Macroeconomics (overview)

1a) Explain how a change in government spending will influence aggregate demand and output.

1.1 Explanation mathematically & verbally
1.2 Explanation graphically
1.3 Explanation with a table
1.4 Examples (Product market with positive and negative state expenditure) Sources

1.1. Explanation mathematically & verbally

If the government increases spending (expensive fiscal policy ) we will have an increase in aggregate demand.

If the government reduces spending (restrictive fiscal policy ) we will have a reduction in aggregate demand (AD).

Aggregate demand = C onsumption + I nvestment + G overnment spending

Taxation reduces the income available for consumption. Some households receive transfer payments (unemployment benefits, childcare payments,…) The disposable income is equal to national income y, less direct taxes (T) + received transfer payments (Tr)

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With government expenditure consumption will be given by: C = C +c.yd

The equilibrium output with government expenditure:

C = C + cTr + c.(1-t)y

C= autonomous consumption

c. = marginal propensity to consume

Tr= transfer payments

(1-t) = tax rate

y = income

After substituting for aggregate demand we get the following function:

AD = A + c(1-t)y

A = autonomous expenditure

In equilibrium aggregate demand is equal to income y:

y = [1/ 1-c(1-t)] * [ C + c.Tr + I + G]

1.2 Explanation graphically

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Increased Government spending

Source: self-made in imitation of what we have done in the course

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Y1 is equilibrium output income with G = G1. y2 is the new equilibrium output income with G = G2. If the government increases government spending to G2, the aggregate demand function will shift upwards by ∆G. ∆y is larger than the increase in government spending ∆G because of the multiplier effect. The 45 degree line can be used to show all the points where the output is equal to aggregate demand. This happens where the 45 degree line crosses the aggregate demand function.

1.3 Explanation with a table

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An increase in Government spending

Source: Macroeconomics in Context, Goodwin, et al.

Copyright © 2006 Global Development And Environment Institute, Tufts University, (Chapter 10 page 4)

In this table we raise government spending each period by 80. This has the effect that the aggregate demand raises also up by 80. The intended investment raised up by 60. A raise in aggregate demand by 80 implies a raise in consumption also by 80. In this example a raise of government spending by 80 has also the effect that the income raises by 100 each period.

But the question is why does the government spending has such an effect? The answer is that government spending enables for example an industrialist to buy goods and services (for example steel or to pay the workers). This creates aggregate demand. The workers will spend their wage for goods. This creates the multiplier effect.

1.4 Examples

Product market with positive state expenditure

Consider a simple economy in which consumption is given by C = 100 + 0.8yd and investment by I=50, while the government´s fiscal policy is given by G1=200 and G2 = 250, Tr = 62.5 and t=0.25

mathematical solution:

Calculation of the equilibrium output with G1:

AD = y in equilibrium

AD1 = [1/ [1-0.8*(1-0.25)] * [100 + (0.8*62.5) + 500 + 200 = 1000

Calculation of the equilibrium output with G2:

AD2 = [1/ [1-0.8*(1-0.25)] * [100 + (0.8*62.5) + 500 + 250 = 1125

Value of the multiplier:

The multiplier is a formula to calculate the changes in income because of changes in government spending. The change in equilibrium income is equal to the change in government spending multiplied by the multiplier. The multiplier says how often the change in income is higher or lower than the change in government spending.

[1/ [1-0.8*(1-0.25)] = 2.5

Change in Output y:

∆y = y2 –y1 = [1/ [1-0.8*(1-0.25)] * [250 -200] = 125

graphic solution:

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If the government increases government spending from 200 to 250 the multiplier process will lead to a new equilibrium income 1125 from 1000. The difference between y2 and y1 is 125.

Product market with negative state expenditure

In this second example the government spending will be reduced from 200 to 150. So we have a negative change of the government spending by 50. We assume that the multiplier is again 2.5. Then we would have an equilibrium ∆y = -125. Income would fall from 1125 to 1000.

Sources:

1. Notes during the macroeconomics course
2. Macroeconomics in Context, Goodwin, et al. Copyright © 2006 Global Development And Environment Institute, Tufts University

1b) Why does a country’s propensity to import affect the impact of a change in government spending?

1.5 Verbal explanation
1.6 Mathematical explanation
1.7 Example with multiplier Sources

1.5 Verbal explanation

If we consider the exports and imports than we will have the following aggregate demand function:

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