QUICK
REVIEW
LRAS
PRICE LEVEL
SRAS
AD
Q1
Qn
REAL GDP
PRICE LEVEL
LRAS
SRAS
AD
Qn
REAL GDP
Price Level
LRAS
SRAS
Short-run
equilibrium
Long-run
equilibrium
AD
0
QN
Natural
Real GDP
Answer the following:
What is Say’s law?
 What three things must be flexible in the
Classical model?
 What is the Classical solution for too much
unemployment?
 How does the self-regulating economy get
out of a recessionary gap?

Self-Regulating Economy
KEYNESIAN ECONOMICS
J. M. Keynes wrote during the Great
Depression
 Keynes focused on the demand side of the
economy
 Keynes did not believe that the economy
was necessarily self-correcting

KEYNES ON WAGES AND PRICES
Keynes believed that wages and prices were
STICKY DOWNWARD
 The lack of wage and price flexibility
suggested that the economy might get
STUCK in a recessionary gap.
 Keynes tended to focus on the short run
because
 “IN THE LONG RUN WE ARE ALL
DEAD”

KEYNES AND INCOME
Keynes focused his analysis on Total
Expenditures in the economy
 In particular, he focused on Consumption
 CONSUMPTION is a function of
DISPOSABLE INCOME
 SAVING is also determined by
DISPOSABLE INCOME

CONSUMPTION AND
SAVING TERMS
Autonomous Consumption - the portion of
consumption that is not related to income (it
is the amount of Cons. when income is 0).
 MPC - marginal propensity to consume (it
is change in C / change in Y)
 MPS - marginal propensity to save (it is the
change in saving / change in Y)

CONSUMPTION AND
SAVING TERMS

Break-even income - the level of disposable
income where consumption spending is just
equal to disposable income.
 C = Yd
 S must be zero
EQUATION FOR C AND S
C = a + b(Yd)
 Consumption = autonomous consumption +
the MPC * (disposable income)

S = -a + (1-b)(Yd)
 Saving = negative autonomous consumption
+ MPS * ( disposable income)

EXAMPLE
C = 100 + .75 (Yd)
 Find Aut. Cons., MPC, MPS, and C and S
when Yd=1000.
 Aut. Cons. = 100
 MPC = .75 MPS = .25
 C = 100 + .75 (1000) = 100 + 750 = 850

CONSUMPTION FUNCTION
INCOME
0
100
200
300
500
600
CONS.
100
180
260
340
500
580
SAVING
-100
-80
-60
-40
0
20
Find MPC
 Find MPS
 Find Autonomous Consumption
 Give the equation for consumption
 Give the equation for saving
 Find breakeven income
 Find C and S when income is 700

CONSUMPTION FUNCTION
A change in Disposable Income causes a
MOVEMENT ALONG the Consumption
Function
 A change in Autonomous Consumption
causes a SHIFT of the Consumption
Function

SAVING
SAVING is the unspent portion of a
consumer’s income.
 SAVING = Income - Consumption Exp.

INVESTMENT
2 components
Capital goods (producer durables) - goods
used by businesses to produce other goods
and services. They have an expected
service life of more than one year.
 Inventory investment - changes in the
stocks of finished goods, goods in process,
and in raw materials a firm keeps on hand.

TOTAL EXPENDITURES
Total Expenditures = C + I + G + (X-M)
 C depends on Disp. Y
 S depends on Disp. Y
 Disp. Y = C + S
 I depends on the interest rate ( not Y )
 G is assumed to be autonomous

EQUILIBRIUM
TOTAL EXPENDITURES
 are equal to
 TOTAL PRODUCTION
 is equal to
 INCOME

DISEQUILIBRIUM
TOTAL OUTPUT < TOTAL EXPENDITURES
unplanned inventories
 production
 employment
 Real GDP
 income

DISEQUILIBRIUM
TOTAL OUTPUT > TOTAL EXPENDITURES
unplanned inventories
 production
 employment
 Real GDP
 income

C = 200 + .80(Yd)
I = 300
Find Autonomous Cons., MPC, and MPS
 Find breakeven income
 Find equilibrium income
 In Qn=3000, identify the following: type of
gap, size.

