CHAPTER
14
Aggregate Demand
and Fiscal Policy
Prepared by: Jamal Husein
© 2006 Prentice Hall Business Publishing
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Learning Objectives




Why do governments cut taxes to
increase economic output?
Why is the U.S. economy more stable
than it was prior to World war II?
If consumers become more confident
about the future of the economy, can that
confidence lead to faster economic
growth?
If a government increases spending by
$10 billion, could total GDP increases by
more than $10 billion?
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Behind the AD Curve: A short Run
Analysis




The demand for goods and services
determines output, or the level of GDP, at least
in the short run.
The short run is a period of time during which
prices do not change, or change very little.
In the short run, producers supply all of the
output that is demanded.
In the short run, the economy rapidly adjusts
to reach the equilibrium level of output, where
total demand equals production, i.e., AD
equals AS.
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Shifts in Aggregate Demand
Price,
P
A shift in AD curve from AD0
to AD1 increases output from
y0 to y1.
SRAS
AD1
AD0
y0
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Output, y
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Shifts in Aggregate Demand
An increase of government spending of $10 billion will
initially shift original AD by $10 billion (from A to B).
Total AD will increase by more than $10 billion after a
period of time due to the multiplier effect.
Price,
P
A
B
C
Final AD
Initial shift
Original AD
y0
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y2
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Output, y
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The Consumption Function & the
Multiplier

The relationship between consumer spending
and income is called the consumption function:
C = Ca + by

Ca= autonomous consumption spending, or the
amount of consumption spending that does not
depend on the level of income.

by = induced consumption, or the amount of
consumption induced by higher income.

b= marginal propensity to consume (MPC).

y= level of income in the economy.
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Consumption Function


The consumption function
is a line that intersects the
vertical axis at Ca. the
value of autonomous
consumption spending.
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.
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The MPC & the MPS

The slope of the consumption function is the marginal
propensity to consume (MPC), or the value of b in the
linear equation.

For each additional dollar of
income received, a consumer
will spend part of it and save
the rest.

The fraction that the
consumer spends is given by
his or her MPC or the slope
of the consumption function
b.
The MPC is always less than
one

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The MPC & the MPS

The fraction that the consumer saves is
determined by his or her marginal propensity
to save (MPS).

For example, if b (MPC) = 0.6, then 60 cents
of each additional dollar are consumed and
40 cents (MPS = .4) are saved.

The sum of the MPC and the MPS is always
equal to one
MPC + MPS = 1
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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 the marginal propensity to
consume
Factors that cause autonomous
consumption to change are:

Consumer wealth, or the value of stocks,
bonds, and consumer durables held by the
public (Franco Modigliani).

Consumer confidence.
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Changes in the Consumption Function

Factors that cause the marginal
propensity to consume to change are:
Consumers’ perceptions of changes in
income. Studies show that consumers
tend to save a higher proportion of a
temporary increase in income, and
spend a higher proportion of income if
the increase in income is perceived to be
permanent.
 Changes in taxes, as we will see later in
this chapter.

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Changes in the Consumption Function
Impact of a change in
autonomous
consumption
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Impact of a change in the
marginal propensity to
consume
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Determining Aggregate Demand

In an economy without government or
the international sector, AD will be
determined by consumption (C) and
investment spending (I).

We stack up the amount of investment
on top of consumption function.
At any level of output (income), total
demand for goods and services can be
read of the C + I line.

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

Equilibrium output,
where y = C+I, is
found where the 450
line intersects the
demand line (C+I).
The y* level of output
means that firms are
producing precisely
the level of output
necessary to meet the
consumption and
investment demands
by households and
firms.
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Demand
Determining Aggregate Demand
450
E
C
Ca + I
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C+I
Ca
y*
Output, y
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The Multiplier




The model of AD can be used to explain what
happens to equilibrium output (employment)
if there is a change in investment spending (an
autonomous expenditure);
An increase in investment, i.e., from I0 to I1
(called ∆I) will shift the initial C+I0 curve
upward by ∆I to C+I1;
The intersection of C+I1 curve with the 45
degree line shifts equilibrium from E0 to E1;
As a result AD increases from Y0 to Y1;
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The Multiplier

The change in AD (∆y) is greater than the increase
in I, which is the general result that the increase in
output always exceeds the increase in investment;

This explains the multiplier or why the final shift
in AD is greater than the initial shift in AD;

The Multiplier is a number that shows by how
much equilibrium output will change as a result of
a change in the value of autonomous expenditures.

For example, if b = 0.75, then the multiplier equals
4. A one-dollar increase in autonomous
consumption or in investment, will increase
equilibrium income by 4 dollars.
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The Multiplier
E1
Demand
y1
∆I
450
C+I1
C+I0
y0
E0
C
I1
I0
CA
∆y
y0
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y1
Output, y
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The Multiplier in Action (millions $)
Round of
Spending
Increase in
Demand
1
$10
Increase in
GDP and
Income
$10
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
Multiplier
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Increase in
Consumption
$8
1
(1 – MPC)
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Government Spending and Taxation



Both the level of government spending and
the level of taxation, through their influence
on the demand for goods and services, affect
the level of GDP in the short run.
Using taxes and spending to influence the
level of GDP (shift the AD curve) in the short
run is known as Fiscal Policy.
Government purchases of goods and services
are a component of total spending;
Total Spending including government = C + I + G
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Government Spending
Increases (decreases) in government spending
shifts the C+I+G curve upward (downward),
just as changes in investment;
450
450
C+I+G1
C+I+G0
C+I+G0
y0
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Demand
Demand
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y1 Output, y
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y0 Output, y
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The Impact of Taxes

