Unit 14
AND FISCAL POLICYUNEMPLOYMENT
Unit 14 Roadmap
The transmission of The multiplier model Household target Investment – Unit
shocks: The (consumption) – 14.2 wealth – 14.3 14.4
multiplier process –
14.1
The role of Stabilising the The multiplier in The governments
government – Unit economy – 14.6 practice – Unit 14.7 finances – Unit 14.8
14.5
Fiscal Policy and the Aggregate demand
rest of the world – and unemployment –
Unit 14.9 Unit 14.10
The Context for This Unit
Aggregate demand (GDP) can fluctuate due to consumption
and investment decisions.
The aggregate decisions of households and firms can(Unit 13)
destabilize the economy.
How can government intervene to stabilize the economy?
Why are government policies sometimes ineffective?
How can we model the link between output and
unemployment?
Keynesian theory and economic stability
Keynes developed the theory that 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 and hence
the need for government intervention.
For example, Keynes suggested that the cause of
the Great Depression was an unusually low level
of aggregate spending
This diagnosis suggests an immediate remedy:
use government policies to increase aggregate
spending
Extra income leads to extra spending, which leads
to further increases in output and income. The
process continues around and around the circular
flow
Figure 14.1. Fluctuations in output and the size of government in the US (1870-2015).
President Roosevelt’s New US War on
Deal: 1933-36 Poverty begins:
1964 Start
US deploys of
Start of
End End ground troops global
Great
of of in Vietnam: financi
Depressi
W WW 1965 al
on: 1929
WI: II: crisis:
1970
191 1945 2008
s
8
14.1 Transmission of shocks: Multiplier process
Remember:
Firm and household spending behaviors affect the economy
Households prefer consumption smoothing- source of stability
Firms cluster investment decisions- source of volatility
Changes in current income influence spending, affecting the income of
others.
Indirect effects through the economy amplify the direct effect of a shock
to aggregate demand (often shortened to AD) .
AD = C + I + G + NX
14.1 Transmission of shocks: Multiplier process
The multiplier process is a tool to understand:
the impact of firms and households' decisions on economy.
The magnitude of direct and indirect impact of the decisions
How government behavior can help stabilize the impacts through policy.
The Multiplier
Multiplier (k) = Change in Real GDP (Y) / Aggregate
demand
∆GDP
∆AD
If the total increase in GDP is equal to the initial
increase in spending: We say that the multiplier is
equal to 1.
If the total increase in GDP is greater or less than
the initial increase in spending: We say that the
multiplier is greater than 1 or less than 1.
The multiplier process in a 2-sector closed economy
In the 2-sector economy
there are only two types of
expenditure
Consumption[C] by
households
Investment spending [I]
by firms
Y= C + I
Multiplier process
The multiplier process helps us to explain why GDP
increases more than the initial increase in investment
spending.
The process is explained through the aggregate
consumption function = consumption spending (C)
for the aggregate economy.
Multiplier process
Consumption depends on income
For consumption smoothing households: an increase in income will not
increase their consumption one-for-one, or even at all.
Non-smoothing households will increase their current consumption one for
one in response to a temporary increase in their income.
The multiplier is > 1, if the additional consumption spending resulting from a
temporary increase in income is greater than zero but less than 1 (e.g.,60
cents)
14.2 The multiplier model
REMEMBER
Figure 13.6. The circular flow model
Consumption function [C]
𝐶 = 𝑐 0 +𝑐 1𝑌
where:
 Autonomous consumption, the intercept of the aggregate spending/demand curve
 Induced consumption dependent on income, the 𝑐1 in 𝑐1𝑌 is equal to the marginal propensity
to consume (MPC) and is the slope of the consumption function.
Consumption function (C)
consumption
C = co + c1 x (Yd) dependent on
income, the
variable
amount
autonomous consumption
= the fixed amount spent,
independent of income
MPC = marginal (disposable) income
propensity to
consume
Slope of consumption function (c1) = marginal propensity to consume (MPC),
the change in consumption when disposable income changes by one unit.
→ MPC is positive, but less than 1:
part of the income is consumed – the rest is saved
Yd = C + S
part of the income
is consumed the rest is saved
MPC + MPS = 1
Consumption function
𝑐1𝑌= Consumption
dependent on income, the
variable amount.
If marginal consumption is
0.6 then consumption
increases by R1*0.6=0.60c
Consumption function
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
incomes varies.
Aggregate demand function
Remember: We are ultimately interested in how changes in aggregate
demand results in changes in output and employment.
