Income and Spending

Unit 3
(Rudiger Dornbusch, Stanley Fischer, Richard Startz )

• Central questions in macroeconomics are why output fluctuates around its potential
level.
• Growth is highly uneven. In business cycle booms and recessions, output rises and
falls relative to the trend of potential output.
• This chapter offers a first theory of these fluctuations in real output relative to trend.
• The Keynesian model of income determination that we develop in this chapter,
assume for the time being that prices do not change at all and that firms are willing to
sell any amount of output at the given level of prices.
• Thus, the aggregate supply curve, is assumed to be entirely flat.

• Key finding in this chapter is that because of the feedback between spending and
output, increases in autonomous spending—increased government purchases, for
example—generate further increases in aggregate demand.

9-1 AGGREGATE DEMAND AND EQUILIBRIUM OUTPUT

• Aggregate demand is the total amount of goods demanded in the economy.

• Output is at its equilibrium level when the quantity of output produced is equal to the
quantity demanded.
 • Thus, an economy is at equilibrium output when

• When aggregate demand—the amount people want to buy—is not equal to output,
there is unplanned inventory investment or disinvestment.

• If output is greater than aggregate demand, there is unplanned inventory investment,

IU > 0. As excess inventory accumulates, firms cut back on production until output
and aggregate demand are again in equilibrium. Conversely, if output is below
aggregate demand, inventories are drawn down until equilibrium is restored.

9-2 THE CONSUMPTION FUNCTION AND AGGREGATE

DEMAND

• We now focus on the determinants of aggregate demand, and particularly on

consumption demand.
• For simplicity, we omit the government and foreign trade, therefore setting both G
and NX equal to zero.
• So,

• In practice, the demand for consumption goods is not constant but, rather, increases
with income: Families with higher incomes consume more than families with lower
incomes, and countries where income is higher have higher levels of total
consumption.
• The relationship between consumption and income is described by the
consumption function.

• Variable ̅𝐶 , the intercept, represents the level of consumption when income is zero.
• For every dollar increase in income, the level of consumption increases by $ c.
• The slope of the consumption function is c, have a special name, the marginal
propensity to consume (MPC).
• The marginal propensity to consume is the increase in consumption per unit increase
in income.
• It lies between 0 and 1.
• What happens to the rest of the dollar of income, the fraction (1- c), that is not spent
on consumption?
• If it is not spent, it must be saved. Income is either spent or saved
• Income not spent on consumption is saved.

• We call the budget constraint, implies a savings function.

• Saving is an increasing function of the level of income because the marginal

propensity to save (MPS), s = 1 – c, is positive.

• Now we add investment, government spending and taxes, and foreign trade to our
model, but we assume for the moment that each is autonomous, that is, determined
outside the model and specifically assumed to be independent of income.

• Assume that investment is 𝐼 ,̅ government spending is 𝐺̅ , taxes are 𝑇𝐴

̅̅̅̅ , transfers are
̅̅̅̅ ̅̅̅̅
𝑇𝑅 , and net exports are 𝑁𝑋 .

• Consumption now depends on disposable income.

• Aggregate demand is the sum of the consumption function, investment, government
spending, and net exports. Continuing to assume that the government sector and
foreign trade are exogenous,

• Part of aggregate demand is independent of the level of income, or autonomous. But

aggregate demand also depends on the level of income.
• It increases with the level of income because consumption demand increases with
income.

• The aggregate demand schedule is obtained by adding (vertically) the demands for
consumption, investment, government spending, and net exports at each level of
income.
• The equilibrium level of income is such that aggregate demand equals output (which
in turn equals income).
• The 45°-line, AD = Y, shows points at which output and aggregate demand are equal.
• Only at point E, and at the corresponding equilibrium levels of income and output,
does aggregate demand exactly equal output. At that level of output and income,
planned spending precisely matches production.
• At any income level below Y, firms find that demand exceeds output and inventories
are declining, and they therefore increase production. Conversely, for output levels
above, firms find inventories piling up and therefore cut production.
• This process leads to the equilibrium output level, at which current production exactly
matches planned aggregate spending and unintended inventory changes ( IU ) are
therefore equal to zero.
• FORMULA FOR EQUILIBRIUM OUTPUT: Y = AD

