©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 21: Spending and Output in the Short...

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 21: Spending and Output in the Short Run


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Learning Objectives

1.Identify the key assumptions of the basic Keynesian model and explain how this affects firms' production decisions

2.Discuss the determination of planned investment and aggregate consumption spending and how these are used to develop the model of planned aggregate spending

3.Analyze, using graphs and numbers, how an economy reaches short-run equilibrium in the basic Keynesian model


3

Learning Objectives

4.Show how a change in planned aggregate expenditure can cause a change in short-run equilibrium output and how this is related to the income-expenditure multiplier

5.Explain why the basic Keynesian model suggests that fiscal policy is useful as a stabilization policy, and discuss the qualifications that arise in applying fiscal policy in real-world situations


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Recessionary Gap

Great Depression Available resources are unemployed Demand for goods and services unmet

A decrease in spending leads to lower production Laid-off workers reduce their spending Insufficient spending to support the

normal level of productionConventional economic policy of the

1920s and 1930s would not solve this problem John Maynard Keynes revolutionized

economic thought and public policy


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John Maynard Keynes (1883 – 1946)

After World War I, Keynes recognized that the terms of the peace would lead to another war German war reparations would prevent

growth and recoveryThe General Theory of Employment,

Interest, and Money (1936) is his best-known work Problem was explaining why economies

kept a recessionary gap for long periods Aggregate spending is too low for full

employment Stabilization policies use government spending

or taxes to substitute for spending in other sectors


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Keynesian Model

Building block for current theories of short-run economic fluctuations and stabilization policies

In the short run, firms meet demand at preset prices Firms typically set a price and meet the

demand at that price in the short run Menu price is the cost of changing prices

• Determining the new price• Incorporating prices into the business• Informing consumers of new prices

Firms change prices when the marginal benefits exceed the marginal costs


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Technology of Changing Prices

Technology has reduced menu costs Bar codes and scanners reduce costs of

changing prices in the store Online surveys

Highly segmented airline pricing Internet mechanisms for setting price

eBay ■ PricelineOther costs remain

Competitive analysis ■ Deciding the new prices

Informing consumers


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Planned Aggregate Expenditure (PAE)

PAE is planned spending on final goods and services

Four components of planned aggregate expenditure Consumption (C) by households Investment (I) is planned spending by

domestic firms on new capital goods Government purchases (G) are made

by federal state and local governments Net exports (NX) is exports minus

imports


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Planned versus Actual Investment Example

Suppose Khedr Papyrus Company produces $5 million of Egyptian papyrus paintings per year Expected sales are $4.8 million and planned

inventory increase is $0.2 million Capital expenditure of $1 million is planned

Total planned investment is $1.2 million If actual sales are only $4.6 million

Unplanned inventory investment of $0.2 million

Actual investment is $1.4 million If actual sales are $5.0 million

Unplanned inventory decrease of $0.2 million Actual investment is $1.0 million


10

Planned Aggregate Expenditure

Actual spending equals planned spending for Consumption Government purchases of final goods and

services Net exports

Adjustments between actual and planned spending are accomplished with changes in inventories

The general equation for planned aggregate expenditures is

PAE = C + IP + G + NX


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Consumption Spending and the Economy

Consumption (C) accounts for two-thirds of total spending Powerful determinant of planned

aggregate spending Includes purchases of goods,

services, and consumer durables, but not houses

Rent is considered a service

C depends on disposable income, (Y – T)


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The Egyptian Consumption Function, 2007- 2011


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The Turkish Consumption Function, 2007- 2011


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The UAE Consumption Function, 2007- 2011


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Consumption Function

The consumption function is an equation relating planned consumption to its determinants, notably disposable income (Y – T)

C = C + (mpc) (Y – T)where C is autonomous consumption

spending and mpc is the change in consumption for a given change in (Y – T)

Autonomous consumption is spending not related to the level of disposable income

A change in C shifts the consumption function


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C = C + (mpc) (Y – T)The wealth effect is the tendency

of changes in asset prices to affect household's wealth and this consumption spending This effect is included in C

C also captures the effects of interest rates on consumption Higher rates increase the cost of using

credit to purchase consumer durables and other items


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C = C + (mpc) (Y – T)Marginal propensity to consume

(mpc) is the increase in consumption spending when disposable income increases by $1 mpc is between 0 and 1 for the economy If households receive an extra $1 in income,

they spend part (mpc) and save part(Y – T) is disposable income

Output plus government transfers minus taxes

Main determinant of consumption spending


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Disposable income (Y – T)

Con

sum

ptio

n sp

endi

ng (

C)

CC = C + (mpc) (Y – T)

C

Intercept

Slope = Δ C / Δ (Y – T)

slope


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Planned Aggregate Expenditure And Output

