Unit 14

UNEMPLOYMENT AND FISCAL POLICY

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 Unit 14 Roadmap
14.1 The transmission of shocks: The multiplier process
14.2 The multiplier model (consumption)
14.3 Household target wealth
14.4 Investment
14.5 The role of government
14.6 Stabilising the economy
14.7 The multiplier in practice
14.8 The government’s finances
14.9 Aggregate demand and unemployment

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 Learning outcomes (lesson 1-3) – the learning
outcomes for the rest of the unit follow later
• Calculate and interpret the multiplier.
• Interpret, calculate and explain the components of the consumption
function.
• Interpret, calculate and explain the components of the aggregate demand
function.
• Draw the consumption function and indicate the value of each component
on the graph.
• Draw the goods market equilibrium graph.
• Explain the goods market equilibrium and translate changes in C and I onto
a graph.
• Explain the multiplier process.
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 The Context of This Unit
Aggregate demand (real GDP) can fluctuate due to
consumption and investment decisions. (Unit 13)

The aggregate decisions of households and firms can

destabilise the economy.
• How can government intervene to stabilise the economy?
• Why are government policies sometimes ineffective?
• How can we model the link between output and
unemployment?
 Keynesian theory and economic stability
• Keynes suggested that the cause of
the Great Depression (1929-1933)
was an unusually low level of
aggregate spending
• This diagnosis suggests an
immediate remedy: use government
policies to increase aggregate
spending [Unit 9.6-9.7]
• Extra income leads to extra
spending, which leads to further
increases in output and income. The
process continues around and
around the circular flow 5
 US War on Poverty
President Roosevelt’s
begins: 1964 Start of
New Deal: 1933-36
40% US deploys ground troops global
End of in Vietnam: financial
End of
Government revenue (as a percent

WWII: 1945 1965 crisis: 2008

WWI: 1918
30% Start of
of GNP) / GDP growth (%)

Great 1970s
Depression:
20% 1929

10%

0%

-10%

-20%
1870
1875
1880
1885
1890
1895
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
GDP growth Government size
Stabilisation policy and South Africa
 Main aim of unit 14 Part 1
• Building the multiplier model (in TWO STEPS) to understand how the
decisions of households (C) and firms (I) affect real GDP/ aggregate
demand/output.

• Step 1: Build the consumption function (households only)

• Step 2: Build the AD function by adding I (firms) to C.

• Then we will evaluate the equilibrium of this model.

14.1 The multiplier effect
 The multiplier effect in a private economy
• A private economy consists of households and firms.

• We are only looking at consumption (C) by households and

Investment (I) by firms.

• Later in the unit we will add the other expenditure components…..

 14.1 Transmission of shocks: Multiplier process
Remember (Unit 13):
• Firm and household spending behaviour affect the economy
• Changes in current income influence spending, affecting the income of
others –
• so indirect effects through the economy amplify the direct effect of a
shock to aggregate demand (often shortened to AD)
AD = C + I [+ G + NX]

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 14.1 Transmission of shocks: Multiplier process

AD = C + I [+ G + NX]

Changes in household consumption (C) and investment by

firms (I) affect real GDP (output).

The multiplier is a tool that helps us to understand how

changes in C and I affect real GDP (output).

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 14.1 Transmission of shocks: Multiplier process
The multiplier helps us understand:

1. How the impact of firms and households’ spending decisions will affect
the whole economy

2. How large the direct and indirect impact of the change will be on real
GDP

3. And/ or what the effect of lower government spending will be, etc…

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 The Multiplier
The multiplier represents the relative magnitude of total
change in output (real GDP) as a result of an initial change in
autonomous expenditure.

Δreal GDP Δ real GDP

or
Δ𝑐0 Δ𝐼

If R1 is spent in the economy, by how much will that R1

change the real GDP of that economy.
 The multiplier effect
• The total change in output can be greater than the initial change in C
or I because of the circular flow of expenditure, income, and output.

• If multiplier = 1: the increase in real GDP is equal to the initial increase

in spending

• If multiplier > 1: the total increase in GDP > the initial increase in
spending

• If multiplier < 1: the total increase in GDP < the initial increase in
spending
 Multiplier process
• The multiplier process helps us to explain why real GDP increases more
than the initial increase in (autonomous) spending.
• The process is explained through the aggregate consumption function =
consumption spending (C) for the economy as a whole
→ combining the behaviour of consumption smoothing and non-
consumption smoothing households
• Consumption depends on income
• For consumption smoothing households: an increase in income will not increase
their consumption one-for-one, or even at all.
• Non-smoothing households will increase their current consumption one for one in
response to a temporary increase in their income.
• The multiplier is > 1, if the additional consumption spending resulting from a
temporary increase in income is greater than zero but less than 1 (e.g.,60 cents)
 14.2 The multiplier model

Now that we have seen how the multiplier process

works, let’s look at the multiplier model.
14.2 The multiplier model

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 REMEMBER
Figure 13.6. The circular flow model

simple model:
private economy
2 sectors
Households – C
Firms – I

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 The consumption function
• The consumption function is the first component of the multiplier
model.

• It shows the various components of household consumption and how

households respond to changes in income.

