Jim Whitney | Economics 102 |
The general case:
The two fundamental equations:
(1) AE = C + I + G + (X-M)
(2) Equil.: AE = Y
The other details:
(3) DY = Y - T
(4) T = To + tY, where
To=lump-sum taxes (such
as property taxes and DMV fees) and
t = the income tax rate
(5) C = Ca + MPC·DY
(6) I = Ia
(7) G = Ga
(8) X-M = (X-M)a
Step 1 (expressing AE as a function of Y and A):
AE = Ca + MPC·DY + Ia + Ga + (X-M)a
The trick is to replace DY with Y. Fortunately, (3) and (4)
allow us to do that:
DY = Y - T = Y - (To + tY) = Y - To - tY = -To
+ (1-t)Y.
So replacing DY with -To + (1-t)Y, we get:
AE = Ca + MPC·(-To + (1-t)Y + Ia + Ga
+ (X-M)a
which multiplies out to:
AE = Ca - MPC·To + MPC(1-t)Y + Ia + Ga
+ (X-M)a.
Now AE is a function of Y and the various components of autonomous
spending.
Step 2 (setting Y = AE for the equilibrium condition):
Y = Ca - MPC·To + MPC(1-t)Y + Ia + Ga
+ (X-M)a.
Step 3 (rearranging terms to solve for Y):
Y - MPC(1-t)Y = Ca - MPC·To + Ia + Ga
+ (X-M)a
(1 - MPC·(1-t))Y = Ca - MPC·To
+ Ia + Ga + (X-M)a
1
Y = -------------·[Ca - MPC·To
+ Ia + Ga + (X-M)a]
1 - MPC·(1-t)
This is the general formula for what we have been
using all along:
the respending ratio, RR = MPC·(1-t)
the spending multiplier, m = 1/(1-MPC·(1-t))
and autonomous spending, A = [Ca - MPC·To
+ Ia + Ga + (X-M)a]
So as always, the general solution is: Y = m·A.
Note1: all ordinary autonomous spending gets multiplied
by the spending multiplier (m).
Note2: lump-sum taxes (To) get multiplied by the
negative of m·MPC. m·MPC is called the tax multiplier. (1)
Its sign is negative because tax increases lower income and vice-versa.
(2) tax changes have a smaller multiplier effect (m·MPC < m since
MPC < 1) because for each $1 tax cut, you spend only MPC of it; you
put the rest goes into savings.