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David Begg, Foundations of Economics , Third Edition McGraw-Hill, 2006

Foundations of Economics. David Begg, Foundations of Economics , Third Edition McGraw-Hill, 2006 Power Point presentation by Peter Smith Adapted for the Third Edition by Lester C Hunt, UniS. Chapter 9 Short-run fluctuations in income and output. 9.1 Output and income in the short run.

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David Begg, Foundations of Economics , Third Edition McGraw-Hill, 2006

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  1. Foundations of Economics David Begg, Foundations of Economics, Third Edition McGraw-Hill, 2006 Power Point presentation by Peter Smith Adapted for the Third Edition by Lester C Hunt, UniS.

  2. Chapter 9Short-run fluctuations inincome and output

  3. 9.1 Output and income inthe short run By the end of this section, you should understand: ◆ Actual output and potential output ◆ Aggregate demand and equilibrium output ◆ The consumption function ◆ Shifts in aggregate demand ◆ The multiplier ◆ The paradox of thrift

  4. Short run equilibrium output • Potential output • National output when all inputs are fully employed • Actual output • What is actually produced in a period • which may diverge from the potential level • Output gap • Difference between actual and potential output

  5. Output gap

  6. Consumption demand 1 • Personal disposable income • household income from firms, plus government transfers, • minus taxes • It is household income available to be spent or saved. • Consumption function • relates desired consumption to personal disposable income • Autonomousconsumption • Consumption unrelated to income. • The marginal propensity to consume MPC • the fraction of each extra pound of disposable income that households wish to consume

  7. Consumption demand 2 So consumption function is: C = 10 + 0.9Y With no transfer payments or taxes, consumption function shows consumption demand C at each level of national income Where it crosses vertical axis shows the level of autonomous consumption Slop represents the MPC Consumption C 0.9 1 10 Income Autonomous consumption

  8. Investment demand • Investment demand for fixed capital (plant and equipment) and working capital (inventories) reflects firms’ current guesses about how fast the demand for their output will rise in future • Therefore the current level of output tells us little about how output will change • With no close connection between the output level and investment demand, we initially assume that investment demand is autonomous • i.e. it is independent of current output and income.

  9. Aggregate Demand (AD) AD is total desired spending at each level of income With only firms and households AD =C +I It is the vertical addition of C and I. The slope is the MPC (parallel to the consumption function). AD = C + I Aggregate demand C=10+0.9Y I 10 Income

  10. Equilibrium Output 1 45o line Desired spending • 45° line reflects any point on the horizontal axis into the same point on the vertical axis • The AD schedule crosses the 45° line only at point E • Equilibrium output and income are Y* • At this income, the AD schedule tells us that the demand for goods is also Y*. AD E Y* Y* Output, income

  11. Equilibrium Output 2 45o line Desired spending H • At output Y0(<Y*) AD is above the 45° line so that AD at A exceeds actual output at B, there is excess demand • which firms initially meet by an unplanned reduction of inventories • And soon raising output to meet the excess demand. • When output rises to Y* SR equilibrium is restored • AD = actual output • At output Y1(>Y*) AD is below the 45° line so that AD at J is below actual output at H – firms cannot sell all their output • Firms reduce their output • Until SR is restored at Y* • And AD = actual output AD J E Y* A B Y0 Y* Y1 Output, income

  12. Planned saving and investment • In SR equilibrium planned leakages must equal planned injections • With no government or foreign sector, equilibrium output Y* equals AD • which is planned investment plus planned consumption • But income Y* is devoted only to planned consumption or planned saving • Hence, in equilibrium, planned saving equals planned investment • Planned investment is assumed to be given • The saving function shows desired saving at each income level • The marginal propensity to save (MPS)is the fraction of each extra pound of income that households wish to save

  13. Savings function So saving function is: S = -10 + 0.1Y S S For a consumption function C =10 +0.9Y i.e. autonomous consumption = 10; MPC =0.9 The saving function has Autonomous saving = -10 And MPS = 0.1 0.1 1 0 -10 Output, Income

  14. Equilibrium Output: An alternative approach 1 * An equivalent view of equilibrium is seen by equating * planned investment (I) * to planned saving (S) * again giving an equilibrium at E S, I S=-10+0.1Y I E I 0 Y* Output, Income -10 The two approaches are equivalent.

