Topic 2-Short-run Macroeconomic Equilibrium and Fiscal Policy Flashcards
What is Keynesian economics and give an example
. various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand
. : the economic problems of the 1930s -caused by weak demand → active role for government spending, i.e. ‘fiscal policy
What is the Keynesian cross diagram model of equilibrium output?
SImplified short run approach
. prices of goods & services do not change
. assume fixed interest rates for borrowing & lending
. simple economy: no trade & government → we only have the following spending:
- consumers (consumption) - firms (investment)
What is aggregate demand (planned expenditure) in the short-run approach?
AD = Consumption (C) + Investment (I)
What is the definition of equilibrium?
Situation where aggregate demand/expenditure is equal to the output of firms
What is household consumption determined by?
. basic need to consume, e.g. food, clothing & transport
. level of income
What is the consumption function? and explain components
. C = a + bY For example: C = 7 + 0.8Y
C: consumption expenditure
Y: income
a: autonomous consumption = £7 = a basic level of consumption
b = the marginal propensity to consume (MPC)
What is autonomous consumption?
Level of consumption that does not change with income. Considered basic level of consumption in order to survive.
What is the marginal propensity to consume (MPC)? and equation
. the proportion of an increase in income spent on consumption
. the MPC is the slope or gradient of the consumption function with 0 < MPC < 1
. 𝑀𝑃𝐶= ∆𝐶/∆𝑌
What is the household savings function?
Savings = income – consumption = Y – C
the savings function: S = -a + sY
What is the marginal propensity to save (MPS) and equation? what would S= if C=7+0.8Y
is the proportion of an increase in income saved, equal to: ∆𝑆/∆𝑌
0 < MPS < 1
MPC + MPS = 1, so MPS = 1 - MPC
In our example: C = 7 + 0.8Y, so savings must be equal to:
S = -7 + 0.2Y
What does firm investment depend on in the Keynesian cross diagram?
. business confidence, expectations & sentiment or ‘animal spirits’ according to Keynes
-the cost of borrowing, e.g. the level of interest rates in the Keynesian cross diagram is assumed not to change so investment decisions are not determined by interest rates
. Therefore autonomous to any level of income-horizontal
How does the uncertainty of Brexit effect investment decisions?
. Prevents some firms from investing due to greater risk
. but higher risk=higher reward if future turns out positive
In equilibrium national output/income(Y)= planned expenditure so what is Y when AD=57+0.8Y
Y = AD: Y = 57 + 0.8Y
Solve for Y: 0.2Y = 57
so Y = 57/0.2
= £285
What is the importance of the 45-degree line?
On the 45 degree line:
Aggregate demand = output = income
i.e. demand for goods & services = supply of goods & services
Along the 45 degree line the economy is in equilibrium
In equilibrium consumption & investment decisions go unchanged
What is the adjustment by firms to equilibrium?
If output > 45-degree line: firms experience an increase in stock levels (inventories) & reduce output
If output < £45-degree line: firms experience a decrease in stock levels (inventories) & increase output
Are injections equal to withdrawals in equilibrium?
. Injections = investment (I) = 50
. Withdrawals = savings (S
. Yes, investment = savings when the economy is in equilibrium
What is the multiplier?
Measures the change in output following a change in autonomous expenditure e.g. investment
Explain the multiplier.
Investment of firm into computers gives income to computer manufacturers
. computer manufacturer gives workers extra income which is spent depending on MPC
. wages spent received by another firm given to their workers and cycle repeats
What is the multiplier when an investment has increased from 50 to 100 for the consumption function of C=7+0.8Y
AD = C + I' = 7 + 0.8Y + 100 = 107 + 0.8Y In equilibrium Y = AD Y = 107 + 0.8Y Solve for Y: 0.2Y = 107 so Y = 107/0.2 = £535bn . Income has increased from £285 to £535, i.e. by £250bn > increase in investment of 50
. There has been a multiplier effect of 5, i.e. national income has increased five times more than the increase in investment
What is the equation of the multiplier?
Multiplier = 1/(1-MPC)
=1/MPS
The multiplier has a higher value the higher the value of the MPC
What is an example of the multiplier?
Goldman Sachs (2012): The Olympics and Economics
Short-run impact: boost to UK GDP over 12 months of 1.2% to 1.6%
‘London 2012’ cost £9 billion to the UK government
UK GDP was £1.4 trillion in 2012 so the cost of the Olympics = 0.64% of the total economy
What is the equation of Aggregate Demand (AD) with government?
AD = C + I + G
What two things does the government do?
Expenditure (G): e.g. healthcare, education, defence & pensions
Raises revenue: taxes household income, e.g. wages & profits
Why is the multiplier important for governments?
