8. determination of national income and the role of fiscal policy

8. Determination of National Incomeand the role of Fiscal Policy

The Equilibrium Level ofNational Income


• The circular flow of income• The circular flow of income

The circular flow of income

Cd


CdIncomes


Cd

W = S + T + M

Incomes


Cd

W = S + T + M

J = I + G + X

Incomes




• Effect on national income of a change in injections and/or withdrawals

– J>W : national income rises

– W>J : national income falls

• The Keynesian diagram: the withdrawals and injections approach

– the withdrawals curve






OY

W

Cd, W, JDeriving equilibrium national income








– the injections curve







OY

W

Cd, W, J

J

Deriving equilibrium national incomeDeriving equilibrium national income









– equilibrium







– equilibrium

OY

W

Cd, W, J

J

Y1

b

a

Deriving equilibrium national income

OY

W

Cd, W, J

J

Y2

d

c


OY

W

Cd, W, J

J

Ye

x




• The Keynesian diagram: the income and expenditure approach

– the 45° line


– the 45° line

OY

Y = Cd + W

W

Cd, W, J

J





– the 45° line

– the expenditure curve


– the 45° line


OY

W

Cd, W, J

J

Cd

Y = Cd + WE = Cd + J

J





– the 45° line


– equilibrium


– the 45° line


– equilibrium

OY

W

Cd, W, J

J

Cd


Y1

f

e


OY

W

Cd, W, J

J

Cd


Y2

h

g


OY

W

Cd, W, J

J

Cd


Ye

x

z


The MultiplierThe Multiplier

• The multiplier: introduction

– the circular flow of income and effects of changes in injections

– definition of the multiplier: ΔY/ΔJ

• The withdrawals and injections approach

– graphical analysis: shift in the J line

• The multiplier: introduction

– the circular flow of income and effects of changes in injections


• The withdrawals and injections approach

– graphical analysis: shift in the J line

The multiplier: (a) a shift in injections

OY

W

W, J

J1

Ye1

a

OY

W

J1

J2

Ye1

a

Ye2

b

W, JThe multiplier: (a) a shift in injections

OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

Multiplier = Y / J

= Y / W= ca / bc



• The multiplier: introduction– the circular flow of income and effects of

changes in injections


• The withdrawals and injections approach– graphical analysis: shift in the J line

– the formula : 1/mpw

– or : 1/(1–mpcd)






– or : 1/(1–mpcd)

OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

Multiplier = Y / J= Y / W= ca / bc

= 1/mpw








– or : 1/(1–mpcd)

– graphical analysis: shift in the W line






– or : 1/(1–mpcd)

– graphical analysis: shift in the W line

The multiplier: (b) a shift in withdrawals

OY

W1

J

Ye1

a

W, J

OY

W1

J

Ye1

a

W, J

W2

Ye2

c


b

OY

W1

J

Ye1

a

W, J

W2

Ye2

c

Y

W

Multiplier = Y / W= ca / ab




changes in injections– definition of the multiplier: ΔY/ΔJ

• The withdrawals and injections approach– graphical analysis: shift in the J line– the formula : 1/mpw– or : 1/(1–mpcd)– graphical analysis: shift in the W line

• The income and expenditure approach




• The income and expenditure approach





• The income and expenditure approach– graphical analysis: shift in the E line




• The income and expenditure approach– graphical analysis: shift in the E line

The multiplier: (c) a shift in the expenditure curve

OY

E, W, J

Y

E1

Ye1

OY

Y

E1

Ye1

E2

Ye2

E, W, JThe multiplier: (c) a shift in the expenditure curve

OY

Y

E1

Ye1

E2

Ye2

Multiplier = Y / J= ca / ba

a

c

Y

J

E, W, J

b

The multiplier: (c) a shift in the expenditure curve

The Keynesian Analysis of Unemployment and InflationThe Keynesian Analysis of

Unemployment and Inflation

• 'Full-employment' national income

• 'Gap' analysis– the deflationary gap



OY

W

W, J

J

Ye

The deflationary gapThe deflationary gap

OY

W

W, J

J

YeYF

Deflationary gap

c

d


OY

W, J, E

YeYF

Y

E


OYYe

YF

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap

OY

W

J

YeYF

c

d

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap





– the inflationary gap




OY

W

W, J

Ye

J

The inflationary gap

OY

W

W, J

YeYF

J


OY

W

W, J

YeYF

Inflationary gap

Jg

h


OY

YE

W, J, E

Ye


OYYF

YE

Inflationary gap

W, J, E

e

f

Ye


OYYe

YF

YE

Inflationary gap

e

f

W

Jg

h

W, J, EThe inflationary gap






– policy implications











• Inflation and unemployment together





• Inflation and unemployment together







• Inflation and unemployment together– inflationary pressures before the full-

employment level of income















– implications for shape of AS curve







– implications for shape of AS curve

OY

Pri

ce le

vel

YF

AS1

Unemployment and inflation

OY

AS1

Pri

ce le

vel

YF

AS2

Unemployment and inflation



• 'Full-employment' national income• 'Gap' analysis

– the deflationary gap– the inflationary gap– policy implications


employment level of income– implications for shape of AS curve– effect of an increase in aggregate demand

