Ch. 9 -- Consumption, Investment, and Equilibrium:

Building the Aggregate Expenditures Model

Ch. 10 -- The Multiplier Concept

(plus pp. 219-220, 227)

Ch. 12 -- Fiscal Policy

(only pp. 234-238, 243-250)

Ch. 18 -- Budget Deficits and Public Debt: So What?

(plus pp. 239-240)

Suggested Textbook Questions:

Ch. 9: pp. 189-90 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12

Ch. 10: pp. 210-12 2, 3, 5, 6, 7, 8, 9, 10, 11

Ch. 12: pp. 251 2, 3, 4, 9, 10, 11

Ch. 18: pp. 378 1, 2, 4, 5, 6, 7, 8, 9, 11, 12

(See answers to Key Questions in textbook, and answers to other questions in this Coursebook)

Suggested Study Guide Questions:

(Please see the Syllabus section "How to Pass Economics ... #3" before doing these problems)

Ch. 9:

Multiple-Choice Questions - pp. 100-102 1, 2, 3, 5, 6, 7, 8, 9, 11, 12, 15, 16, 17, 18, 19, 21, 22, 23, 25

Problems - pp. 102-105 1, 2, 4, 5

Ch. 10:

Multiple-Choice Questions - pp. 112-114 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 13, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28

Multiple-Choice Questions - pp. 127 4, 5, 8

Problems - pp. 114-114-118 1, 2, 3, 4, 6

Ch. 12:

Multiple-Choice Questions - pp. 140-142 2, 3, 4, 5, 12, 14, 15, 17, 19, 20

Problems - pp. 142 1

Ch 18:

Multiple-Choice Questions - pp. 219-221 1, 2, 3, 8, 10, 13, 14, 15, 16, 17, 18, 19, 20, 25

Problems - pp. 221-223 1, 2, 3


Consumption, Investment, and Equilibrium:

Building the Aggregate Expenditures Model

I. Introduction Capitalism and the 4 Es

A. The 4 Es

B. Capitalism

1. characteristics

2. capitalism and the 4 "E"s

a. allocative efficency?

b. productive efficiency?

c. equity?

d. full employment?

3. capitalism and full employment

a. Classical view

b. Keynesian view

C. Review AD--AS Model -- What's missing: HOW MUCH?

1. determinates of AD



II. The Classical Theory of Employment: Historical Backdrop

A. Introduction: the Great Depression and Pres. Herbert Hoover

B. Why Full Employment is the Norm

1. two basic concepts

a. underspending is unlikely -- Say's Law

b. if there is underspending price and wage adjustments will acheive full employment again

2. implications

a. full employment is the norm

b. Laissez-faire Policy

III. The Great Depression and Keynes

A. John Maynard Keynes

B. Capitalism Does NOT Necessarily Maintain Full Employment

1. underspending likely

2. prices and wages are "sticky" downwards: the ratchet effect

IV. The Keynesian Model

A. Preliminary Information

1. assumptions

a. closed economy

b. ignore government

c. saving by households only

d. zero depreciation and net income earned abroad

e. constant PL

f. investment independent of income

2. implications

a. GDP = C + I

b. GDP = NDP = NI = PI = DI

3. aggregate expenditures:

relationship between spending and output (income)

"The amount of goods and services produced and therefore the level of employment depend directly on the level of total or aggregate expenditures."

(AE = C + I + G + Xn)

4. consumption and investment

B. Consumption (C) and Saving (S)

1. introduction

a. DI = C + S

b. the income consumption-relationship

c. the income-saving relationship

2. consumption and saving schedules

a. average propensity to consume (APC)

1) definition

2) formula

b. average propensity to save (APS)

1) definition

2) formula

3) APC + APS = 1

c. marginal propensity to consume (MPC)

1) definition

2) formula

d. marginal propensity to save (MPS)

1) definition

2) formula

3) MPC +MPS = 1

3. consumption and saving graphically

a. 45o line

b. MPC = slope of consumption function

c. saving and dissaving

d. MPS = slope of saving function

4. non-income determinants of C and S

a. wealth

b. expectations

1) future prices

2) money income

3) availability of goods

c. consumer indebtedness

d. taxation

5. shifts and stability

a. terminology

1) change in quantity consumed

a) graphically

b) cause

2) change in consumption (schedule shift)

a) graphically

b) cause

(1) wealth, price level, expectations, indebtedness

(2) taxation

b. stability

C. Investment (I)

1. expected rate of net profit

2. real interest rate

3. investment demand curve

4. shifts in investment demand (determinates)

a. acquisition, maintenance, and operating costs

b. business taxes

c. technological change

d. stock of capital goods on hand

e. expectations

5. investment and income

a. constant (autonomous) investment assumption

b. investment may increase with income

6. instability of investment

V. Equilibrium GDP

A. Simplifying Assumptions

1. closed economy

2. ignore government

3. saving by households only

4. zero depreciation and net income earned abroad

5. a constant price level

6. investment independent of income

B. Review

1. Keynesian tools of analysis (C + I)

2. equilibrium

C. Two Approaches

1. aggregate expenditures = domestic output

2. leakages = injections


VI. Aggregate Expenditures = Domestic Output Approach

C + Ig = GDP

A. Tabular Analysis

1. real domestic output (GDP=NI)

2. aggregate expenditures (C + Ig)

3. equilibrium GDP: where C + Ig = GDP

4. disequilibrium: why production moves toward equilibrium GDP

a. Review Investment

b. investment: planned and actual

c. disequilibrium and unintended inventory changes

d. achieving equilibrium: what will businesses do?

