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▼FIGURE 11.5 Moments of the Consumption Function

▼FIGURE 11.5 Moments of the Consumption Function

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11.2 THE CONSUMPTION FUNCTION (3 of 3)

Changes in the Consumption Function
Two factors that can cause autonomous consumption to change:




Increases in consumer wealth will cause an increase in autonomous consumption.
Increases in consumer confidence will increase autonomous consumption.

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APPLICATION 1

FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING
APPLYING THE CONCEPTS #1: How do changes in the value of homes affect consumer spending?
Home equity is the difference between the home value and what is owed on the mortgage.



The largest component of net wealth for most families.



Changes in home equity like other forms of wealth affect consumer spending.

From 1997 to mid-2006 housing prices rose by about 90 percent and consumer wealth grew by $6.5 trillion.
This ended in 2006 as housing prices began to fall.
According to a review of studies by the Congressional Budget Office, each $1 decline in consumer wealth would lower consumption spending between $.02
and $.07, or $21 to $72 billion of spending.
This would reduce economic growth 0.1 to 0.5 percent during 2007.

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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (1 of 4)


Equilibrium output is determined where the C + I line intersects the 45° line.



At that level of output, y*, desired spending equals output.

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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (2 of 4)
Saving and Investment



Savings function
The relationship between the level of saving and the level of income.

S=y−C

y=C+I

y−C=I

S=I

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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (3 of 4)
Saving and Investment
Equilibrium output is determined at the level of output, y*, where savings
equals investment.

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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (4 of 4)
Understanding the Multiplier
When investment increases from I0 to I1, equilibrium output increases from y0
to y1.
The change in output (Δy) is greater than the change in investment (ΔI).

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APPLICATION 2

MULTIPLIERS IN GOOD TIMES AND BAD
APPLYING THE CONCEPTS #2: Are multipliers for government spending higher during recessions?


A common belief is that fiscal multipliers are larger during recessions, when there is more slack in the economy. But, it is quite difficult to estimate
government multipliers accurately.



Valerie Ramey and Sarah Zubiary find no evidence of greater multipliers during slack times in the U.S.



Daniel Riera-/Crichton, Carlos Veigh, and Guillermo Vuletin found different results. By carefully looking at periods when both government spending increased
and the economy had slower or negative growth, they found the multiplier to be 2.3. This is larger than conventionally calculated multipliers.

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11.4 GOVERNMENT SPENDING
AND TAXATION (1 of 5)


Fiscal Multipliers



Planned expenditures including government = C + I +

G

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11.4 GOVERNMENT SPENDING
AND TAXATION (2 of 5)


Fiscal Multipliers

The consumption function with taxes is

The formula for the tax multiplier is

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11.4 GOVERNMENT SPENDING
AND TAXATION (3 of 5)
Using Fiscal Multipliers
Although it is very simple, our income-expenditure model illustrates some important lessons:



An increase in government spending will increase total planned expenditures for goods and services.



Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in planned expenditures for goods and services.



Policymakers need to take into account the multipliers for government spending and taxes as they develop policies.

In the long run, of course, we are better off if government spends the money wisely, such as on needed infrastructure such as roads and bridges. This is an
example of the principle of opportunity cost.

PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.

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APPLICATION 3

THE BROKEN WINDOW FALLACY AND KENSESIAN ECONOMICS
APPLYING THE CONCEPTS #3: How does Keynesian Economics change our normal ideas of economic scarcity?



Austrian economist, Henry Hazlitt, popularized the “Broken Windows” fallacy in economics. Imagine that a hoodlum threw a brick through a store window. While at first this
seems to be a tragedy, the store owner has to hire a firm to fix the window. That generates business for the window repair firm and, through a multiplier, additional business
throughout the community. Was the broken window good for society?



The fallacy here is that the money that the store owner paid to have the window repaired would have been spent elsewhere in the economy, say on clothing.



Hazlitt applies a similar argument to public spending financed by taxes. A government spending program may appear to increase business, but the taxes needed to finance
the spending—either paid now or in the future—will mean less business for other firms. Government spending and the taxes necessary to finance it will just crowd out other
production of goods and services in the economy.



But in the Keynesian world, where resources are underemployed, the story is quite different. Here the increase in spending—even financed by taxes—will bring resources
that are not being utilized into the economy. As long as there is excess capacity in the economy, the extra spending will increase output and not crowd out other goods and
services.

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