Today schedule (22 March)

18:30 to 19:15 Lecture (Topic 9)

19:15 to 19:25 Break/Q&A via chat function
19:25 to 19:35 Classwork 1
19:35 to 19:40 Answer for Classwork 1
19:40 to 20:20 Lecture (Topic 9)
Fiscal Policy
Topic 9
Keynesian Model
• In the short run, firms meet demand at preset prices
• Firms typically set a price and meet the demand at that price in the short run
• Menu costs are the costs of changing prices
• Determining the new price
• Incorporating prices into the business
• Informing consumers of new prices

• Firms change prices when the marginal benefits exceed the marginal
costs
• In other words, prices are sticky, i.e., change very slowly.
• Technological advances can reduce costs of changing prices.
• In this model, prices are assumed to be fixed
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Planned Aggregate Expenditure
• Planned aggregate expenditure (PAE) is total planned spending on final goods
and services
• Four components of planned aggregate expenditure
• Consumption (C) by households
• Investment (I) is planned spending by domestic firms on new capital goods
• Government purchases (G) are made by federal, state, and local governments
• Net exports (NX) equals exports minus imports
PAE = C + I + G + X – M = C + I + G + NX
Note:
PAE is not the same as GDP.
GDP refers to goods actually produced over a period of time.
PAE refers to goods we want over a period of time.
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Planned Investment Example
• Firm A produces $5 million of toys per year
• Expected sales are $4.8 million and planned inventory increase is $0.2 million
• Capital expenditure of $1 million is planned
• Total planned investment is $1.2 million (i.e. Investment I in PAE is $1.2 million)
• If actual sales are only $4.6 million
• Unplanned inventory investment of $0.2 million
• Actual investment is $1.4 million (i.e. Investment I in GDP is $1.4 million)
• If actual sales are $5.0 million
• Unplanned inventory decrease of $0.2 million
• Actual investment is $1.0 million (i.e. Investment I in GDP is $1.0 million)

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Planned Aggregate Expenditure (PAE)
• Actual spending equals planned spending for
• Consumption
• Government purchases of final goods and services
• Net exports
• Adjustments between actual and planned spending are accomplished
with changes in inventories
• The general equation for planned aggregate expenditures is

PAE = C + IP + G + NX

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Consumption Expenditures
• Consumption (C)
• Powerful determinant of planned aggregate expenditure
• Includes purchases of goods, services, and consumer durables, but not new
houses
• Rent is considered a service
• C depends on disposable income, (Y – T)
• Output Y, real income
• Tax (T)
• T = To, a fixed amount
• T = tY, proportional income tax system and t is the tax rate

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Consumption Function
• The consumption function is an equation relating planned consumption
(C) to its determinants, notably disposable income (Y –T)

C = Co + (mpc) x (Y – T), where

Co is autonomous consumption spending
Autonomous consumption is spending not related to the level of disposable income
mpc is the change in consumption for a given change in disposable income
0 < mpc < 1

A change in Co shifts the consumption function

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Consumption Function
C = Co + (mpc) x (Y – T)
• The wealth effect is the tendency of changes in asset prices to affect
household's wealth and thus their consumption spending
• This effect is included in Co
• Autonomous consumption Co also captures the effects of interest
rates on consumption
• Higher rates increase the cost of using credit to purchase consumer durables
and other items. Hence, higher rate reduces consumption.

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Consumption Function
C = Co + (mpc) x (Y – T)
• Marginal propensity to consume (mpc) is the increase in
consumption spending when disposable income increases by 1
• mpc is between 0 and 1 for the economy
• If households receive an extra 1 in income, they spend part (mpc) and save
part
• (Y – T) is disposable income
• Output plus government transfers minus taxes
• Main determinant of consumption spending

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Planned Aggregate Expenditure (PAE)
• Two dynamic patterns in the economy
1. Declines in production lead to reduced spending
2. Reductions in spending lead to declines in production and income
• Consumption is the largest component of PAE
• Consumption depends on output, Y
• PAE depends on Y
When Y goes up, C increases and Y goes up further…
When Y goes down, C decreases and Y goes down further…