B. Graphic Analysis

1. 45-degree line

2. aggregate expenditures

3. equilibrium GDP: where C + Ig = GDP

4. disequilibrium and unintended inventory changes

VII. Leakages = Injections Approach

Leakages = Planned Injections

A. Introduction

1. assumptions

a. closed economy

b. ignore government

c. saving by households only

d. zero depreciation and net income earned abroad

e. a constant price level

f. investment independent of income

2. the income - expenditure stream

3. saving as a leakage (other leakages)

4. investment as an injection (other injections)

B. Tabular Analysis

C. Graphic Analysis


The Multiplier Concept

I. Review AD--AS Model -- What's missing: HOW MUCH?

A. Determinates of AD


II. Changes in Equilibrium GDP and the Multiplier: HOW MUCH

A. Macroeconomic Instability: Shifting C or I

1. tabular analysis

2. graphic analysis

B. Multiplier Effect

1. GDP = initial spending x multiplier

2. multiplier = change in real GDP

initial change in spending

3. rationale -- how does the multiplier work?

4. multiplier and marginal propensities (slopes)

a. MULTIPLIER = 1 = 1______



(1/MPS + MPM + MPT)


C. Leakages = Injections Approach

1. tabular analysis

2. graphic analysis

III. International Trade and Equilibrium Output

A. Keynesian Model Assumptions

B. Adding the Foreign Sector

1. net exports

2. aggregate expenditures

3. equilibrium GDP

a. tabular analysis

b. graphic analysis

IV. Equilibrium vs. Full-Employment GDP

A. Unemployment and the Recessionalry Gap

B. Inflation and the Inflationary Gap


(pp. 219-220, 227)

Chapter 12

Fiscal Policy

(plus pp. 199-205, and pp. 234-238, 243-250)

I. Introduction

A. Assumptions

1. closed economy

2. I independent of GDP

3. taxes independent of GDP

4. no crowding out

5. ignore supply-side effects

6. saving by households only

B. Preview: fiscal policy tools

1. G

2. T

3. BB

II. Discretionary Fiscal Policy (FP) Government and the Economy

A. Government Purchases and Equilibrium GDP

1. tabular analysis

2. graphic analysis


4. leakages = injections

B. Taxation and Equilibrium GDP

1. lump-sum tax, DI, and Consumption

2. tabular analysis

3. graphic analysis


5. leakages = injections


III. Fiscal Policy Over the Cycle

A. Expansionary FP

B. Contractionary FP

IV. Problems, Criticisms, and Complications

A. Problem of Timing

1. recognition lag

2. administrative lag

3. operational lag

B. Political Problems

1. other goals

2. state and local finance

3. expansionary bias?

4. political business cycle?

C. Crowding-out Effect

D. Supply-side Fiscal Policy


Deficits and Debts: So What?

I. Deficits and Debt: Definitions

II. Budget Philosophies

A. Annually Balanced Budget : Procyclical

(also pp. 239-240)

B. Cyclically Balanced Budget

C. Functional Finance

III. The Public Debt

A. The Facts

1. nominal size

2. the growing debt

3. debt and GDP

4. international comparisons

5. accounting and inflation

B. Causes of the Debt

C. Who Does the Government Owe? (ownersip of the debt)

D. Effects of the Debt

Does the debt put a burden on our children and grandchildren?

1. false issues

a. going bankrupt

1) refinancing

2) taxation

3) creating money

b. interest on the debt and shifting burdens

1) who do we owe?

2) we owe ourselves

2. real issues

a. income (re)distribution

b. incentives

c. external debt

d. curb on fiscal policy

e. crowding out and the capital stock

1) but: gov't also invests

2) but: if there is UE then little crowding out

IV. Recent Federal Deficits

A. The Size they Tell Us

B. The Real Size

V. Budget Deficits Cause Trade Deficits


Suggested Textbook Questions


Ch. 9: pp. 189-90 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12

9-2 Explain what relationships are shown by (a) the consumption schedule, (b) the saving schedule, (c) the investmentdemand curve, and (d) the investment schedule.

(a) The consumption schedule or curve shows how much households plan to consume at various levels of disposable income at a specific point in time, assuming there is no change in the nonincome determinants of consumption, namely, wealth, the price level, expectations, indebtedness, and taxes. A change in disposable income causes movement along a given consumption curve. A change in a nonincome determinant causes the entire schedule or curve to shift.

(b) The saving schedule or curve shows how much households plan to save at various levels of disposable income at a specific point in time, assuming there is no change in the nonincome determinants of saving, namely, wealth, the price level, expectations, indebtedness, and taxes. A change in disposable income causes movement along a given saving curve. A change in a nonincome determinant causes the entire schedule or curve to shift.

(c) The investmentdemand curve shows how much will be invested at all possible interest rates, given the expected rate of net profit from the proposed investments, assuming there is no change in the noninterestrate determinants of investment, namely, acquisition, maintenance, operating costs, business taxes, technological change, the stock of capital goods on hand, and expectations. A change in any of these will affect the expected rate of net profit and shift the curve. A change in the interest rate will cause movement along a given curve.

(d) The investment schedule shows how much businesses plan to invest at each of the possible levels of output or income.

9-3 Precisely how are the APC and the MPC different? Why must the sum of the MPC and the MPS equal 1? What are the basic determinants of the consumption and saving schedules? Of your own level of consumption?

