(Reference: Dornbusch, Fischer and Startz, Chapter 9)
- Output is at its equilibrium level when the aggregate demand for goods is equal to the level of output.
- Aggregate demand consists of planned spending by households on consumption, by firms on investment goods, and by government on its purchases of goods and services and also includes net exports.
- When output is at its equilibrium level, there are no unintended changes in inventories and all economic units are making precisely the purchases they had planned to. An adjustment process for the level of output based on the accumulation or rundown of inventories leads the economy to the equilibrium level of output. Know, that AD is equal to planned aggregate spending, on the 45 degree line Aggregate Spending=Output. When the AD curve intersects the 45 degree line planned aggregate spending equals output and Saving equals planned investment.
- The level of aggregate demand is itself affected by the level of output (equal to the level of income) because consumption demand depends on the level of income.
- The consumption function relates consumption spending to income. Consumption rises with income. Income that is not consumed is saved, so the savings function can be derived from the consumption function.
- The multiplier iss the amount by which a $1 change in autonomous spending changes the equilibrium level of output. The greater the propensity to consume, the higher the multiplier.
- Government purchases and government transfer payments act like increases in autonomous spending in their effects on the equilibrium level of income. A proportional income tax has the same effect on the equilibrium level of income as a reduction in the propensity to consume. A proportional income tax thus reduces the multiplier.
- The budget surplus is the excess of government receipts over expenditures. When the government is spending more than it receives, the budget is in deficit.The size of the budget surplus or (deficit) is affected by the government’s fiscl policy variables-government purchases, transfer payments, tax rates.
- The actual budget surplus is also affected by changes in tax collection and transfers resulting from movements in level of income that occur because of changes in private autonomous spending. The full employment budget surplus is used as a measure of the active use of fiscal policy. The full employment surplus measures the budget surplus that would exist if output were at its potential(full-employment) level.