Lec 6 - Fiscal Policy & The Multiplier

Question 1

Keynseian model
(How does the Keynesian model describe the economy?)

Answer 1

Keynesian model describes the economy in the very short run when prices are fixed.

Because each firm’s price is fixed, for the economy as a whole:

1. The price level is fixed.
2. Aggregate demand determines real GDP.

Keynesian model explains fluctuations in AD at fixed prices by identifying forces that determine expenditure plans.

Question 2

Link between aggregate expenditure and real GDP

Answer 2

Other things remaining the same, an increase in real GDP increases aggregate expenditure: when real GDP increases, planned consumption expenditure and planned imports increase (induced expenditure). Planned investment plus planned government expenditure plus planned exports are not influenced by real GDP (autonomous expenditure).

An increase in aggregate expenditure increases real GDP.

This two way link is the reason behind the multiplier effect.

Question 3

Influences on consumption expenditure

What are the main four?

Answer 3

Consumption expenditure is influenced by many factors:
Disposable income
Real interest rate
Wealth
Expected future income

The higher disposable income, the higher potential consumption.
The higher the real interest rate, the higher the incentive to save and the lower the incentive to consume or borrow. Thus IR cause lower consumption.
The higher the expected future income, potentially causes higher consumption, even before the higher income is actually realised, which smooths consumption over the consumer’s lifecycle.

Question 4

Disposable income definition

Answer 4

Aggregate income or real GDP, Y, minus net taxes, T:
YD = Y – T

Disposable income is either spent on consumption goods and services, C, or saved, S.
YD = C + S

Question 5

Marginal propensity to consume definition & formula

Answer 5

The fraction of a change in disposable income spent on consumption.
Change in consumption/change in disposable income.

MPC + MPS = 1

MPC is higher among poor than rich.

Question 6

Marginal propensity to save definition & formula

Answer 6

The fraction of a change in disposable income saved.
Change in saving/change in disposable income.

MPC + MPS = 1

Question 7

Consumption function

Answer 7

Anything on 45 degree line means consumption expenditure is equal to disposable income.

Consumption function shows how much consumption will increase in response to disposable income.
The slope of the consumption function is the marginal propensity to consume.

Some amount of consumption still exists when disposable income is 0: autonomous consumption.

Question 8

Saving function

Answer 8

Saving function shows how much saving will increase in response to disposable income.
The slope of the saving function is the marginal propensity to save.

Some amount of saving still exists when disposable income is 0: autonomous consumption.

Question 9

Aggregate expenditure curve

What does it show?

Answer 9

The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure curve.

Question 10

Autonomous expenditure

Answer 10

Investment depends on interest rates, not GDP
Government expenditure depends on government policy, not GDP
Exports depend on interest rates and foreign economies, not GDP

These three together are called autonomous expenditure: they are independent of GDP.

Question 11

Equilibrium expenditure

Answer 11

the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

Question 12

The multiplier definition

Answer 12

The amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.

Question 13

The multiplier in practice

Answer 13

↑ Investment ⇒ ↑ Real GDP (National Income)
↑ Real GDP (National Income) ⇒ ↑ Consumption
↑ Consumption ⇒ ↑ Real GDP (National Income)

As long as slope of the AE is greater than 0 the multiplier will be greater than one.

Question 14

The multiplier and firms

Answer 14

An increase in autonomous expenditure brings an unplanned decrease in inventories.

So firms increase production and real GDP increases to a new equilibrium.

Question 15

The multiplier formula

Answer 15

Multiplier = 1/(1 – Slope of AE curve)
The larger the slope, the steeper the aggregate expenditure curve, which in turn means the larger the multiplier.

Multiplier = 1/(1 – MPC)*
*Under no imports or income taxes
When real GDP is equal to disposable income, the higher the MPC means the higher the multiplier.

Question 16

The multiplier process

Answer 16

The MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves towards equilibrium expenditure.

Question 17

The multiplier and the business cycle

Answer 17

Turning points in the business cycle – peaks and troughs – occur when autonomous expenditure changes.

An increase in autonomous expenditure brings an unplanned decrease in inventories or stocks, which triggers an expansion.

A decrease in autonomous expenditure brings an unplanned increase in inventories or stocks, which triggers a recession.

Question 18

Aggregate Expenditure & Aggregate Demand - firms

Answer 18

Real firms don’t hold their prices constant for long.
When firms have an unplanned change in inventories, they change production and prices.
And the price level changes when firms change prices.

The AS/AD model explains the simultaneous determination of real GDP and the price level.
The two models are related.
The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, holding all else constant.
The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, holding all else constant.

Question 19

Policy& Great Depression & Keynesian Model

Answer 19

Markets won’t automatically clear, Keynes argued that the solution to theGreat Depressionwas to stimulate the economy 
A reduction in interest rates (monetary policy)
Government investment  (fiscal policy)

Basis of the Keynesian Model:
The idea that aggregate demand (expenditure plans) determines real GDP
The powerful consumer - consumers are the most important part of the economy.
Short run model – price level is fixed

Question 20

Taxes & Government spending

Answer 20

T – lowering taxes leads to increased disposable income leads to increased consumption.
G = part of aggregate expenditure function, part of real GDP.
These variables are independent of each other.

Question 21

Tax multiplier definition

Answer 21

The quantitative effect a change in taxes has on aggregate demand.

Question 22

Consumption formula

Answer 22

Marginal propensity to consume x (income - tax)

Question 23

Limitations of discretionary fiscal policy

Answer 23

The use of discretionary fiscal policy is seriously hampered by three time lags:

Recognition lag − the time it takes to figure out that fiscal policy action is needed.

Law-making lag − the time it takes Parliament to pass the laws needed to change taxes or spending.

Impact lag − the time it takes from passing a tax or spending change to its effect on real GDP being felt.