Lec 6 - Fiscal Policy & The Multiplier Flashcards
Keynseian model (How does the Keynesian model describe the economy?)
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:
- The price level is fixed.
- Aggregate demand determines real GDP.
Keynesian model explains fluctuations in AD at fixed prices by identifying forces that determine expenditure plans.
Link between aggregate expenditure and real GDP
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.
Influences on consumption expenditure
What are the main four?
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.
Disposable income definition
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
Marginal propensity to consume definition & formula
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.
Marginal propensity to save definition & formula
The fraction of a change in disposable income saved.
Change in saving/change in disposable income.
MPC + MPS = 1
Consumption function
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.
Saving function
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.
Aggregate expenditure curve
What does it show?
The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure curve.
Autonomous expenditure
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.
Equilibrium expenditure
the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.
The multiplier definition
The amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.
The multiplier in practice
↑ 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.
The multiplier and firms
An increase in autonomous expenditure brings an unplanned decrease in inventories.
So firms increase production and real GDP increases to a new equilibrium.
The multiplier formula
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.
The multiplier process
The MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves towards equilibrium expenditure.
The multiplier and the business cycle
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.
Aggregate Expenditure & Aggregate Demand - firms
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.
Policy& Great Depression & Keynesian Model
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
Taxes & Government spending
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.
Tax multiplier definition
The quantitative effect a change in taxes has on aggregate demand.
Consumption formula
Marginal propensity to consume x (income - tax)
Limitations of discretionary fiscal policy
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.
