Suppose that demand for money increases as people

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Unformatted text preview: sloping straight line because as income increases so does planned expenditure E. The slope of the line is the marginal propensity to consume. We assume that the economy is in equilibrium when actual expenditure = planned expenditure. We can write this equilibrium condition as: Actual Expenditure = Planned Expenditure, Y = E. Plotting a 45- degree line (actual expenditure) against the planned expenditure function, the intersection point gives the equilibrium level of income, output, and expenditure. This is the Keynesian cross. If the economy is at a lower level of income than the equilibrium level, planned expenditure exceeds actual expenditure; firms will see inventories decrease and will hire more workers and increase production, increasing Y. Similarly, if the economy is at a higher level of Y, firms are selling less than they are producing, and will lay off workers and reduce production, decreasing GDP. An increase in government purchases leads to an even greater increase in income. That is, ΔY is larger than ΔG. The ratio ΔY/ ΔG is called the government- purchases multiplier. It tells us how much income rises in response to a $1 increase in government purchases. When expenditure rises by ΔG, income rises by ΔG, which in turn raises consumption by MPC x ΔG. This raises expenditure and income once again, which raises consumption this time by MPC x (MPC x ΔG), and then again by MPC x (MPC2 x ΔG), etc. This is an example of an infinite geometric series. The result from algebra shows us that: ΔY/ ΔG = 1/(1 – MPC) A decrease in taxes of ΔT immediately raises disposable income Y – T by ΔT and increases consumption by MPC x ΔT. ΔY/ΔT is the tax multiplier, the amount income changes in response to a $1 changes in taxes. For any level of Y, planned expenditure is now higher. The planned expenditure curve shifts up by MPC x ΔT. The initial change in expenditure, now MPC x ΔT, is multiplied by 1/(1 – MPC). The overall effect on income of a change in taxes is: ΔY/ ΔT = –MPC/(1 – MPC) Page 31 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 The IS Curve The Keynesian cross is useful because it show how spending plans determine the economy’s income. However, it a...
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