The APC is an average whereby total spending on consumption (C) is compared to total income (Y): APC = C/Y. MPC refers to changes in spending and income at the margin. Here we are comparing a change in consumer spending to a change in income: MPC = change in C / change in Y.

When your income changes there are only two possible options regarding what to do with it: You either spend it or you save it. MPC is the fraction of the change in income spent; therefore, the fraction not spent must be saved and this is the MPS. The change in the dollars spent or saved will appear in the numerator and together they must add to the total change in income. Since the denominator is the total change in income, the sum of the MPC and MPS is one.

The basic determinants of the consumption and saving schedules are the levels of income and output. Once the schedules are set, the determinants of where the schedules are located would be the amount of household wealth (the more wealth, the more is spent at each income level); expectations of future income, prices and product availability; the relative size of consumer debt; and the amount of taxation.

Chances are that most of us would answer that our income is the basic determinant of our levels of spending and saving, but a few may have low incomes, but with large family wealth that determines the level of spending. Likewise, other factors may enter into the pattern, as listed in the preceding paragraph. Answers will vary depending on the student's situation.

9-4 Explain how each of the following will affect the consumption and saving schedules or the investment schedule:

(a) A decline in the amount of government bonds which consumers are holding

(b) The threat of limited, nonuclear war, leading the public to expect future shortages of consumer durables

(c) A decline in the real interest rate

(d) A sharp decline in stock prices

(e) An increase in the rate of population growth

(f) The development of a cheaper method of manufacturing pig iron from ore

(g) The announcement that the social security program is to be restricted in size of benefits

(h) The expectation that mild inflation will persist in the next decade

(i) An increase in the Federal personal income tax

(a) If this simply means households have become less wealthy, then consumption will decline and saving will increase. The investment schedule will also shift down. However, if what is meant is that households are cashing in their bonds to spend more, then the consumption schedule will shift up and the saving schedule will shift down. If the increase in consumption should boost national income, and if the investment schedule is then upsloping, there will be movement upward (to the right) along it and investment will increase.

(b) This threat will lead people to stock up; the consumption schedule will shift up and the saving schedule down. If this puts pressure on the consumer goods industry, the investment schedule will shift up. The investment schedule may shift up again later because of increased military procurement orders.

(c) The decline in the real interest rate will increase interestsensitive consumer spending; the consumption schedule will shift up and the saving schedule down. Investors will increase investment as they move down the investmentdemand curve; the investment schedule will shift upward.

(d) Though this did not happen after October 19, 1987, a sharp decline in stock prices can normally be expected to decrease consumer spending because of the decrease in wealth; the consumption schedule shifts down and the saving schedule upwards. Because of the depressed share prices and the number of speculators forced out of the market, it will be harder to float new issues on the stock market. Therefore, the investment schedule will shift downward.

(e) The increase in the rate of population growth will, over time, increase the rate of income growth. In itself this will not shift any of the schedules but will lead to movement upward to the right along the upward sloping investment schedule.

(f) This innovation will in itself shift the investment schedule upward. Also, as the innovation starts to lower the costs of producing everything made of steel, steel prices will decrease leading to increased quantities demanded. This, again, will shift the investment schedule upward.

(g) The expected decrease in benefits will cause households to save more; the saving schedule will shift upward, the consumption schedule downward.

(h) If this is a new expectation, the consumption schedule will shift upwards and the saving schedule downwards until people have stocked up enough. After about a year, if the mild inflation is not increasing, the household schedules will revert to where they were before.

(i) Because this reduces disposable income, consumption will decline in proportion to the marginal propensity to consume. Consumption will be less at each level of real output, and so the curve shifts down. The saving schedule will also fall because the disposable income has decreased at each level of output, so less would be saved.

9-5 Explain why an upshift in the consumption schedule typically involves an equal downshift in the saving schedule. What is the exception?

If, by definition, all that you can do with your income is use it for consumption or saving, then if you consume more out of any given income, you will necessarily save less. And if you consume less, you will save more. This being so, when your consumption schedule shifts upward (meaning you are consuming more out of any given income), your saving schedule shifts downward (meaning you are consuming less out of the same given income).

The exception is a change in personal taxes. When these change, your disposable income changes, and, therefore, your consumption and saving both change in the same direction and opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1. Now, if your taxes increase by $100, your consumption will decrease by $90 and your saving will decrease by $10.

9-6 (Key Question) Complete the accompanying table.

Level of Ouput

and income

(GDP = DI) Consumption Saving APC APS MPC MPS

$240 $_____ $-4 _____ _____

_____ _____

260 _____ 0 _____ _____

_____ _____

280 _____ 4 _____ _____

_____ _____

300 _____ 8 _____ _____

_____ _____

320 _____ 12 _____ _____

_____ _____

340 _____ 16 _____ _____

_____ _____

360 _____ 20 _____ _____

_____ _____

380 _____ 24 _____ _____

_____ _____

400 _____ 28 _____ _____

_____ _____

(a) Show the consumption and saving schedules graphically.

(b) Locate the breakeven level of income. How is it possible for households to dissave at very low income levels?

(c) If the proportion of total income consumed decreases and the proportion saved increases as income rises, explain both verbally and graphically how the MPC and MPS can be constant at various levels of income.

Answers to Key Questions appear in the text.

9-7 What are the basic determinants of investment? Explain the relationship between the real interest rate and the level of investment. Why is the investment schedule less stable than the consumption and saving schedules?

