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  Changes in Fiscal Policy and Government Purchases on the Flow-of-Funds

Changes in Fiscal Policy:

Presume the economy is in equilibrium when policy makers decide to increase annual government purchases by the amount ΔG—as prior to Δ a capital Greek letter delta, symbolized "change."

Let’s look at what occur to the components of aggregate demand one by one. First the change in government purchases has no consequence on consumption. For the reason that potential output doesn’t change, national income doesn’t change. Neither baseline consumption, national income, the tax rate, nor the marginal propensity to consume shifts, so there is no consequence on the consumption function:

C = C0 + Cy(1-t)Y

Therefore:

ΔC = 0

While the shift in government acquires has no direct effect on investment, there will be an indirect consequence. Investment lies on the interest rate and the interest rate will change as a result of the change in government purchases. Therefore from the investment function:

I = I0 - Irr

We can finish that the level of investment spending will change by:

ΔI = - IrΔr
     
Explicitly the shift in investment spending will be equivalent to the sensitivity of investment to the interest rate times the shift in the equilibrium real interest rate.

Not anything in the international economic environment changes. Nor does the stage of potential output does not change. Therefore looking at the net exports function:

NX = Xyf Yf + Xεεo - Xεεrr + Xεεrrf - IMyY

It is clear that here as well the merely shift will be a proportional change in response to the shift in the equilibrium real interest rate:

ΔNX = - (XεεrΔr)

In conclusion real GDP Y doesn’t change because potential output does not change, moreover this is a full-employment model with real GDP is for all time equal to potential output:

ΔY = ΔY* = 0
     
Putting all these pieces mutually we have assembled the relevant components of aggregate demand in "change" form. We are able to see that as government purchases shift the other components of aggregate demand will have to shift with it:

ΔY = ΔI + ΔG + ΔNX

0 = -IrΔr + ΔG - XsεrΔr
     
Place the change in the real interest rate on the left-hand side of the equation as well as everything else on the right, we find out that the shift in government purchases means that the equilibrium real interest rate must change by:

2260_equillibrium unterest rate.jpg

Effect of a Raise in Government Purchases on the Flow-of-Funds:

342_flow of funds.jpg

Previously the change in the equilibrium interest rate has been calculated determining what happens to the rest of the economy is straightforward. Merely substitute the change in the equilibrium interest rate back into the model's behavioral relationships also so calculate the changes in the equilibrium levels of the components of GDP also in the equilibrium level of the real exchange rate. There is no consequence on the level of real GDP Y or on consumption spending C:

ΔY = o

ΔC = 0

The change in government purchases G is merely equal to itself: the change in government buys was the trigger that shifted the economy’s equilibrium position:

ΔG = ΔG
 
The change in investment expenditure is the interest sensitivity of investment Ir times the change in the equilibrium real interest rate, which we already computed above.

529_change in investment.jpg

The changes in net exports as well as in the exchange rate are as well equal to their sensitivities to the real interest rate times the change in the equilibrium real interest rate.

1005_change in equilibrium interest rate.jpg

The overall picture of the changes produced by the increase in government purchases is clear. The raise in government purchases has led to a shortfall in savings and a rise in real interest rates. The elevated real interest rates have led to lower investment in addition to an appreciation in the home currency: an inferior level of ε. This exchange rate approval has led to a decline in net exports. The refuse in net exports and in investment spending just add up to the increase in government purchases, therefore the level of GDP is unchanged and still equal to potential output--as we presumed it would be.

Note that the fall in investment isn’t as large as the rise in government purchases. The raise in government purchases reduced the flow of domestic savings into financial markets however the increased flow of foreign-owned capital into the market partially offset this reduction.

The Impact of a Change in the Domestic Interest Rate on the Exchange Rate:

1150_impact of domestic interest rate.jpg

Supply Shocks:

Consequently far we have unspecified that the level of potential output is fixed. Whatsoever shocks have affected the economy, they have had no effect on potential output, no effect on aggregate supply. However there are shocks to a flexible-price full-employment economy that change aggregate supply. Supply shocks like the 1973 tripling of world oil prices decreases potential output. Inventions and innovations are able to be positive productivity shocks that increase the level of potential output.
We can utilize the full-employment model of this chapter to analyze the effects on the economy of a supply shock. Nevertheless the effects of a supply shock are different in one important respect from the effects of the demand or international shocks we have analyzed above. In reply to a supply shock the level of GDP does change--even in this full-employment chapter--because the level of potential GDP has changed. In every case call the resulting supply-shock driven change in potential output ΔY*.

If we seem at the changes in the national income identity:

ΔC + ΔI +ΔG + ΔNX  = ΔY*
     
We will find them more multifaceted than in the case of the demand shocks considered in the section above for the reason that the change in real GDP isn’t zero. If we increase the changes form of the national income identity by substituting for every component of GDP the equation for its determinants, we produce:

1362_gdp determinants.jpg

We can regroup as well as solve this equation for the change Δr in the equilibrium interest rate is:

 

1600_equilibrium interest rate.jpg

A negative value for ΔY*--an unfavorable supply shock, one that inferior the level of potential output and GDP--generates an increase in the domestic real interest rate. Why? For the reason that a fall in GDP due to an oil price increase or other adverse supply shock reduces incomes, and so decreases the flow of private savings into financial markets. (It is true that a refuse in incomes carries with it a decline in consumption and in net exports but these declines don’t match the decline in income, therefore domestic savings falls.)

From the change in the level of GDP as well as the change in the interest rate, it is straightforward to calculate the effect of the supply shock on the other economic variables:

268_economic variables.jpg

An unfavorable supply shock--a negative value for ΔY*--leads to declines in consumption, investment, and net exports it leads to an appreciation of the home currency, and therefore to a reduction in the value of foreign currency--in the exchange rate. It as well leads to a rise in the price level, and an acceleration of inflation.

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