THE MULTIPLIER
A dollar injected into the economy
(i.e. investment) has an impact
beyond the initial expenditures. The
dollar continues to be spent
multiplying its impact on the
economy. The number of times it
circulates through the economy is
known as THE MULTIPLIER.
THE MULTIPLIER cont.
The rate of circulation is related to
the MPC and MPS. The larger the
MPC, the more consumption rises as
a result of an increase in income.
This will result in a larger
MULTIPLIER.
Autonomous Government
Spending & the Multiplier
(1)
EXPENDITURE
ROUND
(2)
CHANGE IN
AUTONOMOUS
GOVERNMENT
SPENDING
(3)
CHANGE IN REAL
NATIONAL INCOME
OR REAL GDP
($ millions)
(4)
MPC
(5)
CHANGE IN
CONSUMPTION
($ millions)
Round 1
$60.00
$ 60.00
.80
$ 48.00
Round 2
48.00
.80
38.40
Round 3
38.40
.80
30.72
Round 4
.
.
.
.
.
.
.
.
All other
30.72
.
.
.
.
..
.
.
.80
..
.
.
.
.
.
.
.80
24.57
.
.
.
.
..
.
.
TOTAL
Exhibit 12
122.88
$300.00
98.88
$240.00
(Approx.
THE FORMULA
MULTIPLIER =
1
1 - MPC
or
1
MPS
EXPANSIONARY FISCAL
POLICY
TO ADDRESS A RECESSIONARY GAP
policy aimed at increasing economic
activity through increasing G &/or
decreasing T to increase AD or
increase SRAS
CONTRACTIONARY FISCAL
POLICY
TO ADDRESS AN INFLATIONARY GAP
policy aimed at decreasing economic
activity through decreasing G &/or
increasing T to decrease AD or
decrease SRAS
Fiscal Policy in Keynesian Theory: Ridding the
Economy of Recessionary Gaps
Fiscal Policy in Keynesian Theory: Ridding the
Economy of Inflationary Gaps
Exhibit 2 (2 of 2)
THE MULTIPLIER EFFECT
both G and T are subject to the
multiplier effect SO a change in
either will lead to an even greater
change in equilibrium real output
(which is equilibrium Y)
THE EXPENDITURE
MULTIPLIER
1 / 1- MPC or 1 / MPS
 Change in Real GDP =
multiplier x (change in G)

COMMON MULTIPLIERS
MPC .9
.8
.75
.66
.5
EXP
MULT
5
4
3
2
10
EXAMPLE
Qe = 800 while Qn = 1000
 MPC = .75
 find the G necessary to bring the economy
to natural real GDP

THE TAX MULTIPLIER
- MPC / MPS or ( 1 - exp. mult.)
 Change in Real GDP
= tax multiplier x (change in T)

EXAMPLE
Qe = 1200 while Qn = 800
 MPC = .66
 find the T necessary to bring the economy
to full employment GDP

BALANCED BUDGET
MULTIPLIER
if both G & T increase (or decrease)
by the same amount, then equilibrium
real GDP will increase by the amount
of the increase (or decrease) in G
C = 200 + .80(Yd)
I = 300

Find equilibrium income

In Qn=3000, identify the following: type of
gap, size, fiscal policy options to close it.
Should Fiscal Policy be Used?
NOT
NECESSARILY
Crowding Out
 Lags

CROWDING OUT
increases in G may lead to decreases
in private sector spending ( C or I )
CROWDING OUT
may occur due to:

direct substitution
more on public libraries  fewer books at
bookstores

interest rate effects
more on social programs and defense budget
deficit increases  government’s demand for
credit rises  interest rate rises  investment
drops
Lags and Discretionary Fiscal
Policy





The data lag: not aware of changes in the economy
as soon as they happened
The wait-and-see lag: adopt a more cautious
attitude
The legislative lag
The transmission lag: take time to be put into
effect
The effectiveness lag: take time to affect the
economy
KEYNESIAN PERSPECTIVE
fiscal policy is effective
 crowding out is relatively small
 lags are short

CLASSICAL PERSPECTIVE
fiscal policy is ineffective
 crowding out is significant
 lags are long