Two dynamic patterns in the economy1. Declines in production lead to reduced

spending2. Reductions in spending lead to

declines in production and incomeConsumption is the largest

component of PAE Consumption depends on output, Y PAE depends on Y


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Linking Planned Aggregate Expenditure To Output

PAE = C + IP + G + NXC = C + mpc (Y – T)

PAE = C + mpc (Y – T) + IP + G + NXSuppose that planned spending

components have the following values

PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20

PAE = 960 + 0.8 Y

C = 620 mpc = 0.8 T = 250

IP = 220 G = 330 NX = 20


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Linking Planned Aggregate Expenditure To Output

C = 620 + 0.8 (Y – 250)PAE = 960 + 0.8 Y

If Y increases by $1, C will increase by $0.80 PAE increases by 80 cents

Planned aggregate expenditure has two parts Autonomous expenditure, the part of

spending that is independent of output $960 in our example

Induced expenditure, the part of spending that depends on output (Y)

0.8 Y in our example


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Planned Expenditure Graph

Output (Y)Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

Slope = 0.8

4,800


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Short-Run Equilibrium

Short-run equilibrium is the level of output at which planned spending is equal to output No change in output as long as prices are

constant Our equilibrium condition can be written

Y = PAEUsing our previous example,

PAE = 960 + 0.8 YY = 960 + 0.8 Y

0.2 Y = 960Y = $4,800


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Short-Run Equilibrium Search

Output (Y)

PAE = 960 + 0.8 Y

Y – PAEY =

PAE?

4,000 4,160 –160 No4,200 4,320 –120 No

4,400 4,480 –80 No

4,600 4,640 –40 No

4,800 4,800 0 Yes

5,000 4,960 40 No

5,200 5,120 80 No

Only when Y = 4,800 does planned spending equal output


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Short-Run Equilibrium Graph

Output (Y)Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

45o

Y = PAE

4,800

Slope = 0.8


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Output Greater than Equilibrium

Suppose output reaches 5,000 Planned spending

is less than total output

Unplanned inventory increases

Businesses slow down production

Output goes down

PA

E

Output (Y)

960

PAE = 960 + 0.8Y

45o

Y = PAE

4,800 5,000


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Output Less than Equilibrium

Suppose output is only 4,500 Planned spending

is more than total output

Unplanned inventory decreases

Businesses speed up production

Output goes up

PA

E

Output (Y)

960

PAE = 960 + 0.8Y

Y = PAE

4,8004,700


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Lower Equilibrium

Output Y

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

E

PAE = 960 + 0.8Y

45o

Y = PAE

4,800Y*

Recessionary gap

PAE = 950 + 0.8Y

950

F

4,750


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New Equilibrium

Autonomous consumption, C, decreases by 10 Causes a downward shift in the planned

aggregate expenditures curve The economy eventually adjusts to a new lower

level of equilibrium spending an output, $4,750Suppose that the original equilibrium level,

$4,800, represented potential output, Y* A recessionary gap develops Size of the recessionary gap is 4,800 – 4,750 =

$50 Entire decrease is in Consumption spending

Same process applies to a decrease in IP, G, or NX

–


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New Short-Run Equilibrium Search

Output (Y)

PAE = 950 + 0.8 Y

Y – PAEY =

PAE?

4,600 4,630 –30 No

4,650 4,670 –20 No

4,700 4,710 –10 No

4,750 4,750 0 Yes

4,800 4,790 10 No

4,850 4,830 20 No

4,900 4,870 30 No

4,950 4,910 40 No

5,000 4,950 50 No


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Japan's Recession and East Asia

Japanese recession in 1990s reduced Japanese imports

East Asian economies developed by promoting exports The decrease in exports to Japan

decreased planned aggregate expenditures in these countries

The decrease in planned spending caused the economies to contract to a new, lower level of planned spending and output

Japan exported its recession to its neighbors


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The Multiplier

The income – expenditure multiplier shows the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output Previous example

Initial planned expenditure = 960 + 0.8 Y New planned expenditure = 950 + 0.8 Y Equilibrium changed from $4,800 to $4,750 A $10 change in autonomous expenditures

caused a $50 change in output Multiplier = 5

The larger mpc, the greater the multiplier


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Stabilizing Planned Spending: The Role of Fiscal Policy

Stabilization policies are government actions to affect planned spending with the intention of eliminating output gaps Expansionary policies increase planned

spending Contractionary policies decrease

planned spending Two major stabilization tools are fiscal

policy and monetary policy Fiscal policy uses changes in government

spending, transfers, or taxes Monetary policy uses changes in the money

supply


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Government Purchases and Planned Spending

Government spending is part of planned spending Changes in government spending will directly

affect planned aggregate expenditures Suppose planned spending decreases $ 10

from Y = 960 + 0.8 YtoY = 950 + 0.8 Y

Equilibrium Y decreases from $4,800 to $4,750 Recessionary gap is $50

Stabilization policy indicates a $10 increase in government spending will restore the economy to Y* at $4,800