After taxes and transfers are taken into account,
national income becomes personal disposable
income:

Yd = y - T
The consumption function becomes:
C = Ca + by d

or
C = Ca + b(y  T)
For example, if taxes increase by $1, aftertax income will decline by $1. Since the
MPC is b, this means that consumption (C)
will fall by b×$1 and the C+I+G curve will
shift downward by b×$1 ;
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The Impact of Taxes

Increases (decreases) in taxes shifts the
C+I+G curve downward (upward) and
impact total demand and equilibrium output.
450
450
C+I+G
C+I+G
y0
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Demand
C+I+G
y1 Output, y
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y0 Output, y
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The Impact of Taxes



The multiplier for taxes is less than that
for government spending;
Decreasing government spending (G) by
$1, will shift the C+I+G curve downward
by $1;
However, increasing taxes by $1,
consumers will cut back their consumption
by a fraction of $1 (b×$1), thus the C+I+G
curve will shift downward by less than $1,
or exactly by b×$1;
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Government Spending and Taxation



We use a special terminology to describe
fiscal policy;
Government policies directed towards
increasing AD and GDP are called
expansionary policies such as tax cuts
and increases in government spending;
Government policies directed towards
decreasing AD and GDP are called
contractionary policies such as tax
increases and government spending cuts
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Government Spending and Taxation



Budget deficit, the difference between
government spending and its revenue,
will be impacted by government policies;
An increase in government spending or a
reduction in taxes (expansionary
policies) will increase the government's
budget deficit;
A decrease in government spending or
an increase in taxes (contractionary
policies) will decrease the government's
budget deficit
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Fiscal Policy in Action



According to Keynesian economics,
expansionary fiscal policy—tax cuts and
increased government spending—could pull
the economy out of a recession or depression.
During the 1930s, however, politicians did not
believe in Keynesian fiscal policy, largely
because they feared the consequences of
budget deficits.
Although government spending increased
during the 1930s, so did taxes, resulting in no
net fiscal expansion.
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Fiscal Policy in Action


It was not until the early 1960s, during the
Kennedy administration, that modern fiscal
policy came to be accepted. Tax cuts were
used to try to reduce unemployment.
Estimating the actual effects the tax cuts
had is difficult, but from 1963 to 1966, both
real GDP and consumption grew at rapid
rates. This rapid growth suggests that the
tax cuts had the effect, predicted by
Keynesian theory, of stimulating economic
growth.
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Fiscal Policy in Action



From 1966 to 1969, the unemployment rate
fell below 4%, and fiscal policy was used in
economic policy again.
A temporary surcharge tax, enacted in 1968,
raised the taxes of households by 10%.
But since the tax was temporary, it did not
have a major effect on permanent income, and
the decrease in demand was smaller than
economists had anticipated. Households
simply saved less during that period.
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Fiscal Policy in Action



During the 1970s there was no net change
in fiscal policy. Mild changes in taxes were
enacted in 1975, after the economy went
into a recession in 1973.
Significant tax cuts were enacted in 1981,
but these tax cuts were justified on the
basis of their impact on supply, not
demand.
A major tax increase was passed under
President Clinton that successfully brought
the budget into balance.
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Fiscal Policy in Action


By year 2000, the federal budget began
to show surpluses that set the stage for
tax cuts that were passed by President
George W. Bush.
Post September 11, 2001, the president
and the Congress became less
concerned with balancing the budget
and authorized new spending programs
to provide relief to victims and to
stimulate the economy
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Automatic Stabilizers



Certain taxes and transfers act as automatic
stabilizers for the economy.
When income is high, the government
collects more taxes and pays out less
transfer payments, thereby reducing
spending.
When output is low, the government collects
less taxes and pays out more in transfer
payments, putting more funds into the
hands of consumers.
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Automatic Stabilizers


As such automatic stabilizers
prevent consumption from falling as
much in bad times and from rising
as much in good times.
Other factors contributing to the
stability of the economy is that
consumers base their spending
decisions on permanent income and
not just their current level of
income.
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Growth Rate of U.S. GDP, 1871-2000
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Exports and Imports

Exports (X) and imports (M) affect
AD through their influence on how
foreigners demand goods and services
produced in the U.S.

An increase in exports means an
increase in demand for U.S. goods and
services, while an increase in imports
means an increase in demand for
foreign goods and services by U.S.
residents.
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Exports and Imports

To recognize the impacts of exports and
imports on AD and GDP, we take two steps
and ignore government spending and taxes
for the moment:

Add exports, X, which we assume to be
autonomous because they depend on foreign
income, to other sources of spending; and

subtract imports, M, which depends on the
level of domestic income, from total
spending by U.S. residents
y = C + I + (X – M)
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Exports and Imports


Consumers will buy more foreign
goods and services (M) as income rises;
imports = M = my
Additional spending on U.S. goods and
services out of additional income can
be obtained by subtracting m or the
(marginal propensity to import) from b
or the MPC.
MPC for domestic spending = b – m
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Exports and Imports

For example, if b = 0.8 and m = 0.2, then
Demand
MPC for domestic spending = b – m = 0.8 – 0.2 = 0.6
450
Demand
In an open economy, the level of
equilibrium income is determined
by the intersection of total
demand for U.S. goods and
services with the 45 degree line.
Ca+I+X
y*
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Exports and Imports
Demand
450
Demand
An increase in exports
Will increase the level
of Aggregate Demand.
An increase in marginal
propensity to import will
decrease the level of AD.
450
∆X
Ca+I+X
Ca+I+X
y1
y0
Output, y
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y1
Output, y
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