TheDeterminationofEquilibriumOutputinaGraph

TheKeynesiancrossprovidesbasicintuitionaboutthebuilding and
solving ofmodels,thedeterminationofoutput,andtheroleoffiscal
policy.
First,plotproductionasafunctionofincome:sinceproduction and
income areidenticallyequal,therelationbetweenthemisthe45
degreeline,thelinewithaslopeequalto1.
Second,plotdemandasafunctionofincome.Therelationbetween
demandandincomeisgivenby

3.5 :
.

TheDeterminationofEquilibriumOutputinaGraph
AggregateDemand:

Demanddependsonautonomous spending andonincome

viaitseffectonconsumption.
Thelineisupward sloping buthasaslopeofless than 1.

Figure 3.2:EquilibriumintheGoodsMarketUsing
theKeynesianCross

TheDeterminationofEquilibriumOutput
Inequilibrium,production equalsdemand.Equilibriumincomeisthe
productoftwofactors:autonomous spending andamultiplier.
Considertheeffectsonoutputofanincreaseinautonomous
spendingby$1billionbecauseofanincreaseinconsumer
confidence.
Theaggregatedemand(Z orAD)scheduleshiftsupward,meaning
thatateachlevelofincome,aggregatedemandishigher byan
amount$1billion.

Figure 3.3:TheEffectsonOutputofanIncreaseinAutonomous
SpendingBecauseofanIncreaseinConsumerConfidence

TheDeterminationofEquilibriumOutput

$1 billion becauseofthemultiplier effect

Thefirstroundincreaseindemand (thedistanceAB)equals$1
billion.
Thisfirstroundincreaseindemandleadstoanequal increasein
production,or$1billion,bythedistanceAB.
Thisincreaseinproductionof$1billionimpliesthatincome
increasesby$1billionshownbythedistanceBC
(Recall:income =production).
ThesecondroundincreaseindemandshownbythedistanceCD
$
.
equals$

TheDeterminationofEquilibriumOutput
Thissecondroundincreaseindemandleadstoanequal increasein
productionshownbythedistanceCD,andthusanequal increasein
income shownbythedistanceDE.
Thethirdroundincreaseindemandequals$1
(theincreasein
incomeinthesecondround)
$ ,andsoon.
Totalincreaseinoutput

$1

$1

$1

TheDeterminationofEquilibriumOutputinWords
Productiondependsondemand,whichdependsonincome,whichis
itselfequaltoproduction.
Demand Production Income More demand
More production More income ,andsoon.
Theendresultisanincreaseinoutput thatislarger thantheinitial
shiftindemand,byafactorequaltothemultiplier.
Thesize ofmultiplierisdirectlyrelatedtothevalueofMPC:
thehigher theMPC,thelarger themultiplier.

Example (3.1):EquilibriumOutput
Usethefollowinginformationtocalculateequilibriumoutput(all
valuesareintrilliondollarsof2005dollars):
Consumption:
Investment:
Governmentpurchases:
Netexports
Taxes:
Governmenttransfer
payments

$1.0 0.75
$1.9
$2.0
$0
$2.5
$2.0

Example (3.1):EquilibriumOutput

$1.0 0.75
$2.0

$1.0 0.75

$4.525 0.75
Equilibriumcondition:

$4.525 0.75

0.75
$4.525
0.25Y $4.525

$ .
.

$18.1 trillion

$2.5

$1.9

$2.0

Example (3.1):EquilibriumOutput
b)Nowsupposethatfullemploymentoutput(potentialGDP)equals
$19.0trillion.Ifequilibriumoutputequalstheamountyoucalculatedin
part(a),usethevalueforthegovernmentpurchasesmultiplierto
calculatehowmuchgovernmentpurchaseswouldhavetochangefor
equilibriumoutputtoequalpotentialGDP(assumingthattaxesremain
unchanged).
(Ans.)
Governmentpurchasesmultiplier:

$0.225

$225

Example (3.1):EquilibriumOutput
c)Nowsupposethatfullemploymentoutput(potentialGDP)equals$19.0
trillion.Ifequilibriumoutputequalstheamountyoucalculatedinpart(a),
usethevalueforthetaxmultipliertocalculatehowmuchgovernmenthasto
changeforequilibriumoutputtoequalpotentialGDP(assumingthatG
remainunchanged).
(Ans.)
Taxmultiplier:

$0.3
$300
Noticethatbecausethetaxmultiplierissmaller (inabsolutevalue)than
thegovernmentpurchasesmultiplier,thecutintaxesneedstobelarger
thantheincreaseingovernmentpurchasestoresultinthesame increase
inequilibriumoutput.

