Topic 3: Fiscal Policy
Circular Flow
Investment
Taxes and Government Spending
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AE (with no Govt)
AE = C + I
 AE = Planned Aggregate Expenditure
 C = Consumption
 I = Investment
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In equilibrium (with no Govt)
Y = AE = C + I
 Y = National Income or Aggregate Output
 In equilibrium, output equals planned expenditures
 Why?
 If people buy too little: companies are overproducing,
inventories will rise, then firms slow down production
 If people buy too much: companies don’t produce enough,
inventories fall, then firms increase production
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Types of Investment
1.
2.
3.

Inventories are important:
 If people buy too little: companies are overproducing,
inventories will rise, then firms slow down production
 If people buy too much: companies don’t produce enough,
inventories fall, then firms increase production
 e.g., end of 2008
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What is consumption?
 C usually depends on income Y
C = minC+ mpc * Y
 minC = spending even when there is no income (must eat to
survive)
 mpc = how much each additional dollar of income increases
consumption.
mpc = “Marginal Propensity to Consume”
 mpc = 1-mps, where mps = “marginal propensity to save”
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Solving for Equilibrium Y
 Suppose C = 100 + 0.8 Y and I = 1000.
 What is the equilibrium level of output (income)?
 What happens when consumers become pessimistic and
spend less of their income? Suppose the mpc falls to 0.75.
 What is the new equilibrium output?
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Solving for Equilibrium Y
 Starting with C = 100 + 0.8 Y and I = 1000.
 Now, suppose firms decrease investment by 200.
 What is the new equilibrium output?
ΔY = Δ I [ 1 / (1- mpc) ]
 Illustrate this change using circular flow.
 Initial impact versus long run impact on Y
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AE with Government
AE = C + I + G
 AE = Planned Aggregate Expenditure
 C = Consumption
 I = Investment
 G = Government Spending
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In equilibrium
Y = AE = C + I + G
 Y = National Income or Aggregate Output
 In equilibrium, output equals planned expenditures
 Why?
 If people buy too little: companies are overproducing,
inventories will rise, then firms slow down production
 If people buy too much: companies don’t produce enough,
inventories fall, then firms increase production
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What is consumption?
 C now can depend on income and taxes
C = minC + mpc ( Y – Tx)
 Y – Tx is “Disposable Income” or income after taxes
 In Equilibrium:
Y = AE = minC+ mpc ( Y - Tx) + I + G
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Solving for Equilibrium Y
 Suppose C = 100 + 0.8 Y , I = 1000, G = 500 = Tx.
What is the equilibrium level of output?
 Suppose that the government increases spending by 200, but
does not change taxes.
 Illustrate this increase in spending using circular flow
 What is the new equilibrium output?
ΔY = Δ G [ 1/ (1- mpc) ]
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Solving for Equilibrium Y
 Start with C = 100 + 0.8 Y , I = 1000, G = 500 = Tx.
 Suppose the government decreases taxes by 200.
 Illustrate this change using circular flow.
 What is the new equilibrium output?
ΔY = Δ I [ - mpc / (1- mpc) ]
 Suppose investment increases by 100.
 Illustrate this change using circular flow.
 What is the new equilibrium output?
ΔY = Δ I [ 1 / (1- mpc) ]
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Keynesian Multipliers
 Tells us how much changes in G, Tx, and I influence output
 G: [1/ (1-mpc)]
 I: [1 / (1-mpc)]
 Tx: [-mpc / (1-mpc)]
 Solve a problem without any numbers plugged in…
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The role of inventories
 Initial increase in I or G causes inventories to initially fall
 Planned inventories are greater than actual inventories
 Firms produce more, which causes Y to increase
 The increase in Y results in an increase in C
 The increase in C causes inventories to again fall below
planned level (but not as much as before), which causes the
process to repeat
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Other Examples and Problems
 …..
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