The basic determinants of investment are the expected rate of net profit that businesses hope to realize from investment spending and the real rate of interest.

When the real interest rate rises, investment decreases; and when the real interest rate drops, investment increases --other things equal in both cases. The reason for this relationship is that it makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net profit is less than 10 percent, borrowing the money would be expected to result in a negative rate of return on the borrowed money. Even if the firm has money of its own to invest, the principle still holds: The firm would not be maximizing profit if it used its own money to carry out an investment returning, say, 9 percent when it could lend the money at an interest rate of 10 percent.

For the great majority of people, their only saving is to buy a house and to make the mortgage payments on it. Apart from that, practically their entire income is consumed. Since for the majority of people their incomes are quite stable and since almost all their income is consumed, the consumption and saving schedules are also quite stable. After all, most consumption is for the essentials of food, shelter, and clothing. These cannot vary much.

Investment, on the other hand, is variable because, unlike consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. A firm can continue for years with, say, a tenth of the investment it was carrying out in the boom. Very few families could cut their consumption so drastically.

New business ideas and the innovations that spring from them do not come at a constant rate. This is another reason for the irregularity of investment. Profits and the expectations of profits also vary. Since profits, in the absence of easy access to borrowed money, is essential for investment and since, moreover, the object of investment is to make a profit, investment, too, must vary.

9-8 (Key Question) Assume there are no investment projects in the economy which yield an expected rate of net profit of 25 percent or more. But suppose there are $10 billion of investment projects yielding expected net profit of between 20 and 25 percent; another $10 billion yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present them graphically, putting the expected rate of net profit on the vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent? Explain why this curve is the investmentdemand curve.

Answers to Key Questions appear in the text.

9-9 Explain graphically the determination of the equilibrium GDP by (a) the aggregate expenditures-domestic output approach and (b) the leakages-injections approach for a private closed economy. Why must these two approaches always yield the same equilibrium GDP? Explain why the intersection of the aggregate expenditures schedule and the 45-degree line determines the equilibrium GDP.

These two approaches must always yield the same equilibrium GDP because they are simply two sides of the same coin, so to speak. Equilibrium GDP is where aggregate expenditures equal real output. Aggregate expenditures consist of consumer expenditures (C) + planned investment spending (Ig). If there is no government or foreign sector, then the level of income is the same as the level of output. In equilibrium, Ig makes up the difference between C and the value of the output.

If we let Y be the value of the output which is also the value of the real income, then whatever households have not spent is Y - C = S. But at equilibrium, Y - C also equals Ig so at equilibrium the value of S must be equal to Ig. This is another way of saying that saving (S) is a leakage from the income stream, and investment is an injection. If the amount of investment is equal to S, then the leakage from saving is replenished and all of the output will be purchased which is the definition of equilibrium. At this GDP, C + S = C + Ig, so S = Ig.

Alternatively, one could explain why there would not be an equilibrium if (a) S were greater than Ig or (b) S were less than Ig. In case (a), we would find that aggregate spending is less than output and output would contract; in (b) we would find that C + Ig would be greater than output and output would expand. Therefore, when S and Ig are not equal, output level is not at equilibrium.

The 45-degree line represents all the points at which real output is equal to aggregate expenditures. Since this is our definition of equilibrium GDP, then wherever aggregate expenditure schedule coincides (intersects) with the 45-degree line, there is an equilibrium output level.

9-10 (Key Question) Assuming the level of investment is $16 billion and independent of the level of total output, complete the following table and determine the equilibrium levels of output and employment which this private closed economy would provide. What are the sizes of the MPC and MPS?


levels of Real domestic

employment output (GDP=DI) Consumption Saving

(millions) (billions) (billions) (billions)

40 $ 240 $244 $________

45 260 260 ________

50 280 276 ________

55 300 292 ________

60 320 308 ________

65 340 324 ________

70 360 340 ________

75 380 356 ________

80 400 372 ________

Answers to Key Questions appear in the text.

9-11 (Key Question) Using the consumption and saving data given in question 10 and assuming the level of investment is $16 billion, what are the levels of saving and planned investment at the $380 billion level of domestic output? What are the levels of saving and actual investment? What are saving and planned investment at the $300 billion level of domestic output? What are the levels of saving and actual investment? Use the concept of unintended investment to explain adjustments toward equilibrium from both the $380 and $300 billion levels of domestic output.

Answers to Key Questions appear in the text.

9-12 "Planned investment is equal to saving at all levels of GDP; actual investment equals saving only at the equilibrium GDP." Do you agree? Explain. Critically evaluate: "The fact that households may save more than businesses want to invest is of no consequence, because events will in time force households and businesses to save and invest at the same rates."

You should not agree. The statement is backward --reverse the placement of the planned investment and actual investment. Actual investment is always present-- it is the amount that actually takes place at any output level because it includes unintended changes in inventories (a type of investment) as well as the level of planned investment. If saving is greater than planned investment, the total level of aggregate spending will not be enough to support the existing level of output, causing businesses to reduce their output. If saving is less than planned investment, the total level of aggregate expenditures will be greater than the existing output level and inventories will drop below the planned level of inventory investment, causing businesses to increase their output to replenish their inventories. The only stable output level will be the equilibrium level, at which saving and planned investment are equal.

