (cannot borrow).
Common in emerging economies; rare in advanced economies.
How does inflation affect government debt?
Reduces real debt burden (nominal bonds lose value).
Deflation increases real debt.
Why do aging populations increase debt ratios?
↑ Spending on pensions/healthcare → Requires higher taxes or borrowing.
What are key fiscal policy takeaways for debt management?
Use automatic stabilizers.
Reverse stimulus during growth.
Inflation helps; deflation hurts.
Unsustainable if debt grows faster than GDP.
How do imports affect the multiplier?
Reduce multiplier: Some demand leaks abroad (M = mY).
Flatten AD curve.
Why does trade limit fiscal stimulus effectiveness?
↑ Imports leak demand abroad.
Exchange rate/competitiveness concerns may arise.
When does debt-to-GDP stabilize?
When primary surplus = (r - g) × Debt/GDP, where:
r = interest rate
g = GDP growth rate
Why do financial crises increase government debt?
Bank bailouts.
Recessionary stimulus.
Example: UK debt ↑ to 100%+ after COVID-19
Why is rapid debt reduction counterproductive?
Austerity ↓ growth → ↑ Debt/GDP ratio.
Self-defeating without addressing growth.
Why are government bonds considered safe?
Low default risk (usually).
Fixed interest payments.
What determines a country’s ability to run deficits?
Market confidence in repayment.
Growth potential (to service debt).
