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Use the Keynesian cross-diagram to explain how short-run equilibrium national income is determined. State any assumptions made in your analysis.

An economy will be in equilibrium, when planned withdrawals equal planned injections; hence savings, taxation and import spending will equal investment, government spending and export revenue. This is also consistent with planned aggregate demand equalling planned aggregate supply. It is also consistent with aggregate demand = output = income. Along the 45 degree line the economy is in equilibrium. In equilibrium, consumption & investment decisions go unchanged. The point where the aggregate demand line, that is constructed from C + I + G + (X – M), crosses the 45-degree line will be the equilibrium for the economy. It is the only point on the aggregate expenditure line where the total amount being spent on aggregate demand equals the total level of production. An equilibrium occurs if three conditions hold: 1. The AD function has a positive slope. (It does.) 2. The AD function has a slope less than one. (It does.) 3. The AD function intersects the vertical axis in the positive range.

The Keynesian cross diagram: equilibrium national income Expenditure, £

45 degree line

AD = C + I

285

57

285

Output & income, Y

20

If output was above the equilibrium level, at H, then the real output is greater than the aggregate expenditure in the economy. This pattern cannot hold, because it would mean that goods are produced but piling up unsold so firms reduce output bringing them back to equilibrium. If output was below the equilibrium level at L, then aggregate expenditure would be greater than output. This pattern cannot hold either, because it would mean that spending exceeds the number of goods being produced so firms would increase output. Only point E can be at equilibrium, where output, or national income and aggregate expenditure, are equal.

The planned expenditure curve shifts up if we increase autonomous consumption, investment or government spending, or if we decrease taxation. If this happens we get a higher level of income at equilibrium. The planned expenditure curve shifts down if we decrease autonomous consumption, investment or government spending, or if we increase taxation. If this happens we get a lower level of income at equilibrium.

The multiplier process is seen as a shock or disruption to the Keynesian cross equilibrium. An autonomous injection of an expenditure such as investment expenditures or government purchases disrupts equilibrium by creating an imbalance between injections and leakages and between aggregate expenditures and aggregate production. The multiplier process ends when the change in leakages matches the initial change in injections and equilibrium balance is restored.

b) Use your analysis in Part (a) to explain how fiscal policy can be used to increase equilibrium income. What factors limit the use of fiscal policy in this way?

To increase equilibrium income the government can use expansionary fiscal policy. Fiscal policy is use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance. Keynes said expansionary fiscal policy should be used during a recession – when there is unemployment, surplus saving and falling real output. He argued this injection of government spending could stimulate economic activity and get the unemployed resources back into productive use. This enables the economy to recover more quickly than a laissez-faire approach. A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption, and investment levels in the economy. The multiplier effect is the amount that additional government spending affects income levels in the country. The multiplier effect determines the efficacy of expansionary fiscal policy. Outside of extreme circumstances, the multiplier effect is greater than 1. The formula of the multiplier is 1/ (1-MPC). If the multiplier effect is 3, it means that each £1 of stimulus will lead to £3 in income. This type of effect is due to increased demand that results in increased consumption and spending. This encourages businesses to invest, expand, and hire additional workers, which has ameliorative effects on income and gross

domestic product. In turn, increasing incomes and economic activity also leads to more spending and consumption. Thus, fiscal policy has a multiplier effect. Expansionary fiscal policy can take many forms including reducing direct taxes, indirect taxes and increasing government spending. For example A fall in income tax will cause a rise in disposable income. This will lead to an expansion in consumption and thus increase AD, therefore increasing equilibrium income. Alternatively, if the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand. This injection of money into the economy can also cause a positive multiplier effect. For example, builders who gain a job will also spend more creating jobs elsewhere in the economy. From the government’s initial injection, the final increase in real GDP will be more than the initial investment. However, the impact of expansionary fiscal policy will depend on many factors: There may be a considerable time-lag between spending and the benefits of spending. For example, a decision to increase spending on education will take months to implement, and years and decades to see the full benefits. Indeed, the full benefits may never be ‘seen’ because of information failure Linking back to the multiplier, any change in injections may be increased by the multiplier effect, therefore the size of the multiplier will be significant. If consumers save any extra income, the multiplier effect will be low and fiscal policy less effective. Another limitation of fiscal policy is the amount of spare capacity. A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP. In a deep recession, with spare capacity in the economy, expansionary fiscal policy won’t cause crowding out or inflation. (AD1 to AD2 causes real GDP to rise from Y1 to Y2.)...