The events described in the second quote are predictable, but most would argue that this is of great consequence. When households save more than businesses want to invest, it means they are consuming less. This, in turn, means that aggregate spending (consumption plus investment) will be less than the level of output and current real income. Businesses will experience unplanned inventory buildup and will cut their output levels, which means a decline in employment. The resulting unemployment is not inconsequential --especially to those who lose their jobs, but also in terms of lost potential output for the entire economy.

Ch. 10: pp. 210-12 2, 3, 5, 6, 7, 8, 9, 10, 11

10-2 (Key Question) What is the multiplier effect? What relationship does the MPC bear to the size of the multiplier? The MPS? What will the multiplier be when the MPS is 0, .4, .6, and 1? When the MPC is 1, .90, .67, .50, and 0? How much of a change in GDP will result if businesses increase their level of investment by $8 billion and the MPC in the economy is .80? If the MPC is .67? Explain the difference between the simple and the complex multiplier.

Answers to Key Questions appear in the text.

10-3 Graphically depict the aggregate expenditures model for a private closed economy. Next, show a decrease in the aggregate expenditures schedule and explain why the decrease in real GDP in your diagram is greater than the initial decline in aggregate expenditures. What would be the ratio of a decline in real GDP to the initial drop in aggregate expenditures if the slope of your aggregate expenditures schedule were .8?

If the slope of the aggregate expenditures schedule were .8, then the MPC = .8 and the MPS = .2. Therefore, the multiplier would be 1/(.2) = 5. The ratio of decline in real GDP to the initial drop of expenditures would be a ratio of 5:1. That is, if expenditures declined by $100 million, GDP should decline by $500 million. On the graph it can be seen that a one-unit decline in (C + I) leads to a five-unit decline in real GDP.

10-5 (Key Question) The data in columns 1 and 2 of the table below are for a private closed economy.

(1) (2) (3) (4) (5) (6)

Real Aggregate Net Aggregate

domestic expenditures Net expendi-

output private closed exports, tures,

(GDP=DI), economy, Exports, Imports, private open

billions billions billions billions economy billions

$200 $240 $20 $30 $_____ $_____

$250 $280 $20 $30 $_____ $_____

$300 $320 $20 $30 $_____ $_____

$350 $360 $20 $30 $_____ $_____

$400 $400 $20 $30 $_____ $_____

$450 $440 $20 $30 $_____ $_____

$500 $480 $20 $30 $_____ $_____

$550 $520 $20 $30 $_____ $_____

(a) Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy.

(b) Now open this economy for international trade by including the export and import figures of columns 3 and 4. Calculate net exports and determine the equilibrium GDP for the open economy. Explain why equilibrium GDP differs from the closed economy.

(c) Given the original $20 billion level of exports, what would be the equilibrium GDP if imports were $10 billion larger at each level of GDP? Or $10 billion smaller at each level of GDP? What generalization concerning the level of imports and the equilibrium GDP is illustrated by these examples?

(d) What is the size of the multiplier in these examples?

Answers to Key Questions appear in the text.

10-6 Assume that, without taxes, the consumption schedule of an economy is as shown below:

GDP, Consumption,

billions billions

$100 $120

200 200

300 280

400 360

500 440

600 520

700 600

(a) Graph this consumption schedule and note the size of the MPC.

(b) Assume now a lump-sum tax system is imposed such that the government collects $10 billion in taxes at all levels of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with that of the pretax consumption schedule.

(a) The size of the MPC is 80/100 or .8 because consumption changes by 80 when GDP changes by 100.

(b) The resulting consumption schedule will be exactly $10 billion below the original at all levels of GDP, because people now have to pay $10 billion in tax out of each level of income. The multiplier should be 5 because the MPS is .2 and 1/.2 is 5. We see on the graph that the equilibrium GDP has fallen to $150 billion. That is equilibrium GDP fell by $50 billion when expenditures fell by $10 billion, a multiple of 5 times the decline in expenditures.

10-7 Explain graphically the determination of equilibrium GDP through both the aggregate expenditures-domestic output approach and the leakages-injections approach for the private sector. Now add government spending and taxation, showing the impact of each on the equilibrium GDP.

10-8 (Key Question) Refer to columns 1 and 6 of the tabular data for question 5. Incorporate government into the table by assuming that it plans to tax and spend $20 billion at each possible level of GDP. Also assume that all taxes are personal taxes and that government spending does not induce a shift in the private aggregate expenditures schedule. Explain the changes in the equilibrium GDP which the addition of government entails.

Before G is added, private sector equilibrium will be at 470. The addition of government expen-ditures of G to our analysis raises the aggregate expenditrures (C + Ig +Xn + G) schedule and increases the equilibrium level of GDP as would an increase in C, 1g, or Xn. Note that changes in goverment spending are subject to the multiplier effect. In terms of the leakages-injections approach, government spending supplements private investment and export spending (Ig + X + G), increasing the equilibrium GDP to 550.

Answers to Key Questions appear in the text.

10-9 What is the balanced budget multiplier? Demonstrate the balanced-budget multiplier in terms of your answer to question 8. Explain: "Equal increases in government spending and tax revenues of n dollars will increase the equilibrium GDP by n dollars." Does this hold true regardless of the size of MPS?

The balanced-budget multiplier stems from the fact that increases in government spending go directly into the flow of aggregate expenditures. Whereas the tax increase reduces incomes by the amount of the tax, but spending will be reduced by a fraction of the income reduction (the fraction will be equal to the MPC), and the multiplier effect will work in opposite directions on the increase and the reduction in spending. But the reduction will be less than the increase due to the initial government spending influx, which was not affected by the MPC. Since this initial "shot" of government spending was not offset by an equal and opposite effect on the downside from the tax increase, it is an addition to the aggregate expenditures flow which just equals the change in the budget. Thus, we say the balanced budget multiplier is equal to 1.