NB!!!! The consumption function is NOT the aggregate demand

function. It is a component of the aggregate demand function.
 Multiplier model: Consumption
function (C)
consumption
C = co + c1 x (Yd) dependent on
income, the
variable
autonomous consumption amount
= the fixed amount spent,
independent of income

MPC = marginal (disposable) income

propensity to
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consume
 Multiplier model: Aggregate consumption:
𝐶= 𝑐0 +𝑐1𝑌
𝑐0 = autonomous consumption
= the fixed amount spent, independent of income (necessities
such as food, shelter, clothing)

Expectations about future income are reflected in autonomous

consumption
 Multiplier model: Aggregate consumption:
𝐶= 𝑐0 +𝑐1𝑌
𝑐1𝑌 = consumption dependent on income
= the variable amount

If marginal propensity to consume is 0,6 then consumption increases

by:
R1*0,6 = 0,60c
Slope of consumption function (c1) = marginal propensity to consume (MPC), the
change in consumption when disposable income changes by one unit.
→ MPC is positive, but less than 1:
part of the income is consumed (the rest is saved)
 Yd = C + S
part of the income
is consumed the rest is saved
part of income part of income saved
consumed = MPS
= MPC marginal propensity to save (MPS),
the change in savings when disposable
income changes by one unit

MPC + MPS = 1
 Consumption function
A steeper consumption line
means a larger consumption
response to a change in
income.
A flatter line means that
households are smoothing
their consumption so that it
does not vary much when
incomes varies.
C = 21 380 + 0,672 Yd
Cons = Private consumption expenditure at
constant prices
YPDI = Personal disposable income at constant
prices
Example: Multiplier effect (consumption
only)
 Multiplier model: Aggregate demand
function
• We have now set up the consumption function (households).

• We now add investment (firms) to the consumption function.

• Adding firm’s investment to the consumption function gives us the

complete aggregate demand function (AD= C + I) for a private
economy (households and firms only).
Multiplier model: Aggregate demand function
• How shocks are transmitted through the economy : Look at output
produced and aggregate demand.
• Output=aggregate demand for goods produced in the home economy
Y=AD
• The 45-degree line shows all the combinations where output (Y)=
aggregate demand (AD).
• Considering Investment as the other expenditure component of our
model:
Aggregate demand= consumption + Investment
AD= C + I
= c0 + c1Y + I 32
Multiplier model: Goods market equilibrium
• Aggregate demand (AD) =
consumption function + investment

• Investment is assumed to be
independent of output (Y) (therefore
autonomous)

• The slope of AD line is below 45°

because the MPC<1
Figure 14.4 Goods market equilibrium: The multiplier diagram.

• 45° line is where Y = AD Goods market equilibrium: Y = AD

 The multiplier process
Fall in investment → fall in
aggregate demand → lower
output and income → further
fall in demand and income →
new equilibrium (Z)
 Changes in consumption function
Credit constraints and consumption smoothing is reflected in the
slope of the AD curve and the size of the multiplier through the
autonomous component.

Consumption decisions can also shift the AD curve.

• e.g. a fall in house prices will be bad news for a household with a
mortgage. They may choose to save more (precautionary saving)
and hence their autonomous consumption would fall.
 The multiplier effect
• The total change in output can be greater than the initial change
in C or I because of the circular flow of expenditure, income, and
output.

• If multiplier = 1: the increase in GDP is equal to the initial

increase in spending
• If multiplier > 1: the total increase in GDP > the initial increase in
spending

• If multiplier < 1: the total increase in GDP < the initial increase in
spending
14.2 Multiplier model: Aggregate demand
function
Remember: We are ultimately interested in how changes in C or I
results in changes in output and employment (Unit 9.7)

• Low output high unemployment

• High output low unemployment

Determine this position of the economy by analyzing the individual

components of aggregate demand function
 Exercise
1) In a model where we only consider consumption and investment, if the MPS is 0,4 what is the value
of the MPC?

2) Calculate the value of Keynesian multiplier.

3) Given that consumption expenditure when disposable income is zero is R3500:

Determine the consumption function (using the C and I model only)
If I = R500, what would the aggregate demand (AD) function be?
4) If Investment increases by R500, what is the change in output (AD)?

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 Multiplier Equation
GDP
Economy modelled Y = AD equation ∆GDP
components
∆AD
Households only = 𝑐0 + 𝑐1Y 1
Economy
C =
1
(c )
( 1 − c1) 0 ( 1 − c1 )
= 𝑐0 + 𝑐1Y + I 1
Private Economy C+I =
1
(c + I)
( 1 − c1) 0 ( 1 − c1 )
Closed Economy = c0 +c1Y+I+G 1
(t = 0)
C+I+G =
1
(c + I+ G) ( 1 − c1 )
( 1 − c1) 0
=c0 +c1(1-t)Y+I+G
Closed economy C+I+G =
1
(c + I + G )
1
(taxes considered) ( 1 − c1(1 − t) 0 ( 1 − c1(1 − t))
= c0 +c1(1-t)Y+I+G+X–mY
1 1
Open Economy C+I+G+(X-M) = (c + I + G + X)
( 1 − c1(1 − t) + m) 0 ( 1 − c1(1 − t) + m)