CHAPTER 7
THE KEYNESIAN MODEL WITH A GOVERNMENT AND A
FOREIGN SECTOR
Economic theory has three purposes:
To explain what is happening in the economy
To predict what will happen if something changes
To help us to analyse economic policy.
How does gov spending G and taxes T affect A (aggregate spending),
a (the multiplier) and Y (equilibrium income)?
Gov spending and taxes are also essential ingredients of the budget,
and are the main instruments in fiscal policy
I can define fiscal policy
Decisions by the President and Congress, usually relating to taxation and
government spending, with the goals of full employment, price stability, and
economic growth.
Government spending is essentially a political issue.
I am able to explain the impact of the introduction of government
spending on aggregate spending, the multiplier and the equilibrium level
of income
Increases the level of aggregate spending A
Leaves the multiplier a unchanged
Raises the equilibrium level of income Y₀, cet par
There is no systematic relationship between G and Y – expressed in symbols as:
G= - the stripe indicates that G is autonomous with respect to Y.
Increases in government spending can be used to raise the level of production and income.
Direct method
Government spending on goods and services (G) has to be added to the other components
of aggregate spending, consumption spending (C) and investment spending (I).
Aggregate spending thus becomes: A = C + I + G
G is autonomous and hence affects the position of the A curve but the slope
remains unchanged.
Government spending does not affect the multiplier.
Government spending increased the equilibrium level of income,cet. Par.
To calculate the equilibrium level of income Y:
Y₀ = – c (C + Ī + Ḡ))
General formula still remains : Y₀ = ὰ9 (Ā))
Where Y₀ = equilibrium level of income
ὰ0 = Multiplier
Ā = total autonomous spending
Taxes reduces the disposable (or after-tax) income of households, with the result
, that household can afford to purchase fewer goods and services than before which
indirectly causes consumption spending by households (C) to decrease.
What determines the level of taxes?
Taxes are not autonomous. There is a link between taxes (T) and Income (Y). Taxes are a
certain portion (t) of income Y – this proportion is called the Tax rate. T = tY
Example: tax rate t = 0.2 we have T = 0.2Y – which means that 20 % of the total income in
the economy (or 20cent of each Rand) has to be paid to the government in the form of
taxes.
In the economy as a whole we have a fixed tax rate (proportional tax). During the year
taxes T for the economy as a whole are a certain proportion of income Y – T/Y = t or T = tY.
Disposable income = Yd = Y – T
Since T = tY We can also write: Yd = Y – tY or Yd = (1 - t) Y
As households can only spend their disposable income, the consumption function is:
C = C + cYd or C = C + c(1 – t)Y
The introduction of a proportional tax thus reduces the size of the
multiplier. Multiplier with taxes:
1
1 – c(1 – t)
Since income tax is a leakage, it reduces the equilibrium level of income, ceteris paribus.
I am able to explain the impact of the introduction of a proportional income tax on
- private consumption expenditure is reduced (disposable income)
- leaves autonomous spending Ā unchanged
- the multiplier is reduced
- reduces the equilibrium level of income Y₀, ceteris paribus.
I am able to explain the difference between income and disposable income
With the introduction of a proportional income tax, households cannot spend
all their income. They first have to pay tax. The difference between income
earned and tax paid is disposable income
THE KEYNESIAN MODEL WITH A GOVERNMENT AND A
FOREIGN SECTOR
Economic theory has three purposes:
To explain what is happening in the economy
To predict what will happen if something changes
To help us to analyse economic policy.
How does gov spending G and taxes T affect A (aggregate spending),
a (the multiplier) and Y (equilibrium income)?
Gov spending and taxes are also essential ingredients of the budget,
and are the main instruments in fiscal policy
I can define fiscal policy
Decisions by the President and Congress, usually relating to taxation and
government spending, with the goals of full employment, price stability, and
economic growth.
Government spending is essentially a political issue.
I am able to explain the impact of the introduction of government
spending on aggregate spending, the multiplier and the equilibrium level
of income
Increases the level of aggregate spending A
Leaves the multiplier a unchanged
Raises the equilibrium level of income Y₀, cet par
There is no systematic relationship between G and Y – expressed in symbols as:
G= - the stripe indicates that G is autonomous with respect to Y.
Increases in government spending can be used to raise the level of production and income.
Direct method
Government spending on goods and services (G) has to be added to the other components
of aggregate spending, consumption spending (C) and investment spending (I).
Aggregate spending thus becomes: A = C + I + G
G is autonomous and hence affects the position of the A curve but the slope
remains unchanged.
Government spending does not affect the multiplier.
Government spending increased the equilibrium level of income,cet. Par.
To calculate the equilibrium level of income Y:
Y₀ = – c (C + Ī + Ḡ))
General formula still remains : Y₀ = ὰ9 (Ā))
Where Y₀ = equilibrium level of income
ὰ0 = Multiplier
Ā = total autonomous spending
Taxes reduces the disposable (or after-tax) income of households, with the result
, that household can afford to purchase fewer goods and services than before which
indirectly causes consumption spending by households (C) to decrease.
What determines the level of taxes?
Taxes are not autonomous. There is a link between taxes (T) and Income (Y). Taxes are a
certain portion (t) of income Y – this proportion is called the Tax rate. T = tY
Example: tax rate t = 0.2 we have T = 0.2Y – which means that 20 % of the total income in
the economy (or 20cent of each Rand) has to be paid to the government in the form of
taxes.
In the economy as a whole we have a fixed tax rate (proportional tax). During the year
taxes T for the economy as a whole are a certain proportion of income Y – T/Y = t or T = tY.
Disposable income = Yd = Y – T
Since T = tY We can also write: Yd = Y – tY or Yd = (1 - t) Y
As households can only spend their disposable income, the consumption function is:
C = C + cYd or C = C + c(1 – t)Y
The introduction of a proportional tax thus reduces the size of the
multiplier. Multiplier with taxes:
1
1 – c(1 – t)
Since income tax is a leakage, it reduces the equilibrium level of income, ceteris paribus.
I am able to explain the impact of the introduction of a proportional income tax on
- private consumption expenditure is reduced (disposable income)
- leaves autonomous spending Ā unchanged
- the multiplier is reduced
- reduces the equilibrium level of income Y₀, ceteris paribus.
I am able to explain the difference between income and disposable income
With the introduction of a proportional income tax, households cannot spend
all their income. They first have to pay tax. The difference between income
earned and tax paid is disposable income