© 2019 McGraw-Hill Education. 11

PAE Example
PAE = C + I + G + NX
C = Co + mpc x (Y – T) & T = To, a constant.
PAE = (Co – mpc x To) + mpc x Y + Io + Go + NXo,
Assume that Co, Io, Go, and NXo do not depend on Y.
PAE = Ao + mpc x Y, Ao= (Co – mpc x To) +Io+Go+NXo
If Co = 620, mpc = 0.8, To = 250, Io = 220, Go=330, & NXo =20
PAE = (620 – 0.8 x 250) + 220 + 330 +20 + 0.8Y
PAE = 990 + 0.8Y
If Y increases by 1, C goes up by 0.80 and PAE increases by 0.80.
Two parts of PAE
• Planned aggregate expenditure has two parts

• Autonomous expenditure (Ao),

the part of spending that is independent of output
• $990 in our example

• Induced expenditure, the part of spending that depends on output (Y)

• 0.8 Y in our example
Planned Expenditure Graph
Planned aggregate expenditure (PAE)
PAE = 990 + 0.8Y

4950

990
Slope = 0.8

4,950

Output (Y)

© 2019 McGraw-Hill Education. 14

Short-Run Equilibrium
• Short-run equilibrium is the level of output at which
planned spending (PAE) is equal to output produced (Y)
• No change in output as long as prices are constant
• Our equilibrium condition can be written as
Y = PAE
• Using our previous example, Y=Ao + mpc x Y
Y = 990 + 0.8 Y
0.2 Y = 990
Y = 4,950

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Output Greater than Equilibrium in the Short Run
• Suppose output reaches 5,000 > eqm. Output 4,950
• Planned spending PAE is less than total output Y
• (At Y=5,000, PAE=990+0.8(5000)=4,990 < 5,000)

• Unplanned inventory increases

• Businesses slow down production

• Output goes down

• This process continues until Y=PAE

Output Less than Equilibrium in the Short Run
• Suppose output reaches 4,900 < eqm. Output 4,950
• Planned spending PAE is larger than total output Y
• (At Y=4,900, PAE=990+0.8(4,900)=4,910 > 4,900)

• Unplanned inventory decreases

• Businesses speed up production

• Output goes up

• This process continues until Y=PAE

Question 1
Suppose that Co=300, Io=200, Go=100, NX=50, mpc=0.8, t=0.2 (tax rate).

a. Find the PAE and the equilibrium output.

b. What should be the change in government spending in order to
achieve an output target of 2,000?
Policy goals
• Fiscal and monetary policies can be used to achieve goal set by the
government.
• Inflation target
• Real GDP growth
• Exchange rate target
• Interest rate target … etc.
 Policy Goal: An example
• Premier Li Keqiang said, at the National People’s Congress, China set
An economic growth target of ‘above 6 percent’ for 2021;
A target for consumer price index (CPI) growth (i.e. inflation rate)
around 3 percent for 2021;
A target of creating 11 million new urban jobs (i.e. lower
unemployment rate) for 2021;
Fiscal Policy
Government policies go through fiscal budget.
Fiscal Budget = Taxes (T) minus Government spending (G)
(Budget surplus: T>G; Budget deficit: T<G)

Note:
Government spending G in fiscal budget includes all types of
government expenditure, such as transfer payment.
Types of Fiscal Policy
• Expansionary fiscal policy:
• Aim: increase output and reduce unemployment
• Tools: Increase in G and/or Reduction in T
• This policy increases PAE Effect of G on PAE
is larger than
that of T on PAE.
• Contractionary fiscal policy:
• Aim: decrease inflation rate
• Tools: Decrease in G and/or Increase in T
• This policy decreases PAE
Fiscal Policy in China 2021
• Cuts in taxes and fees.
• Budget deficit to GDP ratio declines but still higher than the level in
2019.
Expansionary Fiscal Policy: An example
PAE = Ao + mpc x Y, Ao= (Co – mpc x To) +Io+Go+NXo
If Co = 620, mpc = 0.8, To = 250, Io = 220, Go=330, & NXo =20
PAE = (620 – 0.8 x 250) + 220 + 330 +20 + 0.8Y
PAE = 990 + 0.8Y & Eqm. Y= Ye1 = 4,950 At the ew eqm.
Now, G increases from 330 to 430 Y=new PAE=1090+0.8Y
Y-0.8Y=1090
PAE = 1,090 +0.8Y & Eqm. Y = Ye2 = 5,450 Eqm Y = 1090/0.2 = 5450

