Topic 2-Short-run Macroeconomic Equilibrium and Fiscal Policy

Question 1

What is Keynesian economics and give an example

Answer 1

. 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

Question 2

What is the Keynesian cross diagram model of equilibrium output?

Answer 2

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)

Question 3

What is aggregate demand (planned expenditure) in the short-run approach?

Answer 3

AD = Consumption (C) + Investment (I)

Question 4

What is the definition of equilibrium?

Answer 4

Situation where aggregate demand/expenditure is equal to the output of firms

Question 5

What is household consumption determined by?

Answer 5

. basic need to consume, e.g. food, clothing & transport

. level of income

Question 6

What is the consumption function? and explain components

Answer 6

. 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)

Question 7

What is autonomous consumption?

Answer 7

Level of consumption that does not change with income. Considered basic level of consumption in order to survive.

Question 8

What is the marginal propensity to consume (MPC)? and equation

Answer 8

. 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

Question 9

What is the household savings function?

Answer 9

Savings = income – consumption = Y – C

the savings function: S = -a + sY

Question 10

What is the marginal propensity to save (MPS) and equation? what would S= if C=7+0.8Y

Answer 10

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

Question 11

What does firm investment depend on in the Keynesian cross diagram?

Answer 11

. 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

Question 12

How does the uncertainty of Brexit effect investment decisions?

Answer 12

. Prevents some firms from investing due to greater risk

. but higher risk=higher reward if future turns out positive

Question 13

In equilibrium national output/income(Y)= planned expenditure so what is Y when AD=57+0.8Y

Answer 13

Y = AD:
Y = 57 + 0.8Y

Solve for Y: 0.2Y = 57
so Y = 57/0.2
= £285

Question 14

What is the importance of the 45-degree line?

Answer 14

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

Question 15

What is the adjustment by firms to equilibrium?

Answer 15

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

Question 16

Are injections equal to withdrawals in equilibrium?

Answer 16

. Injections = investment (I) = 50
. Withdrawals = savings (S
. Yes, investment = savings when the economy is in equilibrium

Question 17

What is the multiplier?

Answer 17

Measures the change in output following a change in autonomous expenditure e.g. investment

Question 18

Explain the multiplier.

Answer 18

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

Question 19

What is the multiplier when an investment has increased from 50 to 100 for the consumption function of C=7+0.8Y

Answer 19

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

Question 20

What is the equation of the multiplier?

Answer 20

Multiplier = 1/(1-MPC)
=1/MPS
The multiplier has a higher value the higher the value of the MPC

Question 21

What is an example of the multiplier?

Answer 21

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

Question 22

What is the equation of Aggregate Demand (AD) with government?

Answer 22

AD = C + I + G

Question 23

What two things does the government do?

Answer 23

Expenditure (G): e.g. healthcare, education, defence & pensions

Raises revenue: taxes household income, e.g. wages & profits

Question 24

Why is the multiplier important for governments?

Answer 24

If the government wishes to control the economy, then it needs to change autonomous expenditure through its fiscal policy.

Question 25

What is the implication for household consumption from government taxation?

Answer 25

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

Question 26

What is MPT?

Answer 26

marginal propensity to tax

Question 27

What is the role of international trade on aggregate demand?

Answer 27

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):

Question 28

What is the MPM and formula?

Answer 28

proportion of £1 additional income spent on imports:

𝑀𝑃𝑀=∆𝑀/∆𝑌

0< MPM < 1

Question 29

What is the impact of government and trade on the multiplier?

Answer 29

The expenditure multiplier is now:

		1/(𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀) Makes the multiplier smaller than gov and trade

Question 30

What is fiscal policy and the policy aim?

Answer 30

Stability is a policy aim because volatile GDP growth is seen to create uncertainty for business

Question 31

What is the fiscal multiplier? and equation

Answer 31

The fiscal multiplier shows by how much national income (Y) will change when government expenditure (G) changes:

∆𝑌=∆𝐺/(𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀)

Question 32

What is the average fiscal multiplier for high-income countries?

Answer 32

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

Question 33

What are the two broad types of fiscal policies?

Answer 33

Expansionary: increase in G and/or reduction in taxation (to increase AD)

Contractionary: decrease in G and/or increase in taxation (to decrease AD)

Question 34

What are the budget positions?

Answer 34

. budget deficit, budget surplus, cumulative debt

Question 35

What are budget deficits/surplus? and example deficit for countries in Eurozone

Answer 35

. annual difference in government revenue & expenditure

e.g. target of 3% of GDP for Eurozone countries

Question 36

What is cumulative debt?

Answer 36

total outstanding government debt from borrowings over many years

Question 37

How does fiscal policy affect businesses?

Answer 37

. 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

Question 38

What are the largest areas of government expenditure?

Answer 38

. Social security, health and education representing more than 60%

Question 39

What are the largest sources of government tax revenue?

Answer 39

. Income tax, national insurance, and VAT

. corporation tax much smaller percentage

Question 40

Who does the government borrow from?

Answer 40

Households:

	- pension funds & insurance companies 
	- international investors & international financial institutions (amount owed depends on exchange rates)
	- commercial banks & Bank of England

Question 41

How does the government borrow?

Answer 41

. Through issuing financial assets known as ‘gilts’ or ‘bonds’ which pay interest to lenders – essentially an IOU

Question 42

What is the importance of borrowing rates in terms of government borrowing/

Answer 42

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

Question 43

What was the fiscal policy objective of the UK government following the 2008 financial crash?

Answer 43

. 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

Question 44

What were the effects to government expenditure of different sectors from 2010?

Answer 44

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

Question 45

What was the 2019/20 budget overview for UK?

Answer 45

. ‘end to austerity’
. Digital tax on tech giants e.g amazon, apple
. incresed funding for NHS, defence

Question 46

What are the limits to the effectiveness of fiscal policy?

Answer 46

. Offsetting changes
. Crowding out
. Time lags
. Inflationary effects

Question 47

What are the effects of offsetting changes?

Answer 47

if the government takes on more debt, households & companies anticipate future tax rises & reduce expenditure (neutralising the fiscal objective)

Question 48

What are the effects of crowding out?

Answer 48

. 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

Question 49

What are the effects of a time lag?

Answer 49

government spending takes time to impact on GDP and by then the economic situation may have changed so gov needs to anticipate changes

Question 50

What are the inflationary effects on fiscal policy?

Answer 50

additional spending may lead to price increases if the economy is near to full employment → erodes real income