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# Section+7 - Section 7 IS-LM PS4 1 Tuesday March 9 2010 The...

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Section 7 IS-LM & PS4 1 Tuesday, March 9, 2010

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The Keynesian Cross Planned Expenditures in the economy: E = C(Y-T*) + I* + G* T* (tax), I* (investment), G* (Gov. Expenditures) are fixed (preselected) C(Y-T*) - Consumption as a function of net income (after tax) - Assume linear: C = C 0 + a(Y-T*) a - the slope of the expenditure line = Marginal Propensity to Consume (MPC - the fraction of ea. additional \$ of income spent on consumption (as opposed to saving) 2 Tuesday, March 9, 2010
The Keynesian Cross E=C(Y-T*)+I*+G* (Planned Expenditures) Y (Income) E=Y Y 0 MPC \$1 E E 0 In Equilibrium : Planned Expenditures = Income or : E 0 =Y 0 The intercept = C 0 + I* + G* C 0 - autonomous consumption C 0 +I*+G* 3 Tuesday, March 9, 2010

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Fiscal Stimulus Potential output of the economy Y 0 Due to recession output falls to Y 1 The output gap = Y 0 - Y 1 = unutilized capacity of the economy Gov. increases its purchases by : Δ G > 0 E for every level of income The equilibrium output rises to Y 0 = Y 1 + Δ Y where: Δ Y = Δ G/(1-MPC) 4 Tuesday, March 9, 2010
The Keynesian Cross E=C(Y-T*)+I*+G* (Planned Expenditures) Y (Income) E=Y Y 1 MPC \$1 E E 1 Δ G Δ Y= Δ G/(1-MPC) Y 2 E 2 5 Tuesday, March 9, 2010

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Government Multiplier The Government Multiplier = Δ Y/ Δ G = 1/(1-MPC) - The increase in income in response to \$1 increase in government purchases Example: Δ G = \$100, MPC = 0.9 Gov. spends \$100 on hiring a teacher Δ Y=\$100 Teacher spends extra \$90 on meal at restaurant Δ Y=\$100+\$90 restaurant spends \$81 on extra chef..
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