Example (3.1):EquilibriumOutput
d)Useagraphtoillustrateyouranswer.
(Ans.)

Multiplier
Q:Byhowmuchdoesa$1increaseinautonomousspendingraisethe
equilibriumlevelofoutput?
A:

autonomous spending
, called the multiplier

Theamountbywhichequilibriumoutputchangeswhen
autonomousaggregatedemandincreasesby1unit
Thelarger themarginalpropensitytoconsume(MPC),thelarger the
multiplierbecauseahighMPCimpliesthatalarger proportionofan
additionalincomewillbeconsumed,andthusaddedtoaggregate
demand,therebycausingalarger inducedincreaseindemand.

Multiplier

Q:Whyfocusonthemultiplier?
A:Becausethemultiplierispotentiallypartoftheexplanationofwhy
outputfluctuates.Themultipliersuggeststhatoutputchangeswhen
autonomousspending(includinginvestment)changesand thatthe
changeinoutputcanbelarger thanthechangeinautonomousspending.

Themagnitudeoftheincomechangerequiredtorestoreequilibrium
dependsontwofactors:
(i)Thelarger theincreaseinautonomousspending,thelarger theincome.
(ii)Thelarger theMPC thatis,thesteeper theaggregatedemand
schedule thelarger theincomechange.

TheGovernmentSector
Wheneverthereisarecession,peopleexpectanddemandthatthe
governmentshoulddosomethingaboutit.
Q:Whatcanthegovernmentdowithrespecttoaggregatedemand?
A:(i)Governmentpurchasesofgoodsandservices(G)
(ii)Taxes(T)andtransfers(TR)affecttherelationbetweenoutputand
income,Y.
Fiscalpolicy
Thepolicyofgovernmentwithregardtothelevelofgovernment
purchases,theleveloftransfers,andthetaxstructure.

TheGovernmentSector
Q:Whathappenstothevalueofthegovernmentspendingmultiplier
ifwetakeintoaccountthetaxrate thathouseholdspayontheir
income?
A:Supposethatthegovernmentimposesaproportionalincometax,
collectingafraction,t,ofincomeintheformoftaxrates:
.

TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

paypartofeverydollarofincomeintaxes andareleftwithonly
1
dollars

TheGovernmentSector

Equilibriumcondition:

3.9 :

Forexample,
Multiplier=

0.2 20% and

.

0.75.
.

2.5

4.
Proportionalincometaxesreduce themultiplierbecausetheyreduce
theinducedincreaseofconsumptionoutofchangesinincome.
Theinclusionoftaxesflattens theaggregatedemandcurve(ZZline)
andhencereduces themultiplier.

TheGovernmentSector

3.9 :

IncomeTaxesandAutomaticStabilizers
Theproportionalincometaxisoneexampleoftheimportantconcept
ofautomaticstabilizers.
Automaticstabilizer
Somepoliciesdesignedtoreducethelagsassociatedwith
stabilizationpolicy policiesthatstimulateordepresstheeconomy
whennecessarywithoutanydeliberatepolicychange
Anymechanismintheeconomythatautomatically thatis,
withoutcasebycasegovernmentintervention reducestheamount
bywhichoutputchangesinresponsetoachangeinautonomous
demand

AutomaticStabilizers
Examples:(i)Thesystemofincometaxesautomaticallyreducestaxes
whentheeconomygoesintorecession:withoutanychangeinthetax
law,individualsandfirmspaylesstaxwhentheirincomefalls.
Inthepresenceofautomaticstabilizersweshouldexpectoutputto
fluctuateless thanitwouldwithoutthem.
(ii)Unemploymentinsuranceandwelfaresystemautomaticallyraise
transfer paymentswhentheeconomymovesintoarecession.
Thismeansthatdemandfallsless whensomeonebecomes
unemployedandreceivesbenefitsthanitwouldiftherewereno
benefits.Thismakesthemultipliersmaller andoutputmorestable.

