Frank & Bernanke 3 rd edition, 2007

1. Frank & Bernanke3rd edition, 2007 Ch. 13: Spending and Output in the Short Run

2. (Neo) Classical Theory • Markets always clear. • When Supply does not equal to Demand, price changes to equate the two. • Labor market works the same way, too. • In the 19th century, general price levels sometimes went up and sometimes down but there hasn’t been any trend.

3. The Great Depression • Living through the Great Depression, people rightfully questioned the received wisdom of economists. • If markets tended to clear, why did the labor market show up to 25% unemployment? • The 1936 publication of TheGeneral Theory of Employment, Interest and Money by John Maynard Keynes provided an explanation for markets not to clear in the short run.

4. The Model by Keynes • Prices (including the price of labor - wages) do not change in the short run. • Firms respond to demand changes by adjusting their production and keeping the price constant. • Demand changes occur all the time and the structure of the economy changes as the demand for say, horse carriages fell and trains and cars rose. This would not affect labor.

5. The Model by Keynes • If the total spending (aggregate demand) fell, then almost all markets would feel the drop in demand. • Production in general would fall. • Recession (and depression) would be felt. • To avoid this aggregate demand shortfall, the government should step in and by the use of monetary and fiscal policies, should stimulate total spending.

6. Why Are Prices Constant in the Short Run? • Menu costs. • Fear of uncertainty. • Contracts. • Information lag.

7. Keynesian Assumption: Firms Meet Demand at Preset Prices • Will new technologies eliminate menu costs? • Keynesian theory assumes that menu cost prevent firms from changing prices. • Many new technologies (bar codes) have reduced menu cost and increased price flexibility. • Pricing decisions also require market analysis, strategic considerations, and cost analysis. • These factors are a component of menu costs.

8. Constant Price Means Wide Output Fluctuations P S Q1 Q2 Q

9. Circular Flow Explanation Consumption Expenditures Firms Households Wages, profits, rent, interest If the upper flow (C+I+G+NX) is LESS THAN the lower flow (Income = Value of Output), inventories will pile up (I>Ip) and the firms will cut back in production. If the upper flow is MORE THAN the lower flow, inventories will fall below the desired level (I<Ip) and the firms will increase production.

10. Circular Flow Explanation Consumption Expenditures Firms Households Wages, profits, rent, interest The upper flow is the aggregate demand: C+I+G+NX. The lower flow is Output: Y. When Aggregate Demand is <Y, Y falls. There is a positive output gap (Y*-Y>0) and the economy has slowed down. When I<Ip, C+I+G+NX is greater than Y, or Y>Y* and there is an expansionary (negative) output gap.

11. Aggregate Demand Fluctuations • Consumption expenditures fluctuate. • Confidence, fear levels, demography, wealth, taxes, etc. change. • Investment expenditures fluctuate. • Optimism/pessimism about the future; interest rate changes. • Government expenditures change. • Budget items, wars… • Net Exports change. • Demand for our exports or exchange rates change.

12. Consumption • Relating Consumption to Income and Other Determinants • The consumption function: • C = a constant; represents the non income determinants of C • Consumer optimism • Wealth • Real interest rates

13. The U.S. Consumption Function, 1960-2004

14. Algebraic Short Run Equilibrium Y = C + I + G + NX (Output=Aggregate Demand) C = a +c (Y-T) (Consumption=Autonomous+c*Disposable Income) c = MPC = Change in Consumption/Change in Disposable Income Y = a +cY -cT + I + G + NX Y = (a + I +G + NX - cT) + cY Aggregate Demand Function is comprised of autonomous and induced parts. Y = [1/(1-c)][a+I+G+NX-cT] Equilibrium income is multiplier times autonomous expenditures.