• This implies,

• The position of the aggregate demand schedule is characterized by its slope, c (the
marginal propensity to consume), and intercept - (autonomous spending).
• A steeper aggregate demand function—as would be implied by a higher marginal
propensity to consume—implies a higher level of equilibrium income.
• Similarly, for a given marginal propensity to consume, a higher level of autonomous
spending, a larger intercept—implies a higher equilibrium level of income.
• Thus, the equilibrium level of output is higher the larger the marginal propensity to
consume, c, and the higher the level of autonomous spending.
• We are interested in knowing how a change in some component of autonomous
spending would change output.

• For example, if the marginal propensity to consume is .9, then 1/(1 − c ) = 10.
• So, a $1 billion increase in government spending increases output by $10 billion,
since the recipients of the increased government spending increase their own
spending, the recipients of that spending increase theirs, and so on.
• Note that we can compute the change in output without specifying the level of output
either before or after the change.
• Alternative formulation of the equilibrium condition that aggregate demand is equal
to output.
• In equilibrium, planned investment equals saving, applies only to an economy in
which there is no government and no foreign trade.
• Without government and foreign trade, the vertical distance between the aggregate
demand and consumption schedules in the figure is equal to planned investment
spending.
• Accordingly, at the equilibrium level of income, and only at that level, the two
vertical distances are equal.
• Thus, at the equilibrium level of income, saving equals (planned) investment.
• By contrast, above the equilibrium level of income, saving (the distance between the
45° line and the consumption schedule) exceeds planned investment, while below the
equilibrium level of income, planned investment exceeds saving.
• Since income is either spent or saved, Y = C + S.
• Without government and foreign trade, aggregate demand equals consumption plus
investment, Y = C + I.
 • This implies, S = I.
• If we include government and foreign trade then Y = C + S + TA + TR and Y = C + I
+ G + NX. Therefore, I = S + TA + TR – G – NX.
• Thus, investment equals private savings (S) plus the government budget surplus
• (TA − TR − G) minus net exports (NX).
• Investment is the leftover corn that will be planted for next year’s crop. The sources
of corn investment are corn saved by individuals, any corn left over from government
tax collections net of government spending, and any net corn imported from abroad.

9-3 THE MULTIPLIER

• By how much does a $1increase in autonomous spending raise the equilibrium level
of income?
• Suppose first that output increased by $1 to match the increased level of autonomous
spending. This increase in output and income would in turn give rise to further
induced spending as consumption rises because the level of income has risen.
• Out of an additional dollar of income, a fraction c is consumed. Assume, then, that
production increases further to meet this induced expenditure, that is, that output and
thus income increase by 1 - c. That will still leave us with an excess demand, because
the expansion in production and income by 1 c will
give rise to further induced spending. This story could clearly take a long time to tell.
Does the process have an end?

• For a value of c < 1, the successive terms in the series become progressively smaller.
In fact, we are dealing with a geometric series, so the equation simplifies to
• The cumulative change in aggregate spending is equal to a multiple of the increase in
autonomous spending.
• The multiple 1/(1 - c ) is called the multiplier.
• The multiplier is the amount by which equilibrium output changes when autonomous
aggregate demand increases by 1 unit.
𝛥𝑦
• The general definition of the multiplier is 𝛥𝐴̅ , the change in equilibrium output when
autonomous demand increases by 1 unit.
• Larger the marginal propensity to consume, the larger the multiplier.
• This is because a high marginal propensity to consume implies that a larger fraction of
an additional dollar of income will be consumed, and thus added to aggregate
demand, thereby causing a larger induced increase in demand.
• If the economy for some reason—for example, a loss in confidence that reduces
investment spending—experiences a shock that reduces income, people whose
incomes have gone down will spend less, thereby driving equilibrium income down
even further. The multiplier is therefore potentially part of the explanation of why
output fluctuates.