In question 8, the added government spending alone would increase GDP by 5 x $20 billion, and the tax increase would reduce GDP by 5 x $16 billion, for a net change of ($100 - $80) billion or $20 billion. This is equal to 1 x the change in G and T so the balanced budget multiplier is 1 in this example. (Note: The multiplier is 5 because MPS = .2 and 1/.2 = 5. The tax increase reduces consumer spending by $16 billion because the tax reduces incomes by $20, and this will reduce spending by a factor equal to the MPC, or .8 x $20 billion.)

The quote does hold true regardless of the size of the MPS. This is true because the only increase in expenditures that will occur is a result of the initial change in government spending. Beyond that, increases in spending from the "ripple" effect of the initial change in G will be exactly offset by decreases in spending which result from the "ripple" effect caused by the higher taxes. It doesn't matter whether the multiplier is 10 or 2, the offsetting effect will occur on all changes except the initial increase in government spending.

10-10 (Key Question) Refer to the accompanying table in answering the questions which follow:

(1) (2) (3)


Possible levels Real domestic expenditures,

of employment. output Ca + Ig + Xn + G,

millions billions billions

90 $500 $520

100 550 560

110 600 600

120 650 640

130 700 680

(a) If full employment in this economy is 130 million, will there be an inflationary or recessionary gap? What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.

(b) Will there be an inflationary or recessionary gap if the full-employment level of output is $500 billion? Explain the consequences. By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.

(c) Assuming that investment, net exports, and government expenditures do not change with changes in real GDP, what are the sizes of the MPC, the MPS, and the multiplier?

Answers to Key Questions appear in the text.

10-11 Which of the two situations in question 10 --the one described in 10-(a) or 10-(b)-- is consistent with the realities of the Great Depression? With the Vietnam war era? Explain your answers.

In part (a) aggregate expenditures are not enough to purchase all of the planned output ($680 is less than $700). Therefore, there is a deflationary gap which is consistent with the realities of the Great Depression. Output and employment would fall until a new low equilibrium is reached.

Part (b) is consistent with the inflationary period of the Vietnam War era. Aggregate expenditures are greater than the full-employment level of output which characterized that period.


Ch. 12: pp. 251 2, 3, 4, 9, 10, 11

12-2 (Key Question) Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal.

Answers to Key Questions appear in the text.

12-3 (Key Question) What are government's fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think a "conservative" economist might favor? A "liberal" economist?

Answers to Key Questions appear in the text.

12-4 (For students assigned Chapters 9 and 10) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary gap or an inflationary gap (Figure 10-8). Use the concept of the balanced budget multiplier to explain how equal increases in G and T could eliminate a recessionary gap and how equal decreases in G and T could eliminate an inflationary gap.

A recessionary gap could be eliminated by increasing government spending and/or decreasing personal taxes. Both of these policies have the effect of raising aggregate demand and shifting the aggregate expenditures schedule upward toward full-employment GDP.

An inflationary gap could be eliminated by pursuing the opposite policies: either decreasing government spending or raising taxes or both. This would reduce aggregate expenditures and would shift actual spending downward toward the full-employment level of real GDP.

Because the balanced budget multiplier essentially multiplies any change in government spending by a factor of 1, an increase in government spending and taxes would still have a positive effect on aggregate expenditures, increasing them by the amount of the initial increase in G. If G were large enough, the recessionary gap could be eliminated. Likewise, a balanced decrease in G and T could eliminate an inflationary gap, because the decline in aggregate expenditures would be equal to G. If the decrease in G were large enough to bring aggregate expenditures to the level of full-employment GDP, then the inflationary gap would be eliminated.

129 (Key Question) Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the notion of a political business cycle. What is the crowdingout effect and why is it relevant to fiscal policy? In what respect is the net export effect similar to the crowdingout effect? Do you think people increase their saving in anticipation of the future higher taxes they believe will follow governmentÕs use of expansionary fiscal policy?

Answers to Key Questions appear in the text.

12-10 In view of your answers to question 9, explain the following statement: "While fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to 'fine-tune' the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely."

As suggested, the answer to question 9 explains this quote. While fiscal policy is useful in combating the extremes of severe recession with its built-in "safety nets" and stabilization tools, and while the built-in stabilizers can also dampen spending during inflationary periods, it is undoubtedly not possible to keep the economy at its full-employment, noninflationary level of real GDP indefinitely. There is the problem of timing. Each period is different, and the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Fiscal policy operates in a political environment in which the unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate economic policies are ignored for political reasons. Finally, there are offsetting decisions which may be made at any time in the private and/or international sectors. For example, efforts to revive the economy with more government spending could result in reduced private investment or lower net export levels.

Even if it were possible to do any fine tuning to get the economy to its ideal level in the first place, it would be virtually impossible to design a continuing fiscal policy that would keep it there for all of the reasons mentioned above.

12-11 Discuss: "Mainstream economists tend to focus on the aggregate demand effects of tax-rate reductions; supply-side economists emphasize the aggregate supply effects." What are the routes through which a tax cut might increase aggregate supply? If tax cuts are so good for the economy, why don't we cut taxes to zero?