15. (1) Output Y (2) Planned aggregate expenditure PAE = 960 + 0.8Y (3) Y - PAE (4) Y = PAE? 4,000 4,160 -160 No 4,200 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 Numerical Determination of Short-Run Equilibrium Output • Equilibrium: Y = PAE; Y (4,800) = PAE (4,800) • If Y = 4,000 < PAE = 960 + .8(4000) = 4,160 • If Y = 5,000 > PAE = 960 + .8(5,000) = 4,960

16. Y = PAE Expenditureline PAE = 960 + 0.8Y Slope = 0.8 • Equilibrium • PAE intersects the 45o line @ 4,800 • Disequilibrium • < 4,800, PAE > Y • > 4,800, PAE < Y 960 45o 4,800 Determination of Short-Run Equilibrium Output (Keynesian Cross) Planned aggregate expenditure PAE Output Y

17. Y = PAE Expenditure line PAE = 960 + 0.8Y Slope = 0.8 • Equilibrium Algebraically • At equilibrium: PAE = C + Ip + G + NX • Y = 960 + 0.8Y • 0.2Y = 960 • Y = 960/0.2 = 4,800 = equilibrium 960 45o 4,800 Determination of Short-Run Equilibrium Output (Keynesian Cross) Planned aggregate expenditure PAE Output Y

18. Y = PAE Expenditure line PAE = 960 + 0.8Y Expenditure line PAE = 950 + 0.8Y E A decline in autonomous aggregate expenditure (C) shifts the expenditure line down F 960 950 Recessionarygap 45o 4,750 4,800 Y* A Decline In Planned Spending Leads to a Recession Planned aggregate expenditure PAE Output Y

19. (1) Output Y (2) Planned aggregate expenditure PAE = 950 + 0.8Y (3) Y - PAE (4) Y – 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 Determination of Short-Run Equilibrium Output After a Fall In Spending • If Y = 4,800 > PAE = 4,790 • Y = PAE @ 4,750 • Output Gap: Y* (4,800) > Y (4,750)

20. Japanese Recession • Why was the deep Japanese recession of the 1990s bad news for the rest of East Asia? • Recession in Japan reduced Japanese imports • The decline in East Asian exports to Japan reduced domestic spending in non-export sectors

21. 2000-2002 Decline in the U.S. Stock Market • From March 2000 to March 2002 the S&P 500 fell 49%. • Households lost $6.5 trillion of wealth in two years • $1 decrease in wealth reduces C by 3 to 7 cents/year • The $6.5 trillion loss could reduce C between $195 and $455 billion

22. 2000-2002 Stock Market • C rose from 2000-2002 • Higher housing prices (greater wealth) • Lower interest rates • Lowering taxes • Increase in disposable income (Y – T) • What caused the 2001 recession in the United States? • Reduction in investment spending

23. Fiscal Policy • Why did the federal government send out millions of $300 and $600 checks to households in 2001? • In the spring 2001, the U.S. economy was slowing. • Summer 2001, families received $38 billion in tax rebates. • A recent study indicated that two-thirds of the rebates were spent by households within six months.

24. Multiplier • If a and I drops, what will happen to Y? • Y = [1/(1-c)][a+I+G+NX-cT] • One can plug in the new values and find Y. • One can take the “Change in Y” to be equal to [1/(1-c)]*Change in a+I. • One can show the effect graphically by shifting AD downward.

25. Multiplier • Suppose a dropped from 400 to 350, and I dropped from 300 to 250. Find the new equilibrium Y. • Y = [1/(1-c)][a+I+G+NX-cT] • Y = 5 (700) = 3500 • DY = 5 (-100) = -500

26. Graphical Short Run Equilibrium AD AD 800 700 Y 3500 4000 What is the value of the multiplier? What is mpc equal to?

27. Role of Fiscal Policy • In the Keynesian system, it is obvious that in response to changes in C, I, and NX, government can counter them by changing G or T. • If a+I fell by 100, how much G should change to keep Y=4000? • If a+I fell by 100, how much T should change to keep Y=4000?

28. The Problem of Deficits • Sustaining government deficits reduce saving and investment in new capital goods. • The goal of keeping deficits low may reduce the incentive to use fiscal policy to control a recessionary gap.

29. Fiscal Policy and the Supply Side • Fiscal policy may affect potential output as well as Aggregate Expenditures. • Public capital • R & D • Human Capital • Transfer payments

30. Limits on Fiscal Policy • The problem of time lags and the legislative process • Competing political objectives • Automatic stabilizers help offset the inflexibility of fiscal policy • Transfer payments • Income tax collections • Fiscal policy may be useful to address prolonged periods of recession

31. Automatic Stabilizers • Without any act by the Congress, fiscal measures kick in to keep Y close to Y*. • Income taxes. • Unemployment insurance. • Welfare payments. • Recession aid transfers.

32. Does military spending stimulate the economy?