02/16/2023

CHAPTER
3
The Influence of Fiscal Policy on
Aggregate Demand

Economics
PRINCIPLES OF

N. Gregory Mankiw

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by Ron Cronovich
by Van Tran
© 2009 South-Western, a part of Cengage Learning, all rights reserved

This chapter
looks for the answers to these questions:

 What are the components and determinants of aggregate

demand?
 When the goods market is in equilibrium, how the economy
adjusts to equilibrium?
 In what ways does fiscal policy affect aggregate demand?

Outline

 Aggregate demand
 Equilibrium in goods market
 The effects of fiscal policy on aggregate demand

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Aggregate demand
Aggregate demand (GDP or Y) is the sum of :
Y = C + I + G + NX
where:
C = Consumption
I = Investment
G = Government purchases
NX = Net exports, foreign demand for goods

12-3

Consumption

 Components
 The spending by households on goods and services
 It includes spending on: food, clothing, shelter, health, education,
etc.
 Determinants of consumption
 Current income level,
 Historical income levels,
 Amount of asset ownership,
 Expectation, etc.

Consumption
 The consumption function
 According to Keynesian, consumption is a function of current
disposable income
C = f (Yd)
In particular, it can be express as
C = c0 + cm .Yd
c0 autonomous (minimal) consumption
cm Marginal Propensity to Consume,
Yd disposable income
cm = ∆C/∆Yd or cm = C/Yd, 0 < cm < 1

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John Maynard Keynes

• 1883 – 1946
• Sinh ra ở Cambridge
• Những ý tưởng của
ông, hình thành
nên Kinh tế học
Keynes, có ảnh hưởng
lớn tới kinh tế học hiện
cũng như các chính
sách tài chính của
nhiều chính phủ.
• Ông ủng hộ cho sự
can thiệp của chính
phủ vào kinh tế, chính
sách tài chính và chính
sách tiền tệ làm giảm
đi những ảnh hưởng
bất lợi do suy thoái
kinh tế hay bùng nổ
kinh tế gây ra.

Saving
 Definition
 is the amount of disposable income left over after consumption
 it can be in the form of cash, bank deposit, life insurance, etc.
 The saving function
S = Yd – C
S = Yd – (c0 + cm.Yd)
S = – c0 + (1 – cm).Yd
set sm = 1 – cm  cm + sm = 1, 0 < sm < 1
S = - c0 + sm.Yd

sm is the marginal propensity to save

sm = ∆S/∆Yd or sm = S/Yd

The Consumption and Saving curves

C = Yd
C,S 450

C  c0  c m  Yd

c0
S  c0  (1  cm )  Yd

Y0 Yd

-c0

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An example
 A country with the consumption function
C = 200 + 0.75 Yd
 The saving function is
S = - 200 + 0.25 Yd
 Graph the consumption and saving curves ?

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Investment

 is the expenditure that aims at an increment in the capital

stock
 Determinants of the level of investment
• Interest rate,
• The level of national income,
• Expectation,
• Current stock of capital,
• The cost of investment, etc.
I = f (i. Y, E, K, C…)
Which determinant is the most important?

Investment
 The investment function
 The reduced form of the investment function
I = f (i. Y)
I = i0 + im . Y + ir . i
i0 the autonomous level of investment,
im the marginal Propensity to Invest (= saving/GDP)
ir interest rate
• When interest rate unchanged, the investment function is
further reduced to
I
I = i0 + im . Y
I = i0 + im.Y

Example i0

I = 100 + 0.2Y
Y

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Government purchases
 Government spending
 (Government) purchases of goods and services
 (Public) investment
 Transfer payments
 Loan payment, etc.
 Determinants of government purchases
 The size of the society
 The size of the economy
 Economic growth
 The government’s decision, etc.
 The government purchases function
G = g0

Tax
 Net tax revenue
… is the difference between tax revenue and transfer payments
net tax revenue = tax revenue - transfer payments
 Determinants of tax revenue
 The size of the economy (Y)
 Tax rate
 The (net) tax function
T = t0 + tm.Y
T net tax revenue
t0 is the autonomous tax level,
tm is the tax rate

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The Government’s budget

 Government spending
 (Government) purchases of goods and services (G)
 (Public) investment
 Transfer payments
 Loan payment, etc.
 Government receipts
 Taxes, fee (T)
 Rent, profit
 Aid, remittances
 The Government’s budget
 The Govt’s budget = Govt’s receipts - Govt’s spending
B=T–G

Vietnamese Government’s Receipts

Vn Govt’s Receipts as a Percentage of GDP 2000-2015

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Vn Govt’s Spending as a Percentage of GDP 2000-2015

