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Chapter 11

Chapter 11. Spending and Output in the Short Run. Learning Objectives. Identify the key assumptions of the basic Keynesian model Discuss the determination of planned investment and planned aggregate expenditure

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Chapter 11

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  1. Chapter 11 Spending and Output in the Short Run

  2. Learning Objectives • Identify the key assumptions of the basic Keynesian model • Discuss the determination of planned investment and planned aggregate expenditure • Analyze how an economy reaches short-run equilibrium in the basic Keynesian model • Show how a change in planned aggregate expenditure can cause a change in the short-run equilibrium output

  3. Keynesian Model Key assumption: • 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 • Eventually, firms change prices when the marginal benefits exceed the marginal costs • Basic Keynesian model developed here ignores this fact.

  4. Planned Aggregate Expenditure • Planned aggregate expenditure 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

  5. Planned Investment Example • Fly-by-Night Kite produces $5 million of kites per year • Expected sales are $4.8 million and planned inventory increase is $0.2 million • Capital expenditure of $1 million is planned • 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

  6. Planned Aggregate Expenditure (PAE) • 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

  7. Consumption Expenditures • 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)

  8. Consumption, 1960 - 2007

  9. 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 spendingmpc 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

  10. Consumption Function C = C + (mpc) (Y – T) • C captures wealth effect • The effect of changes in asset prices on consumption spending • 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

  11. More Consumption Function 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 minus net taxes

  12. Consumption Function C = C + (mpc) (Y – T) C Intercept slope Consumption spending (C) Δ C C Δ (Y – T) Slope = Δ C / Δ (Y – T) Disposable income (Y – T)

  13. Planned Spending Example PAE = C + IP + G + NX C = C + mpc (Y – T) PAE = C + mpc (Y – T) + IP + G + NX • Suppose that planned spending components have the following values PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20 PAE = 960 + 0.8 Y

  14. Planned Spending Example 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

  15. Planned Expenditure Graph PAE = 960 + 0.8Y Planned aggregate expenditure (PAE) 960 Slope = 0.8 4,800 Output (Y)

  16. Short-Run Equilibrium • Short-run equilibrium is the level of output at which planned spending is equal to output • Our equilibrium condition can be written Y = PAE • Using our previous example, PAE = 960 + 0.8 Y Y = 960 + 0.8 Y 0.2 Y = 960 Y = $4,800

  17. Short-Run Equilibrium Graph Y = PAE PAE = 960 + 0.8Y Slope = 0.8 Planned aggregate expenditure (PAE) 960 45o 4,800 Output (Y)

  18. 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 Y = PAE PAE = 960 + 0.8Y PAE 960 45o 4,800 5,000 Output (Y)

  19. 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 Y = PAE PAE = 960 + 0.8Y PAE 960 4,700 4,800 Output (Y)

  20. Lower Equilibrium Y = PAE PAE = 960 + 0.8Y PAE = 950 + 0.8Y E Planned aggregate expenditure (PAE) F 960 950 Recessionary gap 45o 4,800 4,750 Y* Output Y

  21. 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, $4,750 • Suppose 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

  22. 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 • US recessions have similar effects on our major trading partners

  23. Income-Expenditure 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

  24. Stabilization 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

  25. Government 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 Y to Y = 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

  26. $10 Fiscal Stimulus Y = PAE PAE = 960 + 0.8Y PAE = 950 + 0.8Y E Planned aggregate expenditure (PAE) F 960 950 45o 4,800 4,750 Y* Output Y

  27. 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

  28. Taxes and Transfers • 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

  29. Tax Cuts Stimulate – An Example • Original planned spending PAE = 960 + 0.8 Y • Autonomous consumption, C, decreases by 10. Recessionary gap is $50. PAE = C + 0.8 (Y – T) + IP + G + NX • Tax 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

  30. Chapter 23Appendix A An Algebraic Solution of the Basic Keynesian Model

  31. The Basic Keynesian Model PAE = C + IP + G + NX C = C + mpc (Y – T) • The consumption function is defined by • C, autonomous consumption • mpc, the marginal propensity to consume, a number between 0 and 1 • IP, G, T and NX are given – – – –– –

  32. Find Short-Run Equilibrium Output – – – – –– PAE = C + mpc (Y – T) + I + G + NX PAE = C – mpc T + I + G + NX + mpc Y • Equilibrium condition is PAE = Y Y = C – mpc T + I + G + NX + mpc Y Y – mpc Y = C – mpc T + I + G + NX (1 – mpc) Y = C – mpc T + I + G + NX – – – – –– – – – – –– – – – – – – – – – – – – –– –– –– C – mpc T + I + G + NX (1 – mpc) Y =

  33. Short-Run Equilibrium Example – – – – – – –– –– – – 620 – 0.8 (250) + 220 + 300 +20 (1 – 0.8) C – mpc T + I + G + NX (1 – mpc) Y = Y = Y = 960 / 0.2 = 4,800

  34. Chapter 23Appendix B The Multiplier in the Basic Keynesian Model

  35. 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…]

  36. 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 = 0.8 10 [1 + 0.8 + (0.8)2 + (0.8)3…] = 10 = 10 = 10 (1 / 0.2) = 10 (5) = 50 • In this case, the multiplier is 5 1(1 – x) 1 + x + x2 + x3 + x4 + … = = multiplier 1(1 – x) 1(1 – 0.8)

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