Factors that shift the consumption function

1. Changes in wealth – shift the consumption function.– Example: value of stocks, bonds,

consumer durables.2. Changes in consumer expectations

– Shift the consumption function.– Example: Pessimistic expectations

decrease autonomous consumption.3. Taxes and Transfers

– Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down.

4. Prices – Affect the purchasing power of assets.

Shift up in AE lineShift right in AD lineOrShift down in AE lineShift left in AD line

Shift up in AE lineShift right in AD lineOrShift down in AE lineShift left in AD line

Shift AE lineMovement Along AD line

Shift AE lineMovement Along AD line

Determinants of Investment• Interest Rates • Tax Incentives • Technical Change• Expectations about the

strength of demand • Political Stability and the

rule of law

Shift AE lineShift AD lineShift AE lineShift AD line

Government expenditures are determined by the budget process: The president, Congress and the Senate.

Shift AE lineShift AD lineShift AE lineShift AD line

• National Incomes• GDP of other

countries• Relative Prices• Exchange Rates

Shift AE lineShift AD lineShift AE lineShift AD line

Recessionary/Inflationary Gap?

Which AE line will cause a

recessionary gap?

Which AE line will cause a

recessionary gap?

Which AE line will cause an inflationary gap?

Which AE line will cause an inflationary gap?

= 7,000-6,000 =1,000

A recessionary gap occurs when actual GDP falls SHORT of

full employment GDP

A recessionary gap occurs when actual GDP falls SHORT of

full employment GDP

To increase AE, we need an

increase in C, I, G or NX

To increase AE, we need an

increase in C, I, G or NX

To eliminate a recessionary gap, AE

must rise.

To eliminate a recessionary gap, AE

must rise.

To Eliminate a Recessionary/Deflationary Gap

• Increase Consumption by a sufficiently large price drop, a decrease in taxes or an increase in transfers.

• Increase Investment– tax incentives.– lower interest rates

• Increase Government Spending• Increase Exports and reduce Imports: make

dollar weaker (increasing supply of dollars)

= 7,000-8,000 =-1,000= 7,000-8,000 =-1,000

An inflationary gap occurs when equilibrium GDP is higher than full employment GDP

An inflationary gap occurs when equilibrium GDP is higher than full employment GDP

To decrease AE, we need a decrease in C, I, G or NX

To decrease AE, we need a decrease in C, I, G or NX

To eliminate an inflationary gap, AE must fall.

To eliminate an inflationary gap, AE must fall.

To Eliminate an Inflationary Gap

• Decrease Consumption by a sufficiently large price increase, an increase in taxes or a decrease in transfers.

• Decrease Government Spending• Increase interest rates to decrease

spending• Decrease net exports and increase imports:

stronger dollar.

3. If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

4. If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

04/20/23 © 2002 Claudia Garcia-Szekely 13

Fiscal Policy

• Changes in Government Spending and/ or Taxes.

• Induce a change in Aggregate Spending.

Increase AEExpansionary PolicyExpansionary Policy

Decrease AE Contractionary PolicyContractionary Policy