Export
 Exports: the value of goods and services produced within the
country and consumed abroad
 Determinants of exports
 Income (the size) of the exporting country (Y)
 Income (the size) of the rest of the world (Y*)
 Exchange rate (E)
 The export function
X = f (Y, Y*, E)
the effect of Y* on X is more important than that of Y
Y* and E are not determined within the country itself (exogenous)
X = x0

Imports
 Imports the value of goods and services produced abroad and
consumed in the country
 Determinants of imports
 Income (the size) of the exporting country (Y)
 Income (the size) of the rest of the world (Y*)
 Exchange rate (E)
 The import function
M = f (Y*, Y, E)
the effect of Y on X is more important than that of Y*
E is not determined within the country itself (exogenous)
M = m0+ mm.Y

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Aggregate demand
 Aggregate demand is the total expenditure on final goods and
services in an economy
AD = C + I + G + NX
where
C = c0 + cmYd
I = i0 + imY
G = g0
X = x0
M = m0 + mmY
T = t0 + tmY

AD = ?

Aggregate demand

AD = c0 – cmt0 + i0 + g0 + x0 – m0 + [cm(1 – tm) + im – mm] Y (1)

let
AD0 = c0 – cmt0 + i0 + g0 + x0 – m0
ADm = cm(1 – tm) + im – mm

AD = AD0 + ADm Y

Equilibrium in goods market

 The goods market is in equilibrium when aggregate income equals
aggregate demand
Y = AD (2)

 (1) and (2) yields

1
Y  (c0  cmt0  i0  g 0  x0  m0 )
1  [cm (1  t m )  im  mm ]

1
 let k
1  [cm (1  t m )  im  mm ]
then Y = k . AD0
k is aggregate demand multiplier, k > 1,
i.e. an $1 increase in autonomous consumption (AD0) will result in
greater-than-$1 increase in GDP.

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Aggregate demand curve:

in goods market model

AD

AD = AD0+ ADm . Y

AD0

45
°
Y1 Y0 Y2 Y

THE INFLUENCE OF MONETARY AND FISCAL POLICY 27

Aggregate demand curve:

in Aggregate demand and Aggregate supply model

 In the short-run: assume that the over all Price level

unchanged
 In each market, quantity demand has negative relationship
with price
 Similarly, the P
aggregate demand has
negative relationship
with the over all price
P0
level

AD

Y0 Y
THE INFLUENCE OF MONETARY AND FISCAL POLICY 28

An example
 An economy VN has spending functions estimated as follow:
C = 200 + 0,75Yd
I = 100 + 0,2Y
G = 580
T = 40 + 0,2Y
X = 350
M = 200 + 0,05Y

 What is the aggregate demand function?

 What is aggregate demand multiplier?

AD = 200 + 0,75(Y- 40 + 0,2Y) + 100 + 0,2Y + 580 + 350 – (200 + 0,05Y)

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The multiplier effect

A change in government spending (ΔG)

income to individuals (ΔY round 1 = ΔG)

consumer spending (ΔC = cm*ΔY)

income to individuals (ΔY round 2 = cm*ΔY)

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The multiplier effect

 Suppose the Gov’t buys a Boeing plane of $10b, this increases
Boeing’s revenue by $10b.
 The $10b increase will be paid in the forms of wage for workers and
dividend to share holders
 Their family’s income will increase by $10b.
 They will spend a share of which as consumption, i.e. $8b
 Firm’s revenue will increase by $8b
 Individual’s income will increase by $8b for the 2nd round

The multiplier effect: the additional shifts in AD

that result when fiscal policy increases income and thereby
increases consumer spending

THE INFLUENCE OF MONETARY AND FISCAL POLICY 31

The multiplier effect

Tăng lượng sản Tăng lượng sản

c = 0,75 AD tăng do ΔG = 1
xuất (ΔY) xuất (ΔY)
1st round ΔAD = 1 ΔY = 1 ΔG
2nd round ΔAD = 0,75 ΔY = 0,75 c ΔG
3rd round ΔAD = 0,56 ΔY = 0,56 c2 ΔG
4th round ΔAD = 0,31 ΔY = 0,31 c3 ΔG
and so forth and so forth and so forth
Sum: ΔAD = 4 ΔY = 4
The multiplier is the mathematical expression of this expenditure cycle.

