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Aggregate Expenditure,

Equilibrium GDP and The Fiscal policy

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Simple Economy Case

We assume here that we have a simple economy where G = 0 ( no government effect on the economy) and X = 0, M = 0, and hence X-M = 0 (no foreign trade).

In such a case the national spending becomes = C + I.

Let us start with the consumption spending (expenditure)

220/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

3

Consumer Spending and Income The relationship between the level of

income and consumption spending is called the consumption function:

C = Ca + by

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Consumer Spending and IncomeC = Ca + by

• CCa a = = autonomous consumptionautonomous consumption, or the amount of , or the amount of

consumption spending that does not depend on consumption spending that does not depend on the level of income.the level of income.

• byby = the part of consumption that is dependent on = the part of consumption that is dependent on income, where:income, where:

• b b = = marginal propensity to consume (MPCmarginal propensity to consume (MPC), ), or the fraction of additional income that is spent.or the fraction of additional income that is spent.

• y y = level of income in the economy.= level of income in the economy.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

5

The Consumption Function

The consumption function relates desired consumer spending to the level of income.

• The consumption The consumption function intersects function intersects the vertical axis at the vertical axis at CCaa,,

the value of the value of autonomous autonomous consumption.consumption.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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The Consumption Function

When income equals zero, the value of total consumption (C) equals Ca. It corresponds to the amount of consumption that does not depend on the level of income.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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The Consumption Function

The slope of the consumption function is the marginal propensity to consume (MPC), or the value of b in the linear equation.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Consumer Spending and Income The fraction that the consumers spend on

consumption is given by their MPC.

• The fraction that the consumer s save is The fraction that the consumer s save is determined by their determined by their marginal propensity to marginal propensity to save (MPSsave (MPS).).

• The sum of the marginal propensity to The sum of the marginal propensity to consume and the marginal propensity to save consume and the marginal propensity to save is always equal to one. MPC + MPS = 1.is always equal to one. MPC + MPS = 1.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Changes in the Consumption Function The consumption function can change for

two reasons:

• A change in autonomous consumption.A change in autonomous consumption.

• A change in the marginal propensity to A change in the marginal propensity to consume.consume.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Changes in the Consumption Function• Factors that cause autonomous consumption Factors that cause autonomous consumption

to change are:to change are:

• Consumer wealth, or the value of stocks, Consumer wealth, or the value of stocks, bonds, and consumer durables held by the bonds, and consumer durables held by the public (i.e. the consumers). More wealth => public (i.e. the consumers). More wealth => higher consumption spending.higher consumption spending.

• Consumer confidence. More confidence => Consumer confidence. More confidence => higher consumption spending.higher consumption spending.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Changes in the Consumption Function

• An increase in autonomous consumption from An increase in autonomous consumption from CC00

aa to to CC11aa shifts up the entire consumption shifts up the entire consumption

function.function.20/12/2012

Prof. Abdelhamid Mahboub and Dr. Yousuf Hayajneh

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Changes in the Consumption Function

• An increase in the MPC from An increase in the MPC from bb to to bb’ increases ’ increases the slope of the consumption function.the slope of the consumption function.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Changes in the Consumption Function

• The consumption function is determined by the The consumption function is determined by the level of autonomous consumption and by the level of autonomous consumption and by the MPC.MPC.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Changes in the Consumption Function Factors that cause the marginal propensity

to consume to change are:

• Perception of changes in income. Studies Perception of changes in income. Studies show that consumers tend to save a higher show that consumers tend to save a higher proportion of a temporary increase in proportion of a temporary increase in income, and spend a higher proportion if the income, and spend a higher proportion if the increase is perceived to be permanent. increase is perceived to be permanent.

• Changes in taxes.Changes in taxes.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Determining GDP

GDP is determined where the C + I line intersects the 45 line.

• At that level of output, At that level of output, yy*, desired spending *, desired spending equals output.equals output.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Savings and Investment

Savings equals output minus consumption.CyS

• Output is determined by demand, Output is determined by demand, CC + + II, or, orICy

• Subtracting consumption from both sides of Subtracting consumption from both sides of the equation results in:the equation results in:

ICy • The left side shows that The left side shows that y y –– C C equals savings, equals savings,

SS, therefore:, therefore:IS

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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Savings and Investment

• Equilibrium output is determined at the level of Equilibrium output is determined at the level of income where savings equals investment:income where savings equals investment:

• The level of savings in the economy is not The level of savings in the economy is not fixed, and how it changes depends on the real fixed, and how it changes depends on the real GDP.GDP.

• The The savings functionsavings function is the relationship is the relationship between the level of income and the level of between the level of income and the level of savings.savings.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

18

The Multiplier

The multiplier is the ratio of the change in equilibrium output to the change in spending. It measures the degree to which changes in spending are “multiplied” into changes in output.

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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The Multiplier

An increase in investment shifts the C + I line upward.

• When investment When investment increases by increases by ΔII from from II00 to to II11, equilibrium , equilibrium

output rises by output rises by Δ yy from from yy00 to to yy11..

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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The Multiplier

The change in equilibrium output (Δy) is greater than the change in investment (ΔI).

The value of the multiplier = 1/(1-b)

1/(1-b) > 1. Why?

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

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The Multiplier in Action (if b = 0.8)Round of Spending

Increase in C+I

Increase in GDP and Income

Increase in Consumption

1 $10 $10 $8

2 8 8 6.4

3 6.4 6.4 5.12

4 5.12 5.12 4.096

5 4.096 4.096 3.277

… … … …

Total 50 million 50 million 40 million

20/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Multiplier in Action (if b = 0.8) In this numerical example notice that

The value of the multiplier = 1 / (1-b)

= 1 / (1-0.8)

= 1 / 0.2

= 5 And Δ y = Δ I × the multiplier

= 10 × 5

= 50

2220/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Multiplier in Action

In general:

The final change in equilibrium output or income = the initial change in spending ×

the multiplier. The change could be an increase or a decrease. The source of the change in spending could be

from consumption or investment or any other source of expenditure.

2320/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Fiscal Policy

More realistically, we should include in our model the two other items of spending (expenditure) that we assumed out before.

Therefore, AE = C + I + G + (X – M) AE will change when one or more of its

components (on the right hand side) change. An intentional government action to change

AE is called “government economic policy” or “government policy” for short.

2420/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Fiscal Policy

The “fiscal policy” refers to one type of the government policy actions to change the level of GDP through changing the government expenditure or taxes.

Recall that AE = C + I + G + (X – M), and therefore if the government changes its expenditure while all other things remain constant we will have

Δ AE = Δ G. Increasing (decreasing) G by 1 billion SR leads to an

equal increase (decrease) in AE.

2520/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

The Fiscal Policy

If the government knows that the value of expenditure multiplier = 5 and it increases its expenditure by 1 billion SR, it should expect an increase in GDP by 5 billion SR. We refer here to the formula on slide no. 24 before.

If reducing taxes leads to an increase in C by 1 billion SR, we expect the same effect.

Notice that the final increase in GDP will take some time to appear. This time length varies from one economy to another.

2620/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh

Test yourself

1. Why do we say MPC + MPS = 1? Is it possible to be greater than 1? Why or why not?

2. If MPC = 0.75 and the government raised G by 40 million SR, what do you expect to happen to GDP?

3. Give a definition of MPC, MPS and the multiplier.

4. The value of the expenditure multiplier can not be less than 1. Why is this true?

5. If MPC = 0.8 and we need GDP to increase by 10 billion SR, what can the fiscal policy do in order to achieve this goal?

2720/12/2012Prof. Abdelhamid Mahboub and

Dr. Yousuf Hayajneh