Flashcards in L6 - Aggregate Expenditure and the Multiplier Deck (17):

1

## How does a change in GDP effect the Equilibrium diagram?

### - A change in GDP ( usually meaning more income) causes movement along the aggregate spending function

2

## How does a increase in desire spending effect the Equilibrium diagram?

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- A rise in the amount of desired aggregate spending that is associated with each level of GDP will increase equilibrium nation output --> shifts the aggregate spending function upwards

- A fall in the amount of desired aggregate spending that is associated with each level of GDP will lower equilibrium national output -->shifts the aggregate spending function down

3

## What happens when an Investment shock occurs?

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- e.g. fall in Investment --> Suppose from the initial level of equilibrium income there is a fall in investment from I(0) to I(1), where I(0)>I(1)

- The level of AE will fall and the level of equilibrium output will fall from Y(0) to Y(1)

4

## What can we notice about the Equilibrium Income diagram after an investment shock?

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The fall in I is a parallel downward shift in the C+I line

- The fall in Y is greater than in the fall in I. (To see this compare the vertical distance ∆I with the horizontal distance ∆Y)

This is called the multiplier effect – where the fall in investment has a magnified effect on output

The size of the multiplier (k) is given as:

k=1/(1-b)

5

## What is the Multiplier?

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- An initial change in aggregate demand can have a much greater final impact on the level of equilibrium national income. This is known as the multiplier effect

- There is a direct relationship between the size of the mpc (b) and the size k --> the multiplier is equal to the reciprocal of the mps

- an example is if b=0.75 the multiplier (k) would = 1/0.25=4

- So any change in I has an effect on Y which is 4 times larger than the change in I

- The larger the mpc (and k) the bigger the multiplier effect is

6

## What are the different parts of the Government Sector?

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- The government sector consists of exogenous government spending (G) and endogenous (net) tax revenues (T)

- G is assumed to be exogenously given by the need to fund public services such as defence the police etc. which are essentially political rather than economic decisions

- Net tax revenues are defined as tax revenues less transfer payments made. Since tax revenues always exceed transfer payments net taxes, or taxes, are always positive

7

## What is the Tax function?

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The tax (or net tax) function is:

- T = t(0) + tY

- where t is the marginal propensity to tax (mpt) and t = ΔT/ΔY, while t(0) denotes autonomous taxes – not related to income, such as VAT.

- The government budget deficit is therefore given as: G – T = G – t(0) – tY; or alternatively the budget surplus is written as

-T – G = t0 + tY – G

- For given tax rates, the government budget surplus (public saving) increases as GDP rises and falls as GDP falls

8

## Are Tax Rates exogenous/endogenous?

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-exogenous

- the government sets its tax rates and does not vary them as GDP varies

9

## Are Tax Revenues exogenous/endogenous?

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- endogenous

- as GDP rises with given tax rates , the tax revenue will rise

10

## What does the Tax Function look like on a graph?

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With Government Spending and (net) Tax Revenues on the y-axis and Income (Y) on the x-axis

- horizontal line of at the value y=G

- a diagonal line of T=t(0)+tY with the gradient t and y intercept t(0)

- T=t(0)+tY and y=G intercept at the Income value of Y(0)

- the Budget is in surplus to the right of Y(0) and in deficit to the left of Y(0)

11

## What is Fiscal Policy?

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- Fiscal policy can be defined as the discretionary use of changes in G or t to affect the level of output

- The word discretionary is important because the budget itself is only partly exogenous as tax revenue varies with income. Hence changes in income alter the budget position without a change in fiscal policy.

- The critical feature is that the budget deficit (G-T) gets larger so aggregate expenditure increases which boosts output and employment

- Fiscal policy may be used to ensure that the economy is close to full employment output

12

## What does the Expenditure Income model look like including the Government Sector?

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With government the model is now:

- AE = Y = C +I + G

-Consumption is now a function of disposable (post-tax) income so: C = a+b(Y-T)

-Tax revenue is: T = t(0) + tY

-Substituting for T gives:

C= a + bY- bt(0) – btY = (a - bt(0)) + b(1- t)Y

Equilibrium income is now:

- Y = (a - bt(0)) + b(1- t)Y + I + G

- Y = (a - bt(0)+I+G)/(1-b(1-t))

13

## What is the Multiplier including the Government Sector?

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- k(G) = 1/(1-b(1-t)). Since t>0 the multiplier must be smaller than before when t =0

14

## What does the Expenditure Income look like on a graph including the Government Sector?

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- With Consumption, Investment and Government Spending on the y-axis and Income on the x-axis

- AE=Y is the 45 degree line

- a horizontal line of y=I+G

- the diagonal line of C+I+G which has the gradient of b(1-t) and y intercept of a+I+G-bt(0)

- equilibrium is where the AE=Y line intercepts the line C+I+G

- Note the slope is of the C+I+G line is smaller note due to the fact that taxes are a deduction from household spending

15

## How is the can the Multiplier now be changed when including the Government Sector?

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- There are also multiplier effects from a swivelling of the planned expenditure locus – the C+I+G line

- We know the slope of this line is given as b(1-t) – the marginal propensity to consume out of gross income. Any change in b or t will cause the C+I+G line to swivel

- Suppose that the marginal rate of income tax (t) is increased, then the C+I+G line will have a flatter slope

16

## What are the limitations of Fiscal Policy?

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- Time lags: inside lags (recognition lag +decision lag) and the outside lag – means swift policy changes are rarely possible

- Forecasting accuracy is important, but impossible

- Public investment is irreversible – once you have started to build a hospital it makes no sense not to finish it!

- Financing issues: if the budget deficit is already large – as in 2008 – is it sensible to increase it further? Depends on size of country and financing history

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