  15. Equilibrium Output: An alternative approach 2 • At output Y1(>Y*) households want to save more than firms want to invest - desired saving exceeds desired investment • same as saying AD is below actual output • So unplanned stocks pile up and firms cut output • So move back to equilibrium Y* • At output Y0(<Y*) desired investment exceeds desired saving • AD is now too high • firms make unplanned cuts is stocks and raise output • So again adjusts towards the equilibrium Y* S, I S=-10+0.1Y I E I 0 Y1 Y0 Y* Output, Income -10

  16. Equilibrium output (again) Equilibrium output and income satisfy two equivalent conditions: • aggregate demand = actual output • desired saving = desired investment

  17. 20 B 200 Y1* A change in aggregate demand • Desired investment shifts down by 20 • Equilibrium moves from A to B • Giving a matching fall of 20 in desired saving. • Given the saving function slope, the MPS, is 0.1 it takes a horizontal leftward move of 200 in output to achieve a vertical fall of 20 in desired saving • I.e. equilibrium output falls by 200 when desired investment falls by 20 • Desired saving again equals desired investment. S=-10+0.1Y S, I A I0 I1 Y0* Output, Income

  18. The multiplier 1 • The multiplier is the ratio of the change in equilibrium output to the change in autonomous spending that caused output to change • The larger the marginal propensity to consume, the larger is the multiplier. • The higher is the marginal propensity to save, the more of each extra unit of income “leaks” out of the circular flow. • In the example above a fall in investment of 20 resulted in a fall in income of 200 • i.e. the multiplier is 2 • This is simply [1/MPS] • i.e. [1/0.1] = 10 • But given MPC+MPS =1 can also be calculated as: • 1/(1-MPC) • i.e. [1/(1-0.9)] = 10

  19. The Paradox of Thrift • The paradox of thrift is that a change in the desire to save changes equilibrium output and income, but not equilibrium saving. • Since nothing happens to desired investment, so that in the new equilibrium desired saving must be unaffected • A higher desire to save more, and spend less, reduces equilibrium income to the level that leaves desired saving at its original level • People save more out of any given income, but income is now lower • So that desired saving stays the same

  20. 9.2 Adding the governmentand other countries By the end of this section, you should understand: ◆ How government spending and taxes affect equilibrium output ◆ The balanced budget multiplier ◆ Automatic stabilizers ◆ Limits to active fiscal policy ◆ How foreign trade affects equilibrium output

  21. Fiscal policy • Fiscal policy is the government’s decisions about spending and taxes. • Discretionary fiscal policy is when the government alters its spending or tax rates • Automatic stabilisers reduce fluctuations in aggregate demand • Need to add government into the model used in previous section

  22. Government and aggregate demand 1 • Government purchases (G)of final output add directly to aggregate demand • AD= C + I + G • The level of government demand reflects how many hospitals the government wants to build, how large it wants defence spending to be, and so on • Therefore in the SR not affected by changes in actual output • Planned injections also increase to (I + G) • Which in equilibrium must equal desired leakages • So how are desired leakages affected by the government?

  23. Government and aggregate demand 2 • Government levies taxes and pays out transfer benefits • At given tax rates and benefit levels, tax revenue and benefit spending both vary with output • Assume net taxes NT = tY • where t is the net tax rate • Households’ disposable income YD is now Y(1-t) • Assume that t=0.5 and households want to save 10 per cent of each extra pound of disposable income • £1 of gross income adds only 50p to disposable income, and hence only 5p to saving • This is one leakage, but the 50p paid to the government is another leakage not reverting to firms as demand for their output

  24. Government and aggregate demand 3 • Without the government each extra £1 of national income led only to an extra leakage of £0.10 in extra saving • Now it leads to an extra leakage of £0.55 in extra net tax payments and saving. • Whereas each extra £1 of output used to raise consumption demand by £0.90, now it raises it by only £0.45 • Households’ disposable income YD is now Y(1-t) • Assume that t=0.5 and households want to save 10 per cent of each extra pound of disposable income • £1 of gross income adds only 50p to disposable income, and hence only 5p to saving

