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Appendix. INCORPORATING GOVERNMENT SPENDING AND TAXATION INTO THE TOTAL EXPENDITURES MODEL

One conclusion of Keynes's General Theory was that government had a responsibility to use its spending and taxation powers to maintain full employment. Today, this is described as discretionary fiscal policy—the deliberate changing of the level of government spending or taxation in order to guide the economy's performance. This appendix introduces government spending and taxation into the aggregate expenditures model and then illustrates how fiscal policy can be used to combat unemployment or inflation.

Government Spending and Equilibrium Output

For the sake of our analysis, we assume that the level of government spending is determined by political considerations and is independent of the level of output in our economy.4 These assumptions allow us to add government spending to the model as an autonomous constant. Recall that investment spending was introduced in the same way in the body of the chapter, as a component of spending that did not vary with GDP.

Exh. A.1 shows how the inclusion of government spending alters the process of determining equilibrium. Let's assume that the government plans to spend $40 billion per year and that it intends to finance its spending by borrowing rather than by imposing taxes. (For clarity, we will introduce government spending first, note the impact on equilibrium output, and then introduce taxation.) To incorporate this decision into our analysis, we need only add the amount of government spending for goods and services (G) to the total expenditure function (C + I) we constructed in the body of the chapter. In Exh. A.1, total spending is labeled C + I + G. Adding government spending raises total spending by $40 billion at every level of output.

We use the term government spending to mean purchases of goods and services by government. Economists always distinguish between expenditures for goods and services and transfer payments. Government transfer payments are expenditures made by the government for which it receives no goods or services in return (unemployment compensation and Social Security, for example). To avoid unnecessary complexity, our model will ignore transfer payments. The next chapter will discuss the role of transfer payments as "built-in stabilizers" of the economy.

EXHIBIT A.1. Adding Government Expenditures

Adding Government Expenditures

The equilibrium output is determined by the intersection of the total expenditure function (now C + I + G) and the 45-degree line. You can see that the addition of $40 billion of government spending increases the equilibrium output by $160 billion—that is, from $600 billion to $760 billion. Recall from earlier in the chapter that in our hypothetical economy the marginal propensity to consume is 0.75. The multiplier [M = 1/(1 - MPC)], therefore, is 4. This tells us that any change in spending will produce a change in income and output that is four times larger than the initial spending change.

 
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