INCOME AND SPENDING
In the Keynesian model,
the price level is assumed to be fixed
that is, the AS-curve is horizontal
and the level of output is determined solely by aggregate demand. The classical model, on the other
hand, assumes that
prices always fully adjust to maintain a full-employment level of output,
is, the AS-curve is vertical. Since the model of income determination in this chapter assumes that the
price level is fixed, it is a Keynesian model.
An autonomous variable’s value is determined outside of a given model. In this chapter the following
components of aggregate demand have been specified as being autonomous: autonomous
consumption (C*) autonomous investment (I
), government purchases (G
transfer payments (TR
), and net exports (NX
Since it often takes a long time for policy makers to agree on a specific fiscal policy measure, it is
quite possible that economic conditions may drastically change before a fiscal policy measure is
implemented. In these circumstances a policy measure can actually be destabilizing. Maybe the
economy has already begun to move out of a recession before policy makers have agreed to
implement a tax cut.
If the tax cut is enacted at a time when the economy is already beginning to
experience strong growth, inflationary pressure can be created.
While such internal lags are absent with automatic stabilizers (income taxes, unemployment
benefits, welfare), these
automatic stabilizers are not sufficient to replace active fiscal policy
when the economy enters a deep recession.
Income taxes, unemployment benefits, and the welfare system are often called automatic stabilizers
they automatically reduce the amount by which output changes as a result of a change in
These stabilizers are a part of the economic mechanism and therefore work
case-by-case government intervention.
For example, when output declines and
unemployment increases, there may be an increase in the number of people who fall below the
poverty line. If we had no welfare system or unemployment benefits, then consumption would drop
significantly. But since unemployed workers get unemployment compensation and people living in
poverty are eligible for welfare payments, consumption will not decrease as much. Therefore,
aggregate demand may not be reduced by as much as it would have without these automatic
The full-employment budget surplus is the budget surplus that would exist
if the economy were at the
full-employment level of output,
given the current spending or tax structure.
Since the size of the
full-employment budget surplus does not depend on the position in the business cycle and only