ECON 1 – Section 19

1. ECON 1 – Section 19 Demand and Output in the Short Run. ECON 1 – Section 19 – Page 1

2. Contact Details • GSI: Ramon Estopina • Office Hours: No OH this Thursday !! • Office: Evans 508-7 • Email: estopina@haas.berkeley.edu • Handouts (only sections 104 & 133) after class in: http://www.ocf.berkeley.edu/~jaychen/econ1/ • Please read: Read before downloading!. ECON 1 – Section 19 – Page 2

3. Section 19 Agenda • Administrative Stuff (10 min) • Recap Quiz (10 min) • Problem 25.6 (10 min) • Problem 25.7 (10 min) • Problem 25.9 (10 min) • Re-cap (2 min) ECON 1 – Section 19 – Page 3

4. Administrative Stuff • PS #3 ready today from Econ-1 website !!! • Due next Wednesday 13th. • Remember, no class next Monday!! -Veterans Day Holiday. • Opportunity to catch-up and get ready for Midterm. ECON 1 – Section 19 – Page 4

5. Review of Last Lecture - 11/4th • Chapter 25: • AD: planned vs actual spending. • Consumption Function and MPC • Autonomous vs Induced spending • Keynesian Model • Assumptions • Keynesian Cross Diagram • Shifts in AD • Equilibrium Output • Potential Output • Gaps (recessionary/expansionary) • Paradox of thrift & multiplier ECON 1 – Section 19 – Page 5

6. Recap Quiz - 1 • Total planned spending on final goods and service is called • total spending. • total consumption. • aggregate expenditures. • aggregate consumption. • aggregate demand. ECON 1 – Section 19 – Page 6

7. Recap Quiz - 2 • A firm's actual investment will exceed its planned investment when • it sells less than it planned. • It sells more than it planned. • interest rates rise. • interest rates fall. • the economy experiences an unexpected expansion. ECON 1 – Section 19 – Page 7

8. Recap Quiz - 3 • The largest component of aggregate demand is • consumption. • investment. • government purchases. • exports. • imports. ECON 1 – Section 19 – Page 8

9. Recap Quiz - 4 • The objective of stabilization policies is to • affect aggregate supply. • eliminate output gaps. • increase potential GDP. • keep inflation constant. • cause business cycles ECON 1 – Section 19 – Page 9

10. Recap Quiz - 5 • The value of the MPC is assumed to be • less than 1. • greater than 1. • less than 0. • equal to 1. • constant. ECON 1 – Section 19 – Page 10

11. Important to remember: • Equation 1 of the day: • Aggregate Demand (AD): total planned spending on final goods and services. ECON 1 – Section 19 – Page 11

12. Important to remember (2) • Remember: Planned may differ from actual for firms: difference is change in inventories. • Firm sells less than expected: inventories grow (Increase in inventories is counted as actual investment)  I > Ip • Firm sells more than expected: inventories decline  Ip> I ECON 1 – Section 19 – Page 12

13. Important to remember (3) • Components of AD. • A) CONSUMPTION FUNCTION: • = constant term capturing factors other than disposable income • c = MPC (marginal propensity to consume): amount C raises when disposable income rises; • assume 0 < c < 1 ECON 1 – Section 19 – Page 13

14. Important to remember (4) • B) Rest of factors are exogenous. ECON 1 – Section 19 – Page 14

15. Important to remember (5) • Combining all equations: • Composed of: • Autonomous AD & Induced AD ECON 1 – Section 19 – Page 15

16. Important to remember (6) • In equilibrium Y = AD, so: • Multiplier: ECON 1 – Section 19 – Page 16

17. Box 25.2 (F&B page 667) • From Example 25.2 (F&B page 664) we have: • =620 /c = 0.8 / = 220 / =300 / =20 / =250 • We know the definition of Aggregate Demand is: AD = C + Ip + G + NX • And, in the SHORT RUN: ECON 1 – Section 19 – Page 17

18. Box 25.2 (Conclusion) • Substituting the components: AD = [620 + 0.8(Y-250)] + 220 + 200 + 20 • And finally: AD = 960 + 0.8Y • In addition, from the short term equilibrium: Y=AD • So the previous equation will be: Y = 960 + 0.8Y • Solving for Y: Y = 960 / 0.2 = 4,800 ECON 1 – Section 19 – Page 18

19. Problem 25.6 (F&B page 684) • For the following economy, find • Autonomous aggregate demand • The multiplier • SR equilibrium output • Output gap. ECON 1 – Section 19 – Page 19

20. Problem 25.6 (cont’d) • A) The relationship between aggregate demand and output is given by: • Autonomous aggregate demand equals 6200, the part of aggregate demand that does not depend on output. ECON 1 – Section 19 – Page 20

21. Problem 25.6 (cont’d) • To find short-run equilibrium output, use the equation Y=AD and solve for Y: • What is the Output Gap? • Remember last class: Y*-Y ECON 1 – Section 19 – Page 21

22. Problem 25.6 (cont’d) • So we have: • SR equilibrium output (Y) = 12,400 • Potential output (Y*)= 12,000 • Output gap is = –400. • Is this a recessionary or expansionary gap? • Expansionary, Y > Y* ECON 1 – Section 19 – Page 22

23. The multiplier can be found by the formula of the multiplier (obviously) = 1/(1-c) Problem 25.6 (cont’d) • There is another way to solve it (more complicated), but I know you are curious. ECON 1 – Section 19 – Page 23

24. Problem 25.6 (cont’d) • Imagine that autonomous aggregate demand rises from 6200 to 6300. • Now the equation Y=AD becomes Y= 6,300 + 0.5Y • Solving for output yields Y = 12,600, an increase of 200 over the solution found before. • We have shown that an increase in autonomous aggregate demand of 100 raises short-run equilibrium output by 200. Therefore the multiplier must equal 2. ECON 1 – Section 19 – Page 24