• The larger the increase in autonomous spending, represented in Figure 9-3 by the
parallel shift in the aggregate demand schedule, the larger the income change.
• Furthermore, the larger the marginal propensity to consume—that is, the steeper the
aggregate demand schedule—the larger the income change.
• There are three points to remember from this discussion of the multiplier:
• An increase in autonomous spending raises the equilibrium level of income.
 • The increase in income is a multiple of the increase in autonomous spending.
• The larger the marginal propensity to consume, the larger the multiplier arising
from the relation between consumption and income.

9-4 THE GOVERNMENT SECTOR

• What can the government do with respect to aggregate demand?

• The government directly affects the level of equilibrium income in two separate ways.
1. Government purchases of goods and services, G, are a component of aggregate demand.
2. Taxes and transfers affect the relation between output and income, Y, and the
disposable income —income available for consumption or saving—that accrues to the
household, YD.
• Fiscal policy is the policy of the government with regard to the level of
government purchases, the level of transfers, and the tax structure.

• Disposable income (YD) is the net income available for spending by households after
they receive transfers from and pay taxes to the government. It thus consists of income
plus transfers minus taxes, Y + TR − TA.
• we can rewrite the consumption function,

• We assume that the government purchases a constant amount, G , it makes a constant

amount of transfers ; and that it imposes a proportional income tax, collecting a fraction,
t , of income in the form of taxes:

• The presence of transfers raises autonomous consumption spending by the marginal

propensity to consume out of disposable income, c , times the amount of transfers.
• Income taxes, by contrast, lower consumption spending at each level of income.
• The marginal propensity to consume out of income is now c(1 - t ).

• The slope of the AD schedule is flatter because households now have to pay part of
every dollar of income in taxes and are left with only 1 - t of that dollar. Thus, as
equation (20) shows, the marginal propensity to consume out of income is now c(1 – t)
instead of c .
 • We see that the government sector makes a substantial difference. It raises autonomous
spending by the amount of government purchases, and by the amount of induced
spending out of net transfers; in addition, the presence of the income tax lowers the
multiplier.

INCOME TAXES AS AUTOMATIC STABILIZERS

• The proportional income tax is one example of the important concept of automatic
stabilizers.
• As you remember, an automatic stabilizer is any mechanism in the economy that
automatically—that is, without case-by-case government intervention— reduces the
amount by which output changes in response to a change in autonomous demand.
• One explanation of the business cycle is that it is caused by shifts in autonomous
demand, especially investment. Sometimes, it is argued, investors are optimistic and
investment is high—and so, therefore, is output. But sometimes they are pessimistic,
and so both investment and output are low.
• Swings in investment demand have a smaller effect on output when automatic
stabilizers—such as a proportional income tax, which reduces the multiplier—are in
place. This means that in the presence of automatic stabilizers we should expect output
to fluctuate less than it would without them.
• The proportional income tax is not the only automatic stabilizer. Unemployment
benefits enable the unemployed to continue consuming even though they do not have a
job, so TR rises when Y falls. This means that demand falls less when someone
becomes unemployed and receives benefits than it would if there were no benefits. This,
too, makes the multiplier smaller and output more stable.
• Higher unemployment benefits and income tax rates in the post–World War II period
are reasons that the business cycle fluctuations have been less extreme since 1945 than
they were earlier.

EFFECTS OF A CHANGE IN FISCAL POLICY

• Consider first a change in government purchases.

 • Thus, a $1 increase in government purchases will lead to an increase in income in
excess of a dollar. With a marginal propensity to consume of c .8 and an income tax
rate of t .25, we would have a multiplier of 2.5: A $1 increase in government spending
raises equilibrium income by $2.50.

• Suppose that instead of raising government spending on goods and services, the
government increases transfer payments. Autonomous spending, will increase by only 𝑐𝛥𝑇𝑅̅̅̅̅ ,
̅̅̅̅ .
so output will rise by 𝛼𝐺 ∗ 𝑐𝛥𝑇𝑅
• The multiplier for transfer payments is smaller than that for government spending—
by a factor c —because part of any increase in TR is saved.
 • If the government raises marginal tax rates, two things happen.
• The direct effect is that aggregate demand will be reduced since the increased taxes
reduce disposable income and therefore consumption. In addition, the multiplier will
be smaller, so shocks will have a smaller effect on aggregate demand.

