Flashcards in L6 - Aggregate Expenditure and the Multiplier Deck (17):
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
How does a increase in desire spending effect the Equilibrium diagram?
- 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
What happens when an Investment shock occurs?
- 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)
What can we notice about the Equilibrium Income diagram after an investment shock?
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:
What is the Multiplier?
- 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
What are the different parts of the Government Sector?
- 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
What is the Tax function?
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
Are Tax Rates exogenous/endogenous?
- the government sets its tax rates and does not vary them as GDP varies
Are Tax Revenues exogenous/endogenous?
- as GDP rises with given tax rates , the tax revenue will rise
What does the Tax Function look like on a graph?
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)
What is Fiscal Policy?
- 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
What does the Expenditure Income model look like including the Government Sector?
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))
What is the Multiplier including the Government Sector?
- k(G) = 1/(1-b(1-t)). Since t>0 the multiplier must be smaller than before when t =0
What does the Expenditure Income look like on a graph including the Government Sector?
- 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
How is the can the Multiplier now be changed when including the Government Sector?
- 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
What are the limitations of Fiscal Policy?
- 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