EffectsofaChangeinFiscalPolicy

3.9 :

Q:Whyisthemultiplierfortransferpaymentsmallerthanthatfor
governmentpurchasesbyafactor ?
A:BecausepartofanyincreaseinTR issaved.

EffectsofaChangeinFiscalPolicy
Q:Ifthegovernmentraisesmarginaltaxrates,whatwillhappen?
A:Twothingshappen.
(i)Directeffect:aggregatedemandwilldecrease sincethehigher
taxesreducedisposable income andthereforeconsumption.
(ii)Indirecteffect:themultiplierwillbesmaller,soshockswillhavea
smaller effectonaggregatedemand.

TheBudget
Overthelongsweepofhistory,thefederalgovernmenttypicallyran
surplusesinpeacetimeanddeficitsduringwars.
Question:Isthereareasonforconcernoverabudgetdeficit?
Wedealwiththegovernmentbudget,itseffectonoutput,andthe
effectsofoutputonthebudget.
Budgetsurplus(BS):
3.10 :

3.10 ,

TheBudget

3.10 ,

3.10 :

Thebudgetsurplusistheexcess ofgovernmentrevenues(taxes)over
itstotalexpenditureconsistingofpurchasesofgoods
and
services
andtransferpayments.
Thebudgetsurplusisapositive functionofthelevelofincome for
givenG,TR,andincometaxrate,t.

Figure 3.4:TheBudgetSurplus

TheBudget
Atlowlevelsofincome,thebudgetisindeficit (thesurplusis
negative)becausegovernmentspendingexceedsitstaxrevenues.
Athighlevelsofincome,thebudgetisinsurplus.
Q:Doesanincreaseingovernmentpurchases(G)reducethebudget
surplus?
A:Increasedgovernmentpurchasesreduce surplusorincrease
deficit.However,theincreasedgovernmentpurchaseswillcausean
increaseinincome andthereforeincreasetax revenues.

TheBudget

3.9 :

TheBudget

Therefore,anincreaseingovernmentpurchaseswillreduce the
budgetsurplus(orincrease thebudgetdeficit).
Q:Doesanincreaseinthetaxrateincreasethebudgetsurplus?
A:Infact,anincreaseinthetaxrate,keepingG andTR constant,
increases thebudgetsurplus,despitethereductioninincome thatit
causes.

AlternativeWayofThinkingaboutGoodsMarketEquilibrium
Anequivalentwayofthinkingaboutgoodsmarketequilibrium
focusesoninvestmentandsaving.
Savingisthesumofprivate savingandpublic saving.

Privatesavingsrate

Saving Investment
If
, publicsavingispositive
Thegovernmentrunsabudgetsurplus.
If
, publicsavingisnegative
Thegovernmentrunsabudgetdeficit.

3.11 :

Saving Investment
Equilibriumconditioninthegoodsmarket:
Subtract
frombothsidesandmoveC totheleftside:

3.12

Saving Investment

3.12 :

Eq(3.12)saysthatequilibriuminthegoodsmarketrequiresthat
investment equalssaving.Whatfirmswanttoinvest mustbeequal
towhatpeopleandgovernmentwanttosave.
Twoequivalentwaysofstatingtheconditionforequilibriuminthe
goodsmarket:
Production(Y)=Demand(Z) Investment(I)=Saving(S)

Saving Investment
Giventheirdisposableincome,onceconsumershavechosen
consumption,theirsavingisdetermined,andviceversa.

1

3.13

Marginalpropensitytosave (MPS):Howmuchofanadditionalunitof
incomepeoplesave