  25. Government and aggregate demand 4 • This is one leakage, but the 50p paid to the government is another leakage not reverting to firms as demand for their output • Without the government each extra £1 of national income led only to an extra leakage of £0.10 in extra saving • Now it leads to an extra leakage of £0.55 in extra net tax payments and saving. • Whereas each extra £1 of output used to raise consumption demand by £0.90, now it raises it by only £0.45 • Changes in income and output now induce much smaller changes in consumption demand • The multiplier is much smaller • It used to be [1/0.1]=10 but is now only [1/0.55]=1.82

  26. A fall in desired injections (I +G) S+NT • Equilibrium output is initially where the two lines cross at A • A fall in desired injections to [I + G] has a smaller effect on equilibrium output the steeper is the desired leakages line (S NT) • The multiplier is always 1/[marginal propensity to leak] • With a mps of 0.1 and a net tax rate of 0.5 the value of the multiplier is now 1/[0.55]= 1.82. • This value of 1.82 is much smaller than the value of 10 in the previous section • Equilibrium output is much less sensitive to shocks to aggregate demand • The net tax rate acts as an automatic stabiliser • When output Y rises, the government gets more tax revenue tY which helps dampen the expansionary effect of the rise in output A [I + G]0 B [I + G]1 0 Y Y2 Income, output

  27. The balanced budget multiplier If government increases taxes and government spending by the same amount there will be an increase in equilibrium output

  28. Foreign trade and output determination 1 • Introducing exports (X) & imports (Z) • Trade balance • the value of net exports (X - Z) • Trade deficit • when imports exceed exports • Trade surplus • when exports exceed imports • Aggregate demand • AD = C + I + G + X - Z • Desired injections • I + G +X • Desired leakages • S + NT + Z • Equilibrium • I + G + X = S + NT +Z

  29. Foreign trade and output determination 1 S+NT + Z • I + G + X shows desired injections • S + NT + Z shows desired leakages • Which is now steeper than in the previous section given the additional leakage of imports • Equilibrium output Y0* makes them equal • A shift in planned injections to [I + G + X]1 • raises the equilibrium to Y1* • But the increase is less than what it would have been before adding the foreign sector [I + G +X]1 [I + G +X]0 Y0* Y1* Income, output

  30. The open economy multiplier • Exports do not vary with home output • However imports do. So need to take account of the marginal propensity to import (MPZ) • the fraction of each extra pound of national income that domestic residents want to spend on extra imports. • Hence as shown in previous diagram the multiplier is once again reduced by the added leakage

  31. 9.3 Interest rates, aggregatedemand and output By the end of this section, you should understand: ◆ How interest rates affect aggregate demand ◆ How monetary and fiscal policy interact to determine aggregate demand

  32. Monetary Policy • Monetary policy is the decision by the Central Bank about what the interest rate to set. • In the UK, the central bank is the Bank of England, which acts on behalf of the government. • The real interest rate is the difference between the nominal interest rate and inflation • measures the real cost of borrowing and the real return on lending.

  33. How interest rates affectthe economy Interest rates influence: • personal consumption by changing the cost of borrowing for consumption • investment demand by raising the opportunity cost of capital

  34. Interest rates and investment demand Interest rate • For a given rate of output growth the investment demand schedule II shows how a lower interest rate raises investment demand • If the interest rate rises from r0 to r1 desired investment falls from I0 to I1 r1 r0 II I1 I0 Investment demand

  35. Lower interest rates increase aggregate demand 1 • Lower interest rates induce an increase in personal consumption and investment demand increasing AD to AD1 and output to Y1 • diagram (a) on next slide • Equivalently, lower interest rates increase desired investment at any output • but also, by reducing desired consumption, they raise the desire to save at any output • For both reasons desired injections exceed desired leakages at the original output level, so that the equilibrium output rises to Y1 • diagram (b) on next slide

  36. Lower interest rates increase aggregate demand Output

  37. Demand management and the policy mix • Demand management is the use of monetary and fiscal policy to stabilize output near the level of potential output. • The government can use fiscal and monetary policy to control demand • loose fiscal policy can be used with tight monetary policy or vice versa • the former suggests a large public sector; the latter a smaller public sector • the mix of policies affects the composition of output

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