Question

Macroeconomics (consumption, investment and loanable funds) question.

The Current U.S. government spending is $4.746 trillion. That's the federal budget for fiscal year 2020 covering October 1, 2019, to September 30, 2020. It's 21% of gross domestic product. That means that Government Spending in the United States has increased under the current U.S. Administration. Additionally, last year the Congress passed a tax reform that, among other effects, cut payroll taxes:

i) Can you establish the macroeconomics effects of these policies on consumption, investment, interest rate and savings? Use the models (consumption model and loanable funds market) and the graphs. Explain.

ii) If the aggregate demand is composed by consumption, investment, and government spending (closed economy). How do you think these policies affect the aggregate demand in the short run? Explain

Answer 1

(i)

(a) A decrease in payroll tax will increase disposable income, therefore consumption demand will rise. The consumption function will shift upward, increasing real GDP and planned aggregate expenditure.

In following graph, planned aggregate expenditure (PAE) and real GDP (Y) are measured vertically and horizontally respectively. Initial consumption function is C0 and initial PAE curve is PAE0. Initial equilibrium is at point A where PAE0 intersects 45⁰ line with equilibrium GDP Y0 and equilibrium planned aggregate expenditure E0.

When consumption increases, C0 shifts upward to C1, leading to an upward shift in planned aggregate expenditure curve from PAE0 to PAE1. New equilibrium is at point B where PAE1 intersects 45⁰ line with higher equilibrium GDP Y1 and higher equilibrium planned aggregate expenditure E1.

(b) Since higher government spending will increase budget deficit, government will increase borrowing to finance the deficit. Demand for loanable funds will rise, shifting demand curve for loanable funds rightward, increasing both interest rate and quantity of loanable funds (saving/investment).

In following graph, interest rate (r) and quantity of loanable fund (saving/investment) (Q) are measured vertically and horizontally respectively. Initial equilibrium is at point A where initial demand curve D0 and supply curve S0 intersect with initial interest rate r0 and quantity of loanable funds (saving/investment) Q0. After demand rises, D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds (saving/investment) Q1.

(ii)

Higher government spending and lower taxes will together increase consumption and aggregate demand. The AD curve will shift rightward, increasing price level (inflation) and real GDP.

In following graph, price level (P) and real GDP (Y) are measured vertically and horizontally respectively. Initial equilibrium is at point A where initial aggregate demand curve AD0, long-run aggregate supply curve LRAS0 and short run aggregate supply curve SRAS0 intersect with initial price level P0 and real GDP Y0. After aggregate demand rises, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing a short run inflationary gap of (Y1 - Y0).