• Since the theory we are developing implies that changes in government spending and
taxes affect the level of income; it seems that fiscal policy can be used to stabilize the
economy.
• When the economy is in a recession, or growing slowly, perhaps taxes should
be cut or spending increased to get output to rise. And when the economy is booming,
perhaps taxes should be increased or government spending cut to get back down to
full employment. Indeed, fiscal policy is used actively to try to stabilize the economy.

9-5 THE BUDGET

• The fiscal stimulus package generated a record peacetime deficit.

• The federal government typically ran surpluses in peacetime and deficits during wars.

• The budget deficit on which the media and politicians focus is the federal budget.
• “Government” in the national income accounts consists of all levels of government—
federal, state, and local. State and local governments tend to run small (less than 1
percent of GDP) surpluses in boom years and small deficits in recession years.
• Is there a reason for concern over a budget deficit? The fear is that the government’s
borrowing makes it difficult for private firms to borrow and invest and thus
slows the economy’s growth.
• The budget surplus is the excess of the government’s revenues, taxes, over its total
expenditures, consisting of purchases of goods and services and transfer payments.
• A negative budget surplus, an excess of expenditure over revenues, is a budget deficit.

• At low levels of income, the budget is in deficit (the surplus is negative) because
government spending, exceeds income tax collection.
• At high levels of income, by contrast, the budget shows a surplus, since income tax
collection exceeds expenditures in the form of government purchases and transfers.
• For instance, suppose there is an increase
in investment demand that increases the level of output. Then the budget deficit will
fall or the surplus will increase because tax revenues have risen. But the government
has done nothing that changed the deficit.
• Budget deficits in recessions, periods when the government’s tax receipts are low.
And in practice, transfer payments, through unemployment benefits, also increase
during recessions

EFFECTS OF GOVERNMENT PURCHASES AND TAX CHANGES ON THE

BUDGET SURPLUS

• How changes in fiscal policy affect the budget.

• At first sight, this appears obvious, because increased government purchases, from
equation (24), are reflected in a reduced surplus or an increased deficit.
• On further thought, however, the increased government purchases will cause an
increase (multiplied) in income and therefore increased income tax collection. This
raises the interesting possibility that tax collection might increase by more than
government purchases.
• A brief calculation shows,

• which is unambiguously negative.

 • We have therefore shown that an increase in government purchases will reduce the
budget surplus, although in this model by considerably less than the increase in
purchases.
• For instance, for c = .8 and t = .25, a $1 increase in government purchases will
create a $0.375 reduction in the surplus.
• In the same way, we can consider the effects of an increase in the tax rate on the
budget surplus. We know that the increase in the tax rate will reduce the level of
income. It might thus appear that an increase in the tax rate, keeping the level of
government spending constant, could reduce the budget surplus. In fact, an increase in
the tax rate increases the budget surplus, despite the reduction in income that it
causes.
• Another interesting result known as the balanced budget multiplier
• Suppose government spending and taxes are raised in equal amounts and thus in
the new equilibrium the budget surplus is unchanged. By how much will output rise?
The answer is that for this special experiment the multiplier is equal to 1—output rises
by the increase in government spending and no more.
• The effect on the income level will depend on the proportion in which government
expenditure and taxes are changed. If government spending and taxes change in equal
amounts then income will change by an amount equal to the change in Government
expenditure and the value of multiplier will be = 1.

9-6 THE FULL-EMPLOYMENT BUDGET SURPLUS

• Recall that increases in taxes add to the surplus and that increases in government
expenditures reduce the surplus.
• It seems that the budget surplus is a convenient, simple measure of the overall
 effects of fiscal policy on the economy. For instance, when the budget is in deficit,
we would say that fiscal policy is expansionary, tending to increase GDP.
• However, the budget surplus by itself suffers from a serious defect as a measure of
the direction of fiscal policy.
• The defect is that the surplus can change because of changes in autonomous private
spending
• Thus, an increase in the budget deficit does not necessarily mean that the government
has changed its policy in an attempt to increase the level of income.
• Since we frequently want to measure the way in which fiscal policy is being used
to affect the level of income, we require some measure of policy that is independent
of the particular position of the business cycle—boom or recession—in which we may
find ourselves.
• Such a measure is provided by the full-employment budget surplus, which we denote
by BS *.
• The full-employment budget surplus measures the budget surplus at the full-
employment level of income or at potential output.
• Other names- cyclically adjusted surplus (or deficit), the high-employment surplus,
the standardized budget surplus, and the structural surplus.