FISCAL POLICY

Discretionary Fiscal Policy
DISCRETIONARY FISCAL
POLICY
deliberate changes in G and/or T to achieve
particular objectives
 requires new action by Congress

FISCAL POLICY
Discretionary Fiscal Policy
 Automatic Stabilizers

AUTOMATIC STABILIZERS
changes in G and/or T that occur
automatically as economic conditions
change
 these changes do not require new action by
Congress

Four Types of Fiscal Policy
Expansionary
Discretionary
Automatic
Contractionary
Policy Makers G
or T
or both
Policy Makers G
or T
or both
(1)
(2)
Unemployment
Compensation
Welfare Payments
Unemployment
Compensation
Welfare Payments
(3)
(4)
The New Classical View Of
Fiscal Policy
crowding out does occur as people save
more in anticipation of higher taxes
 these adjustments cause expansionary fiscal
policy to be ineffective.

SUPPLY SIDE POLICY
dislike demand side policies because
increases in AD means growth comes with
higher prices
 prefer to focus on tax issues which alter
incentives to work, save, and invest

What Are the Major Federal
Taxes?
Personal income tax
 Corporate income tax
 Social security tax

Exhibit 1
Major
Federal
Taxes
SOURCE: Council of Economic
Advisers, Economic Report
of the President, 1999.
MARGINAL TAX RATE
tax rate applied to additional income
 change in tax payment divided by the
change in taxable income

Three
Income
Tax
Structures
MARGINAL TAX RATES AND
FISCAL POLICY
decreasing marginal tax rates leads to an
increase in SRAS
b/c increases the incentive to work
 if the tax change is permanent, then the
change in AS is too
 the LRAS will shift to the right

Laffer Curve
Tax Rate (percent)
100
C
B to C: Tax rate
and tax revenues
inversely related.
Laffer Curve
Z
B
Y
A to B: Tax rate
and tax revenues
directly related.
X
A
0
TX TZ TY
Tax Revenues
What are the Major Federal
Government Spending
Programs?
National defense
 Income security
 Health
 Medicare
 Social security
 Net interest on the National Debt

Exhibit 3
Major Federal
Spending
Programs
SOURCE: Council of Economic
Advisers, Economic Report
of the President, 1999.
DEBT AND DEFICITS
BUDGET DEFICITS occur when
government expenditures exceed tax
receipts
 A BUDGET SURPLUS occurs when tax
receipts exceed government expenditures

CYCLICAL DEFICITS
The portion of the deficit that is a result of
an economic downturn
 many economists (Keynes) believe that
deficits are natural and necessary during
recessions because tax revenues fall and
benefit payments rise
 Our problem is that we have continued to
run deficits in expansionary periods

STRUCTURAL
DEFICITS
The structural deficit is the portion of a
budget deficit which exists when the
economy is operating at full employment
 Total Budget Deficit = structural deficit +
cyclical deficit

National Debt

NATIONAL DEBT is the total sum of what
the federal government owes its creditors
(the sum of past deficits)
Exhibit 5 Public Debt for 1987–1999
The 1999 amount is for November 1999.
SOURCE: Bureau of the Public Debt.
NATIONAL DEBT
As the debt grows, interest on the debt
grows in its share of the budget.
 The portion of the budget that can be cut in
order to balance the budget is SHRINKING

PORTION OF THE BUDGET
THAT IS CONSIDERED
UNTOUCHABLE
Interest on the Debt
 Social Security
 untouchable total
 National Defense
 Total

14%
22%
36%
20%
56%
WHO BEARS THE BURDEN
OF THE DEBT?
CURRENT GENERATION - if crowding
out occurs then households are giving up
consumption to pay for increases
government spending
 FUTURE GENERATIONS - will have to
pay higher taxes to pay off the bonds when
they come due. They bear the cost while
the bondholders receive the payoffs.

COUNTERPOINT
WE-OWE-IT-TO -OURSELVES - if
American taxpayers make payments to
American bondholders, money is simply
shifted from one pocket to another.
 Only works if debt is held domestically
(currently 14-18% is held by foreigners)