If the government wishes to control the economy, then it needs to change autonomous expenditure through its fiscal policy.
What is the implication for household consumption from government taxation?
Households make consumption decisions based on disposable income, i.e. net of income taxes
Define disposable income = (1 – t)Y
Y: income, t: tax rate
e. g. if t = 20%, disposable income is (1 - 0.20)Y = 0.8Y
i. e. disposable income is 80% of our gross income
What is MPT?
marginal propensity to tax
What is the role of international trade on aggregate demand?
Aggregate demand: C + I + G + (X - M)
X, exports: injection into the circular flow of income determined by global demand for UK exports (autonomous)
M, imports: withdrawal which depends on UK income, i.e. demand for imported goods & services
(X – M): net exports
Marginal propensity to import (MPM):
What is the MPM and formula?
proportion of £1 additional income spent on imports:
𝑀𝑃𝑀=∆𝑀/∆𝑌
0< MPM < 1
What is the impact of government and trade on the multiplier?
The expenditure multiplier is now:
1/(𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀) Makes the multiplier smaller than gov and trade
What is fiscal policy and the policy aim?
Stability is a policy aim because volatile GDP growth is seen to create uncertainty for business
What is the fiscal multiplier? and equation
The fiscal multiplier shows by how much national income (Y) will change when government expenditure (G) changes:
∆𝑌=∆𝐺/(𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀)
What is the average fiscal multiplier for high-income countries?
In the last decade, the multiplier has been estimated to be on average about 1.70 for high income countries* → £1 increase in G leads to a £1.70 increase in Y
Source:IMF
What are the two broad types of fiscal policies?
Expansionary: increase in G and/or reduction in taxation (to increase AD)
Contractionary: decrease in G and/or increase in taxation (to decrease AD)
What are the budget positions?
. budget deficit, budget surplus, cumulative debt
What are budget deficits/surplus? and example deficit for countries in Eurozone
. annual difference in government revenue & expenditure
e.g. target of 3% of GDP for Eurozone countries
What is cumulative debt?
total outstanding government debt from borrowings over many years
How does fiscal policy affect businesses?
. taxes on companies, e.g. corporation tax(so less to pay shareholders+reinvestmentment)
- all companies in the UK pay corporation tax of 19% on profits - some companies get tax breaks for investment
. the macroeconomic environment: level of aggegrate demand from households so less consumer spending and frims lose out
What are the largest areas of government expenditure?
. Social security, health and education representing more than 60%
What are the largest sources of government tax revenue?
. Income tax, national insurance, and VAT
. corporation tax much smaller percentage
Who does the government borrow from?
Households:
- pension funds & insurance companies - international investors & international financial institutions (amount owed depends on exchange rates) - commercial banks & Bank of England
How does the government borrow?
. Through issuing financial assets known as ‘gilts’ or ‘bonds’ which pay interest to lenders – essentially an IOU
What is the importance of borrowing rates in terms of government borrowing/
Borrowing rates do reflect confidence about the state of the economy, e.g.
UK government currently borrows at 1.52%
Germany: 0.45%
Italy 3.56%
. These assets are typically low-risk for investors so are suitable for pension planning, i.e. the risk of default is low
What was the fiscal policy objective of the UK government following the 2008 financial crash?
. global crisis reduced UK growth & increased the size of the budget deficit as receipts fell
. Policy objective: to reduce the deficit & move towards sustainable government finances & surplus
. These policies are often referred to as austerity as they involve reductions in government expenditure
What were the effects to government expenditure of different sectors from 2010?
Tax receipts have increased by more than expected since 2010:
increased spending (G) on the national health service (NHS), school education, defence & housing
personal allowance increased to £12,500 & higher rate tax threshold of 40% raised to £50,000 → reduction in taxation
. less spending in transport, justice and work/pensions
What was the 2019/20 budget overview for UK?
. ‘end to austerity’
. Digital tax on tech giants e.g amazon, apple
. incresed funding for NHS, defence
What are the limits to the effectiveness of fiscal policy?
. Offsetting changes
. Crowding out
. Time lags
. Inflationary effects
What are the effects of offsetting changes?
if the government takes on more debt, households & companies anticipate future tax rises & reduce expenditure (neutralising the fiscal objective)
What are the effects of crowding out?
. private investment is replaced by public spending due to the public sector expanding & taking on more staff & savings being diverted away fro private companies
- this may lower future economic growth
. only likely to occur if labour is in full employment as public vs private are competing for the same factors of production
What are the effects of a time lag?
government spending takes time to impact on GDP and by then the economic situation may have changed so gov needs to anticipate changes
What are the inflationary effects on fiscal policy?
additional spending may lead to price increases if the economy is near to full employment → erodes real income