25. Problem 25.6 (Conclusion) • By how much would autonomous AD have to change to eliminate the output gap? • As the multiplier is 2, to eliminate the output gap of –400, autonomous aggregate demand would have to change by –200, that is, autonomous aggregate demand would have to fall. • If autonomous aggregate demand falls from 6200 to 6000, then short-run equilibrium output equals 12,000 and the output gap is eliminated. ECON 1 – Section 19 – Page 25

26. Problem 25.7 (F&B page 685) • Following with the previous problem but now = 0. • A) What would be the SR equilibrium output? • We proceed as before: ECON 1 – Section 19 – Page 26

27. Problem 25.7 (cont’d) • Then we apply the definition of short-run equilibrium output, Y = AD. ECON 1 – Section 19 – Page 27

28. Problem 25.7 (cont’d) • B) Economic recovery abroad increases the demand for the country’s exports. As a result = 100. • What happens to the SR Equilibrium Output? ECON 1 – Section 19 – Page 28

29. An increase of by 100 implies that autonomous aggregate demand rises by 100, so now we have: So the increase in net exports of 100 has increased output by 200. Problem 25.7 (cont’d) ECON 1 – Section 19 – Page 29

30. Problem 25.7 (cont’d) • C) Now assume foreign economies are slowing and the demand for the country’s exports is reduced. As a result = -100. • What happens to the SR Equilibrium Output? ECON 1 – Section 19 – Page 30

31. A decrease of by 100 implies that autonomous aggregate demand falls by 100, so now we have: So the decline in net exports of 100 lowers output by 200. Problem 25.7 (cont’d) ECON 1 – Section 19 – Page 31

32. Problem 25.7 (Conclusion) • How these results help explain the tendency of recessions and expansions to spread across countries? • The example shows that a weak economy in one country, by reducing that country’s imports from a second country, can create economic weakness in the second country as well. • Similarly, an expansion that increases a country’s purchases of foreign products strengthens the economies of its trade partners. ECON 1 – Section 19 – Page 32

33. Problem 25.9 (F&B page 685) • For the following economy, find how much would Gov. purchases have to change to eliminate any output gap (this is fiscal policy). ECON 1 – Section 19 – Page 33

34. Problem 25.9 (cont’d) • We solve for short-run equilibrium output via the usual two steps. • First, find the relationship of aggregate demand to output: ECON 1 – Section 19 – Page 34

35. Problem 25.9 (cont’d) • Second, use the condition Y = AD to solve for short-run equilibrium output: • The output gap is Y*-Y = 580-600 = -20, so there is an expansionary gap of 20. ECON 1 – Section 19 – Page 35

36. Problem 25.9 (cont’d) • To answer the question about the effects of fiscal policy we need to know the multiplier for this economy. • In this case: ECON 1 – Section 19 – Page 36

37. Problem 25.9 (cont’d) • Now we can find the appropriate fiscal policies to eliminate the output gap. • Because actual output exceeds potential output by 20, and the multiplier is 5, a decrease of 4 in government purchases (from 120 to 116) will eliminate the output gap. • You can verify this directly by setting =116 and re-solving for short-run equilibrium output. ECON 1 – Section 19 – Page 37

38. Problem 25.9 (cont’d) • By how much would taxes have to change? (Assume MPC = 0.8) • For the case of a tax change we have to be careful. A change in taxes of ΔT does not change autonomous aggregate demand by ΔT, because consumers do not spend 100% of any tax cut (or reduce spending by 100% of any tax increase). • A change in taxes of ΔT instead changes autonomous aggregate demand by cΔT , where c is the marginal propensity to consume (MPC) out of disposable income. ECON 1 – Section 19 – Page 38

39. Problem 25.9 (cont’d) • In the case of government spending, eliminating the output gap requires reducing autonomous aggregate demand by 4. • To reduce autonomous aggregate demand by 4 via a tax change, Gov. will increase taxes by 5. • Since the MPC = 0.8, a tax increase of 5 will lead consumers to reduce their spending by 4, as desired. • You can also verify it by setting =115 and solving for short-run equilibrium output. ECON 1 – Section 19 – Page 39

40. Problem 25.9 (cont’d) • What happens if now Y*=630? • If potential output is 630, then the output gap is Y*-Y=30, that is, there is a recessionary gap of 30. • As the multiplier is 5, this gap can be eliminated by raising government purchases by 6. Y=AD AD AD=126+0.8Y AD=120+0.8Y An increase in shifts the expenditure line upwards. 600 Y*=630 Output ECON 1 – Section 19 – Page 40

41. Problem 25.9 (Conclusion) • Alternatively, cut taxes by 6/0.8 = 7.5. Because the MPC is 0.8, a cut in taxes of 7.5 will also stimulate autonomous aggregate demand by 6 and output by 6*5 = 30. • The Keynesian cross diagram in this case shows the expenditure line rising too, rather than falling, to restore Y=Y*. ECON 1 – Section 19 – Page 41

42. Problems for next sections !!! • For next section: • Chapter 26: Problems 3, 8, 9. • Remember: This is not mandatory. • It won’t be graded. Only for those of you that need improvement in Exam grades. ECON 1 – Section 19 – Page 42

43. Next class • Next Class: • Section 20 – Wednesday, Nov 13th • No class next Monday. Veterans Day Holiday. • Due PS#4 !!!! • If you want more practice, work on Next Sections Problems (although you probably have enough). • Read ch. 26 & 27. • You can download handouts this afternoon. • Thank you for coming on time !!! • Enjoy the long weekend & C-U Wednesday !!. ECON 1 – Section 19 – Page 43