• 'Full-employment' national income• 'Gap' analysis

– the deflationary gap– the inflationary gap– policy implications


employment level of income– implications for shape of AS curve– effect of an increase in aggregate demand

O

Pric

e le

vel

National output

YP

The effects of increases in aggregate demandon national output

AS

O Y1

Pric

e le

vel

National output

Y2

AS

Y3 Y4 YP

AD3AD2AD1

AD4

The effects of increases in aggregate demandon national output



• The Phillips curve– the shape of the curve


0

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5 6

The original Phillips curve

Unemployment (%)

Wa

ge in

flatio

n (

%)




– the position of the curve



0

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5 6

The original Phillips curve

Unemployment (%)

Wa

ge in

flatio

n (

%)



• The Phillips curve

– the shape of the curve


– policy implications of the curve











– the breakdown of the curve













– recent relationship between inflation and unemployment






– recent relationship between inflation and unemployment

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Inflation (%)

Unemployment (%)

The breakdown of the Phillips curve?

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Inflation (%)

Unemployment (%)


6763

6265

6664

60

61

Original Phillips curve

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

74

7173

7072

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

76

77

79

7173

7072

78

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7072

78 82

8384

85

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7072

78

90

89

9188

95

82

8384

85

86

93

8792

94

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7072

78

90

89

9796

9188

95

82

8384

85

86

93

8792

94

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

6199

98

0001

Keynesian Analysis ofthe Business Cycle


• The accelerator

– changes in national income and induced investment

– the accelerator effect

– the instability of investment

• The multiplier/accelerator interaction

• Fluctuations in stocks

• The accelerator

– changes in national income and induced investment

– the accelerator effect

– the instability of investment

• The multiplier/accelerator interaction

• Fluctuations in stocks



• Determinants of the course of the business cycle– why do booms and recessions persist?

• time lags• 'bandwagon' effects

– why do booms and recessions end?• ceilings and floors• echo effects• the accelerator• random shocks• changes in government policy

• Determinants of the course of the business cycle– why do booms and recessions persist?

• time lags• 'bandwagon' effects

– why do booms and recessions end?• ceilings and floors• echo effects• the accelerator• random shocks• changes in government policy

The Role of Fiscal PolicyThe Role of Fiscal Policy

• The purpose of fiscal policy

– correcting a fundamental disequilibrium

– fine tuning

• Deficits and surpluses

– central government deficits and surpluses

– public-sector deficits and surpluses

– the PSNCR

– the national debt

• The purpose of fiscal policy

– correcting a fundamental disequilibrium

– fine tuning

• Deficits and surpluses

– central government deficits and surpluses

– public-sector deficits and surpluses

– the PSNCR

– the national debt

The Role of Fiscal PolicyThe Role of Fiscal Policy

• The use of fiscal policy

– automatic fiscal stabilisers

– discretionary fiscal policy

• The use of fiscal policy

– automatic fiscal stabilisers

– discretionary fiscal policy

Effectiveness of Fiscal PolicyEffectiveness of Fiscal Policy

• Factors determining the effectiveness of fiscal policy

– accuracy of forecasting

– effect on J and W

– effect of changes in J and W on national income

– timing of the effects

– effects on the various macro objectives

• Factors determining the effectiveness of fiscal policy

– accuracy of forecasting

– effect on J and W

– effect of changes in J and W on national income

– timing of the effects

– effects on the various macro objectives


• Discretionary policy– problems of forecasting the magnitude of

the effects• effects of changes in government expenditure• crowding out• effects of changes in taxes• size of the multiplier and accelerator effects• random shocks

– problems of timing and time lags• various time lags• policy may be destabilising

• Discretionary policy– problems of forecasting the magnitude of

the effects• effects of changes in government expenditure• crowding out• effects of changes in taxes• size of the multiplier and accelerator effects• random shocks

– problems of timing and time lags• various time lags• policy may be destabilising

Fiscal policy: stabilising or destabilising?

O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4

Path (a): no intervention

O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4


Path (b): policy stabilises


O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4


Path (c): policy destabilisesPath (b): policy stabilises



• Side-effects of discretionary policy

– cost inflation

– welfare and distributive justice

– incentives

• A rules-based approach to fiscal policy

– a 'steady-as-you-go' policy

– the EU Stability and Growth Pact

– UK Labour government's 'Golden Rule'

• Side-effects of discretionary policy

– cost inflation

– welfare and distributive justice

– incentives

• A rules-based approach to fiscal policy

– a 'steady-as-you-go' policy

– the EU Stability and Growth Pact

– UK Labour government's 'Golden Rule'

8. determination of national income and the role of fiscal policy

Documents

national income riseswj

w linethe multiplier

j linethe multiplier

jj1figthe multiplier

mpcdthe multiplier

yjthe withdrawals

injections andor withdrawalsjw

expenditure approachthe