Low output high unemployment
High output low unemployment
Aggregate demand function
The relationship between output (Y)
produced and aggregate demand
(AD) helps us to understand how a
shock is transmitted through the
economy.
Y=AD
The 45-degree line shows all the
combinations where output(Y)=
aggregate demand (AD).
Considering Investment as the other
expenditure component of our model:
Aggregate demand=
consumption + Investment
AD= C + I
= c0 + c1y + I
Goods market equilibrium
[];If income is equal to spending (AD) on
total product: the economy is in equilibrium,
no one has the incentive to change their
behaviour.
[];If total spending (AD) is greater than total
income: then demand for goods and services is
greater than supply giving producers the
incentive to expand their production.
[]; If total spending (AD) is less than to total
income: then demand for goods and services is
less than supply, producers have the incentive
to cut back on production.
Goods market equilibrium: Y =
AD
Goods market equilibrium
Aggregate demand (AD) =
consumption function + investment
Investment is assumed to be
independent of output (Y)
The slope of AD line is below 45°
because the MPC<1
45° line is where Y = AD
Figure 14.4 Goods market equilibrium: The multiplier diagram.
Goods market equilibrium: Y =
AD
Changes in consumption function
Credit constraints and consumption smoothing is reflected in the
slope of the AD curve and the size of the multiplier.
Consumption decisions can also shift the AD curve.
e.g. a fall in house prices will be bad news for a household with a
mortgage. They may choose to save more (precautionary saving)
and hence their autonomous consumption would fall.
The multiplier process
Fall in investment → fall in
aggregate demand → lower
output and income → further
fall in demand and income →
new equilibrium (Z)
The multiplier effect
The total change in output can be greater than the initial change
in aggregate demand because of the circular flow of expenditure,
income, and output.
If multiplier = 1: the increase in GDP is equal to the initial
increase in spending
If multiplier > (<) 1: the total increase in GDP > (<) the initial
increase in spending
Exercise
Question 1
In a closed economy with no government, a R1 billion increase in investment
leads to a R5 billion increase in consumption. What is the value of the marginal
propensity to consume?
Question 2
Assume a nation's GDP is R250 million and its MPC is 0.80. What will the new
GDP be if total spending rises by R10 million?
14.3 Household’s target wealth
Household’s have a target wealth which they aim to ‘preserve’
Changes in household wealth stocks: Households will change their
savings patterns to restore household wealth if the ‘value’ of its assets
(such as a house) decrease relative to its target wealth
Precautionary savings, is the increase in savings as a result of a
decrease in the value of a household’s assets.
Precautionary saving behavior by households is modelled as a fall in
autonomous consumption
Remember pathway: Fall in expenditure, Fall in output, Fall in
employment, Fall in income, Fall in consumption and wealth, Increase
in saving
Study shows surprising
increase in wealth in South
AfricaStaff Writer 22 February
2021
Key Findings:
Real value (expressed in 2010-prices) of
household net wealth increased to R7.7
trillion by the end of the fourth quarter
2020. This is R236.3 billion higher than a
year before.
The increase was due to strong growth in
the value of financial assets ( e.g., shares
and bonds).
Source:
[Link]
The Great Depression
Two ways which consumption fell during Great Depression:
1. Credit constraints in the multiplier process.
2. Changes in wealth relative to target wealth.
3.
Multiplier process: The fall in AD because of a fall in investment, led to a reduction
in output, employment etc..
Target wealth process: Housing prices fell which led to the target wealth of
households falling and precautionary saving increasing which meant a fall in
autonomous consumption
Great Depression: Happened because of multiplier effect AND target wealth process.
Without the reduction in household consumption, there would have only been a
recession.
The Great Depression
Point A: goods market equilibrium (1929)
Point B: fall in investment = downward shift of
AD
Point C: fall in autonomous consumption =
further downward shift of AD
uncertainty due to stock market crash,
pessimism, banking crisis and collapse of
credit
Households who retained their jobs also
cut back on spending
Household wealth
How did target wealth impact consumption in Great Depression?
1.
2. If target wealth is above expected wealth: Decrease in consumption and increase
in savings.
3. If target wealth is below expected wealth: Increase in consumption and decrease
in savings.
The onset of the economic downturn led to job losses which led to pessimism
and a downward revision of expected income.
Housing prices also decreased which led to a large gap between target wealth
and expected wealth
Financial accelerator: Low housing prices meant that households and firms can
not borrow as much as before because their collateral is worth less. This means
that they are credit constrained and leads to decreased consumption.
Household wealth
Household wealth impacts autonomous consumption.