Change in Eqm. Y is 500 > Change in G = 100

WHY?
Multiplier effect
Increase in Co/Io/Go/Xo or decrease in To Ao

When Go increases by 100,

PAE increases by 100.
Hence, Y goes up by 100. Y
When Y increases by 100,
C increases by 0.8 x 100 = 80.
PAE increases by 80,
Y further increases by 80,
Loop
…this process continues
Planned Consumption, C;
Planned Investment, I
 Multiplier effect: Increase in G
Round ΔG ΔC ΔPAE ΔY
1 100 0 100 100
2 0 80 (=100x0.8) 80 80
3 0 64 (=80x0.8) 64 64
4 0 51.2 (=64x0.8) 51.2 51.2
. . . . .
. . . . .
Sum 100 500

PAE = Ao + mpc x Y Multiplier = 1/(1-mpc) = 1/0.2 = 5

Sum ΔPAE = ΔG x Multiplier = 100 x 5 =500
mpc=0.8
Note: sum of an infinite series =a/(1-r), a is the first term and r is the common ratio
 Multiplier effect: Increase in Tax
Round ΔT ΔC ΔPAE ΔY
1 100 -80 (=-100x0.8) -80 -80
2 0 -64 (=-80x0.8) -64 -64
3 0 -51.2 (=-64x0.8) -51.20 -51.20
4 0 -40.96 (=-51.2x0.8) -40.96 -40.96
. . . . .
. . . . .
Sum 100 -400

PAE = Ao + mpc x Y
Multiplier = 1/(1-mpc) = 5
mpc=0.8 Sum ΔPAE = (ΔT x mpc) x Multiplier = (-100x0.8)/0.2= -400
Note:
Fiscal budget = G – T
If ΔG=100 & ΔT=100 (balance budget), ΔPAE = 100
Short run effect of a Fiscal Policy
Expansionary fiscal policy:
In the short run, output increases.

Contractionary fiscal policy:

In the short run, output decreases.
 Determinants of the Multiplier effect
• Saving:
• Y = Saving + Consumption
When we tend to save more, link between income and consumption is weaker and the
multiplier effect is smaller.
• Import:
• Y = Domestic goods + Foreign goods
When we tend to buy foreign goods more, link between income and domestic
consumption is weaker and the multiplier effect is smaller.
• Proportional income tax rate t:
Tax = tY
The larger is the tax rate t, the weaker is the link between income and consumption.
Therefore, the multiplier effect is weaker.
Algebra of the multiplier
C=Co + mpc x Yd, o< mpc <1 and Co>0, Co is autonomous planned consumption.
Yd = Y-tY, o<t<1
I=Io-kr, where r is the real interest rate and k>0. Io>0 and it is autonomous planned investment.
i = r + πe, i is nominal invest rate and πe is expected inflation rate.
G=Go>0 and it is autonomous government spending.
X=Xo>0 and it is autonomous export demand.
M=Mo+ mpi x Y, 0< mpi <1 and Mo is autonomous planned import.
PAE=C+I+G+X-M .
PAE=(Co + mpc x (Y-tY))+(Io-kr)+Go+Xo-(Mo+ mpi x Y) = Ao + (mpc(1-t)-mpi)Y = Ao + bY,
where
Multiplier is larger,
Ao = Co + Io – kr + Go + Xo –Mo & b = mpc (1-t) – mpi when
Multiplier = 1/(1-b) = 1/[1-(mpc (1-t) – mpi)] mpc is larger,
At eqm. Y=Ao+Y & Ye=A0/(1-b); Ao=1, Ye=1/(1-b); Ao=2, Ye=2/(1-b) t is smaller,
Multiplier = ΔYe/ ΔAo = 1/(1-b) mpi is smaller
Question 2
Suppose that Co=300, Io=200, Go=100, NX=50, mpc=0.8, t=0.2 (tax rate).
Furthermore, I = Io – 10r, where r is the real interest rate.
(I = 200 – 10r is the investment demand function)

a. . If r=0.05 (i.e., 5%), what is the equilibrium output and what is the
expenditure multiplier ?
b. What is the relation between real interest rate and equilibrium output?