Mainstream economists come from the Keynesian tradition, which focussed on the demand side of the economy. Keynes emphasized deficient aggregate demand as the major cause of recessions and depressions, and the recessionary gap concept implies that shifting demand is the solution to the unemployment problem. Supply-side economists take their name from their focus on the supply side of the economy. They argue that the tax structure has a major effect on the supply side of the economy through its impact on work incentives and productivity as well as its impact on saving and investment. They argue that a lighter tax burden has an encouraging effect in all of these areas.

Taking these factors one by one, tax cuts will provide more incentive to work harder and longer, as workers and employers keep more of their after-tax earnings; encourage investment, especially if the tax cuts are aimed at promoting saving and business investment via such avenues as tax-free interest on certain types of saving, investment tax credits, and/or lower capital gains income taxes.

Of course, the statement is absurd because there is a certain level of government that all agree is necessary, and we must pay for it. Lower taxes might provide additional revenue under circumstances where the existing structure has imposed an excessive burden, but there is a point below which lower tax rates will mean lower revenue. One might think of the incentive factor of lower taxes as producing diminishing returns.

Ch. 18: pp. 378 1, 2, 4, 5, 6, 7, 8, 9, 11, 12

181 (Key Question) Assess the potential for using fiscal policy as a stabilization device under (a) an annually balanced budget, (b) a cyclically balanced budget, and (c) functional finance.

Answers to Key Questions appear in the text.

182 What have been the major sources of the public debt historically? Why were deficits so large in the 1980s? Why did the deficit rise in 1991 and 1992?

Historically, wars and recessions have caused the public debt to increase. It would have been possible to finance World War II entirely through taxes, but this would have greatly decreased the work incentives deemed essential to get the job done. It would have been possible to finance the war effort by printing new money but, in the conditions of the already excessive demand then existing, this would have been highly inflationary. So, the government borrowed from the public. This reduced purchasing power without greatly impairing the growing wealth and work incentives of the civilian labor force. Recessions have also been responsible for the growing debt. Government deficits to bolster the economy during recessions have not been equaled by surpluses during booms.

The Economic Recovery Tax Act of 1981 has been responsible for much of the large budget deficits of the 1980s. ERTA reduced personal and corporate income tax rates without also reducing government spending. Indeed, defense spending rose considerably during the Reagan administration. Thus, the Federal budget has had a structural deficit built into it: Even at full employment, the Federal budget would now be in deficit.

In 1991 and 1992 three unique events contributed to the deficit: Operation Desert Storm, more funding for the S&L bailout, and a recession that was followed by a slow recovery.

184 Explain or evaluate each of the following statements:

(a) "A national debt is like a debt of the left hand to the right hand."

(b) "The least likely problem arising form a large public debt is that the Federal government will go bankrupt."

(c) "The basic cause of our growing public debt is a lack of political courage."

(d) "The social security reserves are not being reserved. They are being spent, masking the real deficit."

(a) The statement is true about a national debt held internally, but this does not mean a large debt is entirely problem free. In the first place, there is the problem of the transfer of income created by the debt. Generally, government bonds are owned by those who are better off, while everyone pays taxes so the government may make the interest payments. Second, a debt that is growing rapidly because of large budget deficits --the case in the United States since the early 1980s-- is unsettling to financial markets and business, which are in constant fear that the government will finally decide enough is enough and dramatically tighten fiscal policy (especially by raising taxes). This would probably bring on a recession.

(b) The Federal government cannot go bankrupt. Even if it did not have the unlimited taxing power that it does have, it still could not go bankrupt. This is for the simple reason that its promise to repay its debt at maturity is in money that it can produce in unlimited quantities: the government can print as much money as it likes. Of course, if the government did print banknotes in virtually unlimited quantities, the banknotes would be as worthless as the *German marks of late 1923. Those who had lent to the government when the dollar was still worth something might well be bankrupt. But the government would not be; it would have paid its debts in full, just as promised! What must be clearly understood is that the government has not promised to repay in gold or in dollars of any given value. It has merely promised to repay in current dollars, whatever they may be worth on repayment day, if anything.

(c) This last statement is also essentially true. To reduce the annual deficits that are adding to the debt, the government must reduce spending and/or increase taxes --most likely do both. Though most people may agree that it is not helpful to have interest payments on the debt take a larger and larger proportion of the federal budget year after year, very few people will thank the politician responsible for reduced federal spending in their town or for an increase in taxes.

(d) It is true that current social security reserves are being spent, but only in the sense that they are being loaned out to the government as many individuals do with their own savings. As long as government funds are being used for productive purposes, these "loans" should pay off in the future. After all, most individuals regard U.S. government securities as the safest investment they can make. As long as the economy continues to grow, future taxpayers should be able to support this fund in the future. However, there is a concern that the proportion of recipients to contributors is growing, and this is a concern if present trends continue. One solution that is being implemented gradually is to delay the retirement age as people live longer and healthier lives.

185 Is the crowdingout effect likely to be larger during recession or when the economy is near full employment? Explain.

The crowding out effect will be larger when the economy is near full employment. Indeed, in a recession there may be no crowding out at all, especially if the increased government spending is financed by idle funds --in which case there would be no increase in the interest rate-- or by new money (borrowing from the Federal Reserve) -- in which case the interest rate might even fall. Moreover, the increase in government spending, by stimulating aggregate demand in a recession, may actually induce an increase in investment as business optimism rises.

However, should the economy already be close to full employment, an increase in government spending may crowd out an equal amount of private investment spending. Since the two could offset each other, there may be no impact on aggregate demand.

186 Some economists argue that the quantitative importance of the public debt can best be measured by interest payments on the debt as a percentage of the GDP. Can you explain why?

The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing were automatic, there would be no debtload at all. But interest does have to be paid. Lenders insist on that. And to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of the ability of the government to raise in taxes the money needed to pay the interest.

187 (Key Question) Is our $4.6 trillion public debt a burden to future generations? If so, in what sense? Why might deficit financing be more likely to reduce the future size of our "national factory" than tax financing of government expenditures?

Answers to Key Questions appear in the text.

188 (Key Question) Trace the causeandeffect chain through which large deficits might affect domestic real interest rates, domestic investment, the international value of the dollar, and our international trade. Comment: "There is too little recognition that the deterioration of America's position in world trade is more the result of our own policies than the harm wrought by foreigners." Provide a critique of this position, using the idea of Ricardian equivalence.

Answers to Key Questions appear in the text.

189 Explain how a significant decline in the nation's budget deficit would be expected to reduce (a) the size of our trade deficit, (b) the total debt Americans owe to foreigners, and (c) foreign purchases of U.S. assets such as factories and farms.

(a) A significant decline in the Federal budget deficit should reduce the sale of government bonds in the financial markets. The decreased supply of bonds tends to raise their prices which means that interest rates would decline. This will eventually reverse the flow of foreign money that was buying U.S. bonds. Then the international value of the dollar will decline, exports will increase, and imports will decrease; net exports will tend to become positive. In other words, the trade deficit will tend to disappear.

On the other hand, if the Ricardian equivalence theorem is correct, the situation may be like that described in the answer to question 188. A decrease in budget deficits may cause people to shift consumption upward, saving less. Interest rates, therefore, may not decline.

(b) Our international trade deficit is financed largely by the United States going into debt to foreign nations. That is, we consume more imports than our exports finance, and foreigners extend credit to us for this difference. As our trade deficit declines because of the lower interest rates that accompany a reduction in the budget deficit, our indebtedness to the rest of the world will tend to decline.

(c) One means of financing a trade deficit is to sell off a portion of a nation's real assets, for example, factories, real estate, farms, and so forth. In recent years our large trade deficits have caused our major trading partners to accumulate large amounts of dollars, which they in turn have used to purchase real assets in the United States. As a result, many "American" firms are owned by the Japanese and the British. To the extent that a decline in the budget deficit decreases the international value of the dollar and reduces our trade deficits, this process of foreign acquisition of real assets in the United States will be constrained or reversed.

Certainly, American (net) international indebtedness will stop increasing or even decline but a drop in United States' interest rates is more likely to encourage than discourage foreign buying of United States' assets other than bonds. However, until the 1980s, this has never been a problem: decade by decade there was more American direct investment in foreign assets such as factories and farms than similar foreign investment in the United States. Once United States' real interest rates return to their historic levels of 2 or 3 percent, and the United States regains its international competitiveness, there is every reason for the United States to become again a net international creditor.

18-11 Would you favor a constitutional amendment requiring the Federal budget to be balanced annually? Why or why not? Do you favor giving the President the authority to veto line-items of appropriation bills? Why or why not?

An annually balanced budget amendment would significantly weaken the government's ability to use fiscal policy as a stabilization tool. During a recession, tax revenues automatically fall as incomes fall, and government spending rises as more people become eligible for entitlements. However, if the government had to balance its budget, this could not happen, and government would have to raise tax rates and/or cut spending, which could intensify the recession. The amendment would also be procyclical during inflationary times, because as the revenues rose the government could find the budget heading toward surplus, which would no longer be allowed. Thus, the government would have to cut taxes, which could make inflationary spending by its citizens worse. Favoring an annually balanced budget means that you are against having fiscal policy as a tool to help prevent recession or inflation.

Giving the President the power to veto line-items of appropriation bills would allow the president to delete appropriations for projects that may provide local benefits that are less than the costs to the government. Such "pork barrel" projects are often tacked onto much larger government spending bills to enhance the political advantage of members of Congress "back home." If the President vetoed these, then the particular Congress member would not face the major blame and the nation would not have many unnecessary spending projects financed by all taxpayers. On the other hand, critics of the idea state that giving the President line-item veto power is too much power in the hands of one individual and could be abused. However, it must be remembered that presidential vetoes can be overridden by a two-thirds vote of Congress.

18-12 (Last Word) What is meant by the term "entitlement programs"? Cite several examples of these programs. Why have entitlement programs grown so rapidly? What are the implications for future generations if this growth continues?

Entitlement programs are government programs which pay benefits to people who are entitled to them, because they meet the qualifications specified by past legislation. Social security benefits, Medicare, Medicaid, veterans' compensation, agricultural subsidies, food stamps, Aid to Families with Dependent Children, supplemental security income, and other welfare programs are included.

They have expanded as Congress has raised benefit levels and recently because of an explosion of people eligible for such programs, especially social security, Medicare, and Medicaid.

Implications for future generations are serious, primarily with regard to social security and Medicare, which are programs targeted for elderly retirees. Today about 110 million workers pay taxes for transfer to 41 million beneficiaries. By 2029, the number of retirees will grow rapidly as the baby-boom generation reaches retirement age and the employed worker population diminishes in relation to this number. The concern is that the program will no longer be self-supporting without changes in tax rates or benefit levels and eligibility.