THE INFLUENCE OF MONETARY AND FISCAL POLICY 32

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A graphical illustration of the multiplier effect

AD
AD1

AD02
AD1

AD01

Y1 Y2 Y

THE INFLUENCE OF MONETARY AND FISCAL POLICY 33

The influence of fiscal policy on goods

market

 Fiscal policy: is the govt’s decision of its spending and receipts

AD = C + I + G + NX
AD = C(Y – T) + I + G + NX
AD = c0 – cmt0 + i0 + g0 + x0 – m0 + [cm(1 – tm) + im – mm] Y
1
Y  (c0  cmt0  i0  g 0  x0  m0 )
1  [cm (1  t m )  im  mm ]

THE INFLUENCE OF MONETARY AND FISCAL POLICY 34

Expansionary fiscal policy

AD = C(Y – T) + I + G + NX

AD = c0 – cmt0 + i0 + g0 + x0 – m0 + [cm(1 – tm) + im – mm] Y

1
Y  (c0  cmt0  i0  g 0  x0  m0 )
1  [cm (1  t m )  im  mm ]

The gov’t can: increase G and/or decrease T

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Expansionary fiscal policy:

Graphical illustration

AD P

AD2 G, T

AD02 P1
G, T AD1
AD2
AD01
AD1

Y1 Y2 Y Y1 Y2 Y

goods market model AS-AD model

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Contractionary fiscal policy

AD = C(Y – T) + I + G + NX

AD = c0 – cmt0 + i0 + g0 + x0 – m0 + [cm(1 – tm) + im – mm] Y

1
Y  (c0  cmt0  i0  g 0  x0  m0 )
1  [cm (1  t m )  im  mm ]

The gov’t can: decrease G and/or increase T

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Contractionary fiscal policy:

Graphical illustration

AD P

AD1 G, T

AD01 P1
G, T AD2
AD1
AD02
AD2

Y2 Y1 Y Y2 Y1 Y

goods market model AS-AD model

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The crowding-out effect

 Recall: I = i0 + im . Y + ir . i
 Expansionary fiscal policy  AD  Y
 Y  money demand 
 In money market: money supply unchanged, higher money
demand  i 
 i   I   AD 
 So, the size of the AD shift may be smaller than the initial fiscal
expansion.
 This is called the crowding-out effect.

THE INFLUENCE OF MONETARY AND FISCAL POLICY 39

The crowding-out effect: graphical illustration

AD P
AD2

G, T
AD’2

AD02 P1
G, T AD1
AD2
AD01 AD’2
AD1

Y1 Y2 Y Y1 Y2 Y

goods market model AS-AD model

THE INFLUENCE OF MONETARY AND FISCAL POLICY 40

The gov’t budget target and the goods market

 Recall:
 The goods market equilibrium equation
1
Y  (c0  cmt0  i0  g 0  x0  m0 )
1  [cm (1  t m )  im  mm ]

 The aggregate demand multiplier, which is also the

government purchases multiplier

 The tax multiplier

THE INFLUENCE OF MONETARY AND FISCAL POLICY 41

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The gov’t budget target and the goods market

 In some cases, the gov’t needs to raise tax to finance the
increase in its purchase (or to cut its purchase when its
receipts decreases) in order to keep B unchanged
i.e. T = G

 Y = G . kG + T . kT

 Y = G . kG (1 – cm)

THE INFLUENCE OF MONETARY AND FISCAL POLICY 42

Automatic stabilizers
 Automatic stabilizers:
 The tax system: in recession, taxes fall automatically,
which stimulates aggregate demand.
 Govt spending: in recession, more people apply for public
assistance (welfare, unemployment insurance). Govt spending on
these programs automatically rises, which stimulates aggregate
demand.
AD = C + I + G + NX
AD = C(Y – T) + I + G + NX

THE INFLUENCE OF MONETARY AND FISCAL POLICY 43

Keynesians in the White House

1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors were
followers of Keynes.

2001:
George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.

THE INFLUENCE OF MONETARY AND FISCAL POLICY 44

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The case against active stabilization policy

 Monetary policy affects economy with a long lag:

 Firms make investment plans in advance,
so I takes time to respond to changes in i.
 Most economists believe it takes at least
6 months for monetary policy to affect output and
employment.
 Fiscal policy also works with a long lag:
 Changes in G and T require the parliament’s approval.
 The legislative process can take months or years.

THE INFLUENCE OF MONETARY AND FISCAL POLICY 45

The case against active stabilization policy

 Due to these long lags, critics of active policy argue that such
policies may destabilize the economy rather than help it:
By the time the policies affect AD,
the economy’s condition may have changed.

 These critics contend that policymakers should focus on long-

run goals like economic growth and low inflation.

THE INFLUENCE OF MONETARY AND FISCAL POLICY 46

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