Broad wealth = broad assets –
Precautionary saving
Target wealth = the level of wealth
that a household aims to hold,
based on its economic goals (or
preferences) and expectations.
Precautionary saving = An
increase in saving to restore wealth
to its target level.
A fall in expected earnings will lead to cut in consumption
(precautionary savings) to restore target wealth.
Consumption and the housing market
Changes in house prices affect consumption through two channels:
1.
1.
1.
1. Via change in household wealth (home equity)
2. Via change in credit constraints: lower house value
makes it more difficult to borrow (greater credit
constraint)
Exercise
Question 1
Why is precautionary saving seen as a decrease in autonomous spending?
Question 2
What role did house prices play in the Great Depression?
Question 3
Explain the role of expectations about future earnings in household consumption
patterns.
14.4 Investment spending
Firms’ decision about what to do with its profits depends on
Owner’s discount rate (ρ)
Interest rate on assets (r)
Net profit rate on investment (Π)
1. Consume the extra income (dividends) if ρ > r ≥ Π
2. Save the extra income/repay debts if r > ρ ≥ Π
3. Invest (at home or abroad) if Π > ρ ≥ r
A lower interest rate makes investment more likely.
Investment spending: supply side effects
Higher expected rate of profit increases investment, holding
r constant.
Improvement in business environment (reduced risk) also
increases investment.
Change in interest rate is a demand-side factor.
Investment spending Figure 14.9: The effect of interest rates on investment
A lower interest rate
makes investment more
likely.
Investment spending: supply side effects
Higher expected rate of profit Figure 14.10a: The effect of profit expectations on
investment
increases investment, holding r
constant.
Improvement in business
environment (such as fall in the
risk of expropriation by the
government) also increases
investment.
Investment spending: supply side effects
Figure 14.10b: The effect of a permanent change in demand on
investment
However:
Change in interest rate is a
demand-side factor.
(Also remember from Unit 10 that
monetary policy can influence r)
Exercise
Would investment increase or decrease in the following cases
assuming all other things stay constant? Which of the factors
in the previous two slide caused this change?
a) The government makes it easier to register SME’s.
b) The SARB increases the repo rate.
c) The president adresses the nation and promises a very
positive economic outlook.
Aggregate investment function
Figure 14.10c Aggregate investment function: Effects of the interest rate
Aggregate investment function
= An equation that shows how
investment spending in the
economy as a whole depends on
other variables (interest rate and
profit expectations).
In practice, investment is not very sensitive to interest rate.
C to E
Aggregate investment function
Aggregate investment function
= An equation that shows how
investment spending in the
economy depends on other
variables (interest rate and profit
expectations).
In practice, investment is not very sensitive to interest rate. Instead, the shift
factors are much more important.
Previously:
Our model of AD only included Firms and households.
AD = C + I .
Now we expand our model by adding governments and
central banks.
Why are they useful? What effects do they have?
AD = C + I + G + NX
14.5 Adding government to aggregate demand
AD = C + I + G + NX
Government enters AD via
Government spending: exogenous; shifts AD curve
upwards
Consumption: household’s MPC is out of disposable
income (1-t)Y
Investment: depends on the interest rate and after-tax
rate of profit
Adding government to aggregate demand : the components
AD = C + I + G + NX
Consumption (C): disposable income
C =  + (1 - t) Y
autonomous mpc income
consumption
tax
Adding government to aggregate demand: the components
AD = C + I + G + NX
Investment (I)
Government spending (G)
Net exports (NX):
net exports = X – M
= X – mY
X = Exports
M = Imports
m = marginal propensity to import
Y = Income
The multiplier model again
AD = c0 + c1(1 - t)Y + I + G + X - mY
Saving, taxation and imports are referred to as leakages from
the circular flow of income. They reduce the size of the
multiplier.
some household income goes directly to the government
as taxes
and some income is used to buy goods abroad
Smaller multiplier = flatter AD curve.
Derivation exercise
Given that
AD = c0 + c1(1 - t)Y + I + G + X – mY
and
AD = Y
Derive the formula of the multiplier
Net exports and aggregate demand
AD = C + I + G + NX
NX = exports - imports
The amount of exports is taken as exogenous.
The amount of imports depends on domestic income.
Marginal propensity to import = The fraction of each
additional unit of income that is spent on imports
14.6 Stabilising the economy
The government stabilises economic fluctuations in several ways:
1. Government spending is large and exogenous
2. Higher tax rate lowers the multiplier
3. Unemployment insurance helps households smooth their consumption
Failure of private market because of correlated risk, hidden actions,
hidden attributes
4. Deliberate intervention via fiscal policy
The unemployment benefit scheme and proportional tax rate are automatic
stabilizers = they automatically offset an expansion or contraction of the
economy.