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$10 Fiscal Stimulus

Output Y

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

45o

Y = PAE

F

PAE = 950 + 0.8Y

950

4,750

E

4,800Y*


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Japanese Spending

In the 1990s Japan spent over $1 trillion on public works Highways, subways, and transportation

projects Concert halls Re-laying cobblestone sidewalks

Projects did not end the recession Prevented larger decrease in income Eroded consumer confidence because

there was little demand Consumers reduced spending in anticipation of

higher taxes in the future


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Taxes, Transfers and Aggregate Spending

Planned aggregate expenditures are affected by taxes and transfers The effect is indirect, channeled

through the effects on disposable income

Lower taxes or higher transfers increase disposable income

Increases in disposable income lead to higher C


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Tax Cuts Stimulate – An Example

Original planned spending Y = 960 + 0.8 YAutonomous spending decreases Y = 950 + 0.8 YRecessionary gap is $50Tax cut to close the gap must be bigger than $10

Increase disposable income to cause initial increase in spending to be $10

Taxes will have to go down by $12.5

Output (Y)

Net Taxes (T)

Disposable Income (Y – T)

Consumption610 + 0.8 (Y –

T)

4,750 250 4,500 4,210

4,750 237.5 4,512.5 4,220


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Fiscal Policy as A Stabilization Tool: Three Qualifications

Fiscal policy may affect potential output as well as potential spending Investment in infrastructure increases Y* Taxes and transfers affect incentives and

could decrease potential output, Y*Supply-side economists argue the

primacy of supply-side effects of fiscal policy

Current thinking is more moderate Demand-side effect of spending matter Supply-side effects also matter


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Fiscal Policy and Deficit Spending

Government deficit is the difference between government spending and net taxes, (G – T) Large and persistent budget deficits

reduce national saving Less saving means less investment which

means less growth

Managing the impact of the deficit limits the government's ability to use fiscal policy as a stimulus Political considerations make it difficult

to use contractionary fiscal policy


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Fiscal Policy Flexibility

Two limits to fiscal policy flexibility The legislative process requires time

Change in fiscal policy may be slow Competing political objectives

National defense Entitlements such as unemployment

benefits and welfare payments


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Fiscal Policy Can Be Effective

Automatic stabilizers increase government spending or decrease taxes when real output declines Built into laws so no decision is required Unemployment compensation,

progressive income taxFiscal policy may be useful to

address prolonged periods of recession Monetary policy is more often used to

stabilize the economy

Chapter 21Appendix A

An Algebraic Solution of the Basic Keynesian Model


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The Basic Keynesian Model

PAE = C + IP + G + NXC = C + mpc (Y – T)

The consumption function is defined by C, autonomous consumption mpc, the marginal propensity to consume,

a number between 0 and 1IP, G, T and NX are given

–

I = I planned investment T = T net taxes

G = Ggovernment purchases NX = NX net exports–

– –

––


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Find Short-Run Equilibrium Output

PAE = C + mpc (Y – T) + I + G + NX

PAE = C – mpc T + I + G + NX + mpc YEquilibrium condition is PAE = Y

Y = C – mpc T + I + G + NX + mpc YY – mpc Y = C – mpc T + I + G + NX(1 – mpc) Y = C – mpc T + I + G +

NX

––– – ––

––– – ––

––– – ––

––– – ––

Y = C – mpc T + I + G + NX(1 – mpc)

––– – ––

––– – ––


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Short-Run Equilibrium Example

C = 620 I = 220

G = 300 NX = 20

T = 250 mpc = 0.8

Y = 620 – 0.8 (250) + 220 + 300 +20(1 – 0.8)

Y = 960 / 0.2 = 4,800

––

Y = C – mpc T + I + G + NX(1 – mpc)

––– – ––

–

–

–

–

Chapter 21Appendix B

The Multiplier in the Basic Keynesian Model


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The Income and Expenditure Multiplier

Suppose autonomous spending decreases $10 and mpc is 0.8 First decrease in spending is $10

Leads to a decrease in output of $10 Second decrease in spending is $8 Third decrease is $6.40, etc.

Sum of the decreases in spending 10 + 8 + 6.4 + 5.12 + …

= 10 [1 + 0.8 + (0.8)2 + (0.8)3…]


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Income and Expenditure Multiplier

To find the sum of the series, we need a relationship when x is between 0 and 1

In our case, x = 0.810 [1 + 0.8 + (0.8)2 + (0.8)3…]

= 10 = 10

= 10 (1 / 0.2) = 10 (5) = 50In this case, the multiplier is 5

1(1 – x)

1 + x + x2 + x3 + x4 + … = = multiplier

1(1 – x)

1(1 – 0.8)

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 21: Spending and Output in the Short...

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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 21: Spending and Output in the Short...