Week 3: Fiscal Policy Flashcards
Why does aggregate demand fluctuate and what can it do to the economy?
Aggregate demand can fluctuate due to consumption and investment decisions
Aggregate decisions of households and firms can destabilize the economy.
Why did Kennedy need economics?
Kennedy needed economics to develop policies that could promote economic growth, reduce
unemployment but also avoid economic instability
What happened after the Second World War?
Trends after Second World War:
• Increasing role of the government in the
economy
• Reduction in the severity of business cycles
What are some examples of Government spending included in GDP and some that are not?
1) Gov spending Included in GDP: Wages of public sector employees, purchase of goods and services to provide
public services, ) R&D and investment in productive infrastructure like schools, roads, hospitals
2) Gov spending NOT Included in GDP: Interest payments on public debt, unemployment benefits, social security
payments (pensions, disability benefits) and welfare subsidies (e.g., housing subsidies, food assistance)
What does a tax-to-GDP mean and what does the ratios mean?
Measures the share of a country’s GDP collected by the government in the form of taxes:
Ø A very low tax-to-GDP ratio (>10%): indicates insufficient revenue collection, potentially leading to
underfunded public services and reliance on borrowing
Ø A very high ratio (>45%) indicates heavy taxation, could discourage private investment and consumption
What is the multiplier and how does it relate to investment and government spending?
• The multiplier measures the direct and indirect impact of investment changes on the economy.
• It accounts for consumption-smoothing and non-smoothing households.
• Consumption-smoothing households (with credit access) do not fully adjust spending to temporary income changes.
• A rise in investment can have a larger impact than the initial increase.
• Lower government spending can reduce overall demand and economic activity.
What is the multiplier, and how does it explain the impact of investment and government spending?
• The multiplier measures the total economic impact of a change in investment or government spending.
• It considers consumption-smoothing (credit-accessible) and non-smoothing (credit-constrained) households:
• Smoothing households do not fully increase consumption in response to a temporary income rise.
• Credit-constrained households spend the full increase in income immediately.
• The multiplier > 1 if additional consumption spending is between 0 and 1 per €1 income rise.
• The Aggregate Consumption Function models how consumption depends on disposable income and autonomous consumption.
[GRAPH] What is aggregate consumption and how is it calculated?
If government spending and foreign trade are excluded, only two types of expenditure are present in the economy:
Consumption (consumer goods)
Investment (machinery, equipment, buildings)
Aggregate consumption has 2 parts:
Aggregate consumption = Automomous consumption + Consumption which depends on income.
C = c0 +c1y
1) Autonomous consumption (fixed): How much
household will spend, independent of their income (e.g.
basic necessities like food and shelter)
2) A variable amount (not-fixed): Depends on MPC, a
change in consumption when disposable income changes
by one unit (slope of consumption function – red line)
[GRAPH] Why does Marginal Propensity vary?
Marginal propensity to consume (MPC) varies:
Ø For wealthy households, current income matters little for current consumption, their MPC is
small (0.2 or less)
Ø Poor households, typically credit constraints, tend to react strongly to variation in current
income, their MPC is larger (0.8 or more)
A steeper line means a larger consumption response to a change in income
A flatter line means that households are smoothing their consumption, little consumption
response to a change in income
As per the figure in the previous slide, if c1 = 0.6, then an additional unit of income of 1€
increases consumption by €1 × 0.6 = 60 cents
[GRAPH]
Graph Breakdown:
• Horizontal axis: Output produced (Y).
• Vertical axis: Demand for output (AD).
• Black line: Equilibrium where Y = AD (output = aggregate demand).
• AD formula: Consumption function + Investment (no gov. spending).
• Goods Market Equilibrium:
• Point A: Where output (Y) equals AD.
• Economy stays at Y unless spending behavior changes.
• Impact of AD Changes:
• Increase in AD → Higher output (Y) → More employment.
• Decrease in AD → Lower output (Y) → Higher unemployment.
What can a multiplier process do in a reduction in investment?
The economy starts at point A, in goods market equilibrium
Fall in investment → fall in AD (A → B)
Less investment leads to less employment and production
Lower output and income → further fall in AD (B → C)
If households’ incomes fall, they reduce consumption (C → D)
Firms respond by cutting production, output falls (D → E)
The process will go on until the economy
reaches new equilibrium at point Z
A fall in investment of €1.5 billion produces a fall in output of
€3.75 billion, 2.5 times larger than the initial change
What is the multiplier and how can it affect output?
The total change in output can be greater than the initial change in aggregate demand
This is due to the circular flow of expenditure, income and production
The multiplier represents the magnitude of this change
Ø multiplier = 1: the increase in GDP = the initial increase in spending
Ø multiplier > (<) 1: the total increase in GDP > (<) the initial increase in spending
How can a change in consumption affect the AD curve?
A change in consumption and saving behaviour can impact the AD curve
Example: a fall in house prices will be bad news for a household with a mortgage. They may
choose to save more (precautionary saving) and hence their consumption would fall
Precautionary saving can be modelled as a fall in autonomous consumption
Consumption decisions can shift the AD curve while being credit constraints and smooth
consumption is reflected in the slope of the AD curve and the size of the multiplier
[GRAPH] What happened during the Great Depression in the 1930’s?
Point A: goods market equilibrium in 1929
As output and employment fell, households cut spending
(est. multiplier at the time was high at about 1.8)
(A → B): fall in investment = downward shift of AD
Downturn made it worse due to fall in the demand for
consumer goods even by those who kept their jobs
(B → C): fall in autonomous consumption = further
downward shift of AD
Explanations: uncertainty due to stock market crash,
pessimism, banking crisis and collapse of credit
