Unit 14: Unemployment and
Fiscal Policy
Government intervenes with Fiscal Policy in order to assist people.
Aggregate demand (GDP) can fluctuate due to consumption and investment decisions.
The aggregate decisions of households and firms can destabilize the economy.
The transmission of shocks: The multiplier process
Keynesian theory
The level of income [Y] is determined by the level of aggregate spending or demand [A].
There are circumstances where spending will not be able to achieve full employment hence the need
for government intervention.
Changes in current income influence spending, affecting the income of others.
Investment decisions by firms also have an impact on other actors in the economy.
As a result, indirect effects through the economy amplify the direct effect of a shock to aggregate
demand.
Aggregate demand: the total of the components of spending in the economy, added to get
GDP:
Y =C + I + G+ X−M
The probability of a total increase in GDP is to be equal to the initial increase in spending.
Probability of the total increase in GDP to be greater or less than the initial increase in
spending.
The Multiplier
Change∈Real GDP (Y )
Multiplier ( k )= If an amount is input in the
Aggregate demand
economy, by how much will
∆ GDP it change in output.
¿
∆ AD
If the total increase in GDP is equal to the initial increase in spending; the multiplier is equal to 1.
If the total increase in GDP is greater or less than the initial increase in spending; the multiplier is
greater than 1 or less than 1.
, Negative shock = lower demand Increase in investment
Business reduce workers Increase in disposable income
Reduce consumption Increase in consumption
Disinvestment
Level of consumption lower
The multiplier model (close economy)
Simplifying Assumptions
Aggregate demand: The total of the components of spending in the economy, added get
GDP: Y =C + I+ G+ X−M
Closed economy.
- We are operating in the economy with only C + I.
- Goods sold in the economy are nominal goods. *Hold all things constant that affect
- The component of the GDP is to be exogenous. GDP.
- Hold constant the interest rate. *Nominal goods – positively related
- Only households pay tax to income
Multiplier process: A mechanism through which the direct or indirect effect of a change in
autonomous spending affects the aggregate output.
- Helps to explain why GDP increases more than the initial increase in investment
spending.
- The process is explained through the aggregate consumption function =
consumption (C) for the aggregate economy.
- Hold all other factors constant that affects the AD.
Consumption function
Aggregate consumption has 2 parts:
C=C 0+ C1 Y
1. Autonomous consumption C 0: The fixed amount one will pend, independent of Y income.
- The intercept of aggregate spending/demand curve
- Interest rate; expectations and wealth affect autonomous consumption
2. Consumption dependent on income C 1 Y : The upward-sloping line denotes the part of
consumption that depends on current income.
- C 1 Y marginal propensity to consume: The slope of the consumption line is equal to
the MPC. The effect of one additional unit of income on consumption.
- Induced consumption dependent on income, the c 1 in c 1 Y is equal to the marginal
propensity to consume (MPC) and is the slope of the consumption function
, C=C 0+ C1 (Yd)
C 0 → Autonomous consumption = The fixed amount spent, independent of income
C 1 → MPC = Marginal propensity to consume
Yd → Disposable income
C 1(Yd) → Consumption dependent on income (the variable amount)
The C 0 in the aggregate consumption
function captures all the other influences
on consumption that are not related to
current income.
Spending/Consumption but not because
of shift in income changed.
Result of expectation.
Exodontist – result in a shift
Investment not related to income.
Slope of consumption (C 1) = marginal
propensity to consume (MPC), the
change in consumption when disposal
income changes by one unit.
- MPC is positive, but less than 1
- Part of income is consumed – the
rest is saved.
- Saves 40% in graph
Y d =C+ S
- part of income is consumed
- the rest is saved
MPC+ MPS=1
A steeper consumption line means a larger consumption response to a change in income.
A flatter line means that households are smoothing their consumption so that it does not
vary much when income varies.
Fiscal Policy
Government intervenes with Fiscal Policy in order to assist people.
Aggregate demand (GDP) can fluctuate due to consumption and investment decisions.
The aggregate decisions of households and firms can destabilize the economy.
The transmission of shocks: The multiplier process
Keynesian theory
The level of income [Y] is determined by the level of aggregate spending or demand [A].
There are circumstances where spending will not be able to achieve full employment hence the need
for government intervention.
Changes in current income influence spending, affecting the income of others.
Investment decisions by firms also have an impact on other actors in the economy.
As a result, indirect effects through the economy amplify the direct effect of a shock to aggregate
demand.
Aggregate demand: the total of the components of spending in the economy, added to get
GDP:
Y =C + I + G+ X−M
The probability of a total increase in GDP is to be equal to the initial increase in spending.
Probability of the total increase in GDP to be greater or less than the initial increase in
spending.
The Multiplier
Change∈Real GDP (Y )
Multiplier ( k )= If an amount is input in the
Aggregate demand
economy, by how much will
∆ GDP it change in output.
¿
∆ AD
If the total increase in GDP is equal to the initial increase in spending; the multiplier is equal to 1.
If the total increase in GDP is greater or less than the initial increase in spending; the multiplier is
greater than 1 or less than 1.
, Negative shock = lower demand Increase in investment
Business reduce workers Increase in disposable income
Reduce consumption Increase in consumption
Disinvestment
Level of consumption lower
The multiplier model (close economy)
Simplifying Assumptions
Aggregate demand: The total of the components of spending in the economy, added get
GDP: Y =C + I+ G+ X−M
Closed economy.
- We are operating in the economy with only C + I.
- Goods sold in the economy are nominal goods. *Hold all things constant that affect
- The component of the GDP is to be exogenous. GDP.
- Hold constant the interest rate. *Nominal goods – positively related
- Only households pay tax to income
Multiplier process: A mechanism through which the direct or indirect effect of a change in
autonomous spending affects the aggregate output.
- Helps to explain why GDP increases more than the initial increase in investment
spending.
- The process is explained through the aggregate consumption function =
consumption (C) for the aggregate economy.
- Hold all other factors constant that affects the AD.
Consumption function
Aggregate consumption has 2 parts:
C=C 0+ C1 Y
1. Autonomous consumption C 0: The fixed amount one will pend, independent of Y income.
- The intercept of aggregate spending/demand curve
- Interest rate; expectations and wealth affect autonomous consumption
2. Consumption dependent on income C 1 Y : The upward-sloping line denotes the part of
consumption that depends on current income.
- C 1 Y marginal propensity to consume: The slope of the consumption line is equal to
the MPC. The effect of one additional unit of income on consumption.
- Induced consumption dependent on income, the c 1 in c 1 Y is equal to the marginal
propensity to consume (MPC) and is the slope of the consumption function
, C=C 0+ C1 (Yd)
C 0 → Autonomous consumption = The fixed amount spent, independent of income
C 1 → MPC = Marginal propensity to consume
Yd → Disposable income
C 1(Yd) → Consumption dependent on income (the variable amount)
The C 0 in the aggregate consumption
function captures all the other influences
on consumption that are not related to
current income.
Spending/Consumption but not because
of shift in income changed.
Result of expectation.
Exodontist – result in a shift
Investment not related to income.
Slope of consumption (C 1) = marginal
propensity to consume (MPC), the
change in consumption when disposal
income changes by one unit.
- MPC is positive, but less than 1
- Part of income is consumed – the
rest is saved.
- Saves 40% in graph
Y d =C+ S
- part of income is consumed
- the rest is saved
MPC+ MPS=1
A steeper consumption line means a larger consumption response to a change in income.
A flatter line means that households are smoothing their consumption so that it does not
vary much when income varies.
