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04 - DFS Chapter 9
04 - DFS Chapter 9
Chapter 9
Macroeconomics
D
Dornbusch, Fischer & Startz
b h Fi h & S
Income and Spending
Central Question in Macroeconomics – why does output fluctuate around its
potential level?
Boom – output is above potential.
Recession – output is below potential.
The first theory of economic fluctuation that appeared analyzes the interaction
between spending and output:
Spending determines output but output also determines spending.
The basic assumption and a central simplification of this theory are that prices do
not change at all during the period under consideration.
This means that the AS curve is horizontal and that AD shifts are solely responsible
for the movements of equilibrium output.
The Keynesian Model of Income Determination
AD and Equilibrium Output
Definition: AD – total amount of goods demanded in the economy
AD = C + I + G + NX
Equilibrium occurs when output produced is equal to total quantity demanded:
Q = AD = C + I + G + NX
when Q AD, the economy is at a disequilibrium and unplanned inventory
investment piles up: UI = Q – AD ; UI > 0 if Q > AD
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Consumption and AD
The largest component of AD is consumption.
Demand for consumption goods is normally assumed to rise with income, all
else equal.
The relation between consumption demand and income is described by the
consumption function (all variables with 0 subscripts are autonomous):
C = C0 + cQ ; C0 > 0 ; 0 < c < 1
The slope c is assumed to be a fraction; it says that for every additional peso
of income, a fraction, c, is used for consumption; (1 – c) is saved.
c is called the marginal propensity to consume (MPC).
We note that following:
S ≡ Q – C ≡ Q – (C0 + cQ) ≡ –C0 + (1 – c)Q
(1 c) is the marginal propensity to save (MPS).
(1 – c) is the marginal propensity to save (MPS)
Assume that taxes, TA0, are paid by economic agents. Consumption now
depends on disposable income:
C = C0 + cQD = C0 +c(Q – TA0)
Assume further that all other components of AD and taxes are autonomous,
i.e., they are determined outside the model (specifically, that they are
independent of income).
Then, we can write AD as:
AD = C + I0 + G0 + NX0 = (C0 + I0 + G0 + NX0) + cQ = A0 + cQ
This says that there is a component of AD that is independent of income and
a component that is not. This can be shown graphically:
AD AD
Q = AD
AD = A0 + cQ
A0 C = C0 + cQ
C0
Q 45o Q
Equilibrium Income
In equilibrium, Q = AD.
This is shown as a 45 degree line in the AD–Q plane above.
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Substitute the expression for AD in the equilibrium condition to get:
Q = AD
Q = A0 + cQ
Solving for equilibrium Q:
This can be shown graphically:
AD
The Multiplier Q = AD
One can write the expression for
equilibrium output in terms of AD = A0 + cQ
changes instead of levels: ΔA0
ΔA0/(1 – c)
ΔQ*
α is the multiplier and is the amount
by which output changes when
45o Q
autonomous spending changes. Q*
For example, if c = 0.90, a 1 peso increase
in A0 leads to a 1/(1 – 0.90) = 10 peso increase in equilibrium output.
Government Sector
Two ways by which government affects equilibrium income:
1] government expenditures
2] taxes and transfers
Definition: Fiscal Policy – refers to the policy of government concerning their
expenditures, tax structure and levels of transfers.
expenditures, tax structure and levels of transfers.
Assume that the policy is such that expenditures and transfers are
autonomous but that economic agents pay a proportional income tax.
That is, G0and TR0 are constants and TA = tQ where 0 < t < 1 is the tax rate.
The consumption function then becomes:
C = C0 + cQD = C0 + c(Q + TR0 – TA) = C0 + c(Q + TR0 – tQ)
= C0 + cTR0 + c(1 – t)Q
The MPC is now c(1 – t).
Transfers raise autonomous spending while taxes lower disposable income.
Using this, one now can modify the AD equation:
AD = A0 + c(1 – t)Q
where A0 = C0 + cTR0 + I0 + G0 + NX0
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In equilibrium:
Q = A0 + c(1 – t)Q
Solving for Q, we get:
The Government Budget
Budget surplus – is the excess of government revenues and taxes over total
government expenditures.
The effect of an increase in expenditures is to reduces the surplus.
A formal expression of this is seen by looking at the components of the
budget:
BS ≡ TA – G0 – TR0 ≡ tQ – G0 – TR0
To measure the effect quantitatively, differentiate the identity with
respect to G: