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Summary Economics and management for business chapter 11
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Economics and managementChapter 11 – Expenditure and fiscal policy
GDP should be associated witch consumption, investment, government spending, and international
trade (export, and import). There is a complexity of intertwined relationships at the macroeconomic
level, which the firm needs to appreciate. Governments recognize that stability is preferable, volatility
leads to uncertainty, and uncertainty reduces both consumer and business confidence.
Equilibrium is generally defined as the situation where planned aggregate expenditure is equal to the
actual output of firms. Planned aggregate expenditure is the total amount of spending on goods and
services within the economy that is planned by purchasers. In the Keynesian Cross approach inflation
is not considered. We use the 45o line. A closed economy does not trade with the rest of the world.
For simplicity we have a closed economy with no government sector. PE = AD = C + I (planned
expenditure = aggregate demand = consumption + investment). The level of consumption is assumed
to be related to two factors:
Basic need to consume (autonomous consumption does not change if income changes,
autonomous expenditure is not influenced by the level of income)
Level of personal income
The marginal propensity to consume (MPC) is the extra consumption generated by one unit of extra
income. The marginal propensity to save (MPS) is the extra saving generated by one unit of extra
income. You do not have to consume your whole income, for example 100 of income could result in 80
of consumption and 20 of saving. MPC is 0,8 and MPS is 0,2 then MPC + MPS = 1. So if we assume
that autonomous consumption is 7 and MPC is 0,8, we have: C = 7 + 0,8Y (Y = personal disposable
income = 100). C = 7 + 0,8*100 = 7 + 80 = 87. A key driver of marginal propensity to consume is
consumer confidence. Investments are also seen as autonomous. If the investment level is set at 50, it
remains constant for every level of income. We now combine investment and consumption to find the
Keynesian equilibrium:
AD (Y) = C + I (C = 7 + 0,8Y, I = 50)
AD (Y) = 7 + 0,8Y + 50
AD (Y) = 57 + 0,8Y
Y = 57 + 0,8Y
Y – 0,8Y = 57
0,2Y = 57
Y = 57/0,2
Y = 285
This is also the point where the 45o line and AD line intersect. The multiplier measures the change in
output following a change in autonomous expenditure (the essential basic amount of consumption plus
investment). If the multiplier is 3, and increase in investment of 50 will lead to an increase in output of
3*50 = 150. The multiplier is calculated like this: multiplier = 1/MPS = 1/(1 – MPC). For example: 1/0,2
= 5. The higher MPS, the lower the multiplier will be.
Fiscal policy is the government’s decisions regarding taxation and spending. When introducing he
government, the AD is now calculated as followed: AD = C + I + G (G = government spending).
Government spending is also autonomous. We have to take taxes into account, because this will lower
the consumers’ income. Therefore t = tax rate. Consumption is now: C = 7 + 0,8 (1 – t)Y. The MPC
determines how steep the AD line is. A higher MPC will make a steeper AD line. Tax makes the AD line
flatter. When taxes are applied, an increase in income has a lower impact on consumption. After the
introduction of the government, the multiplier is now: multiplier = 1/(MPS + MPT). MPT = marginal
propensity to tax. If MPS is 0,2 and MPT is 0,22, then the multiplier is 1/(0,2 + 0,22) = 2,38. The
balanced budget multiplier states that an increase in government spending, plus an equal increase
in taxes, leads to higher equilibrium output.
The difference between government expenditures and government revenues is a government’s deficit.
Cumulative debt is the total outstanding government debt form borrowings over many years. Fiscal
stance is the extent to which the government is using fiscal policy to increase or decrease aggregate
demand in the economy. Full employment level of the economy is a long-run equilibrium position and
the economy operates on its production possibility frontier. The economy is in neither boon nor
recession. It is also describes as the structural budget. Automatic stabilizers enable the economy to
adjust automatically to changes in aggregate demand. Reasons for economic stabilizers: time lags
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