• The difference between the actual and the full-employment budgets, we subtract the
actual budget surplus from the full-employment budget surplus to obtain

• Difference arises from income tax collection.

• Specifically, if output is below full employment, the full-employment surplus exceeds
the actual surplus.
• Actual output exceeds full-employment (or potential) output, the full-employment
surplus is less than the actual surplus.
• The difference between the actual and the full-employment budget is the cyclical
component of the budget. In a recession the cyclical component tends to show a
deficit, and in a boom, there may even be a surplus.

• Two final words of warning:

• First, there is no certainty as to the true full employment level of output.
• The usual assumptions now are that full employment means an unemployment rate of
about 5.5 percent, although there have been some estimates as high as 7 percent.
Estimates of the full-employment deficit or surplus will differ depending on the
assumptions made about the economy at full employment.
• Second, the high-employment surplus is not a perfect measure of the thrust of fiscal
policy. There are several reasons for this: A change in spending with a matching
increase in taxes, leaving the deficit unchanged, will raise income; expectations about
future fiscal policy changes can affect current income; and in general, because fiscal
policy involves the setting of a number of variables—the tax rate, transfers, and
government purchases—it is difficult to describe the thrust of fiscal policy perfectly
with a single number. But the high-employment surplus is nevertheless a useful guide
to the direction of fiscal policy.

QUESTIONS

1. Explain Balanced budget multiplier.

2. A fiscal policy change of the government raises GDP by Rs. 10000 crores if the
consumption function is C = 50 + 0.75 YD. What change in G lead to such
increase? If the tax revenue is increased by 2500 crores, what would be the change
in the GDP? What is the value of balanced budget multiplier?
3. Explain the equality of aggregate demand and aggregate output in determining the
equilibrium of income.
4. If C = 50 + 0.75 YD,
a) Derive savings function.
b) At what level of income savings become zero?
c) If the autonomous investment is Rs. 200 crores, at what level of income saving
will become equal to investment? Show it graphically.
5. What is fiscal policy? How fiscal policy has a multiplier effect on the economy?
Explain with an appropriate diagram.
6. Describe the use of diagram, equilibrium income using saving investment
approach.
7. C = 100 + 0.5 Y and investment = 50, find the equilibrium level of income? And
if I = 75, what is the new level of income.
8. Explain aggregate demand and aggregate ouput.
9. If C = 85 + 0.5 YD,
T = -40 + 0.25Y
I = 85 crores
G = 60 crores
a) Calculate equilibrium Y
b) Calculate government expenditure multiplier
c) How much government collect in net taxes at equilibrium?
d) Compute the value of government budget deficit/surplus.

10. How is equilibrium of GDP determined in four sector economy? Explain with the
help of diagram using aggregate output-expenditure approach.
11. If C = 50 crores + 0.75 YD and I = 50, G = 130 and T = 100 crores. Calculate
a) Equilibrium Y and C
b) Proportion of national income collected by government as taxes.
 c) The value of multiplier

12. What is meant by multiplier? Explain the working of multiplier using suitable
diagram and example.
13. Derive corresponding saving function for C = 10 + 0.85 Y. Also, find the level of
income where saving is 0. Find the MPC and MPS as well.
14. Explain the determination of equilibrium level of national income in a 2-sector
economy. Is the equilibrium level of income found only at full employment level?
15. What is investment multiplier? Discuss the working of the multiplier process.
16. If C = 50 + 0.6Y and I = 20 crores.
a) Find the value of multiplier
b) By how much consumption and income will increase as a result of increase in
investment by 30 crores?