The paradox of thrift
In a recession, faced with a household budget deficit, a family
worried about their falling wealth cuts spending and saves more.
But in the economy as a whole, spending and earning go together.
The paradox of thrift = the aggregate attempt to increase savings
leads to a fall in aggregate income.
Fallacy of composition: what is true for one part of the economy (a
single household) is not true of the whole economy.
Fiscal stimulus
Government can counteract the
fall in AD from the private sector
via fiscal stimulus.
Cut taxes to encourage the
private sector to spend more
Increase spending (G), which
directly increases AD
The rise in G operates via the multiplier, so the increase in Y will typically be
greater than the increase in G.
Financing fiscal stimulus
Budget balance = T - G
Fiscal stimulus will result in a negative budget balance (government
budget deficit).
Government budget deficit: T < G
Government budget surplus: T > G
If a deficit is not reversed after the recession, it will increase
government debt.
This fear of an increased government debt is why some governments
will implement austerity policy even in recessions.
Austerity policy
Austerity policy can reinforce a recession by further
reducing aggregate demand.
Positive/Negative Feedback Mechanisms
14.7 The multiplier in practice
In our model of aggregate demand, the multiplier depended only
on the marginal propensity to consume, the marginal propensity to
import, and the tax rate.
In reality, it also depends on:
rate of capacity utilisation (the phase of the business cycle):
with fully employed resources, an increase in government
spending would crowd out private spending
expectations of the private sector: the multiplier could be
negative if rising fiscal deficit erodes consumer confidence
The multiplier in practice
The size of the multiplier matters since it determines how
responsive the economy is to government spending.
i.e. will fiscal stimulus have the intended effect, do nothing or make
matters worse?
But determining the actual size of the multiplier is not very easy...
14.8: The government’s finances
Primary budget deficit = G –T
procyclical
the government must borrow to cover the gap between
spending and revenue, by issuing bonds
Government debt = sum of all the bonds sold over time to finance
budget deficit – matured bonds (repaid debt).
Sovereign debt crisis = a situation in which government bonds
come to be considered risky (default risk).
Government debt
The level of indebtedness of
a government is measured
relative to the size of the
economy (debt-to-GDP
ratio).
South African National debt in relation to GDP (Statista)
Debt-to-GDP ratio
Indebtedness can fall
if the primary budget balance
is positive
if GDP is growing faster than
government debt
if inflation is high (real value
of debt falls)
Foreign markets and aggregate demand
1. Fluctuations in the growth rate
of important markets abroad
influence the domestic
economy via demand for
exports.
2. Demand for imports dampens
domestic fluctuations.
3. Foreign trade limits the use of
fiscal stimulus if the marginal
propensity to import is large.
14.10: Aggregate Demand and Unemployment
Supply-side = labour market Figure 14.17 The supply side of the aggregate economy: The labour market
model
Medium-run model: wages
and prices can change, but
capital stock, technology
and institutions are fixed
Aggregate Demand and Unemployment
Demand-side = multiplier Figure 14.19 The demand side of the aggregate economy
model
Short-run model: all
variables fixed
Aggregate Demand and Unemployment
Production function connects employment (N) and output (Y)
We assume labour productivity is constant and equal to λ so the
production function is:
Y = λN
To simplify this and allow for comparison we say λ = 1 so that:
Y=N
Aggregate Demand and Unemployment
Figure 14.19 Business cycle
fluctuations around
equilibrium
unemployment
Cyclical unemployment
Fluctuations in aggregate demand
around the labour market
equilibrium cause cyclical
unemployment.
Figure 14.19 Business cycle fluctuations around equilibrium unemployment
Structural unemployment
South Africa has a large
structural
unemployment
problem.
Legacy of Apartheid -
Oversupply of low/semi-
skilled labour, whilst
economy demands
highly skilled labour.
Summary
1. The aggregate demand function and its components:
AD = C + I + G + NX
2. Shocks to aggregate demand are amplified by the multiplier
3. Government can stabilise economic fluctuations
Automatic stabilisers
Fiscal stimulus – offset decline in aggregate demand from
the private sector
Austerity policies amplify the negative demand shock
4. Fiscal stimulus in a recession must be reversed in a boom to
prevent government debt from escalating (sovereign debt
crisis)
In the next unit
The relationship between unemployment and inflation:
The Phillips curve
How governments use monetary policy to affect
inflation
Developing our model of aggregate demand: What
happens to wages and prices in booms/recessions
