Download The Keynesian Model of Short-Run Fluctuations

What causes fluctuations?
Spending and
Output in the
Short Run
What caused the 2001 recession?
ƒ Lower consumer spending
ƒ Lower investment
Principles of Macroeconomics
Why was it so mild?
ƒ
ƒ
ƒ
Dr. Gabriel X. Martinez
Greater government expenditures
Lower taxes
Improved consumer spending
How did the exact number get
determined?
Ave Maria University
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
2
The Keynesian Model’
Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
In the short run, firms meet the demand for
their products at preset prices.
The Keynesian Model of
Short-Run Fluctuations
ƒ Firms do not respond to every change in the
demand for their products by changing their
prices.
ƒ Instead, they typically set a price for some
period, then meet the demand at that price.
Pronounced like “canesian”
canesian”
Copyright c 2004 by The McGraw-Hill
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The Keynesian Model’
Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
In the short run, firms meet the demand for
their products at preset prices.
ƒ By “meeting the demand,”
demand,” we mean that firms
produce just enough to satisfy their customers
at the prices that have been set.
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Chapter 26: Spending and Output in the
Short Run
5
Chapter 26: Spending and Output in the
Short Run
4
The Keynesian Model’
Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
Meeting Demand at Preset Prices:
ƒ Is a logical management decision because of
menu costs or contracts with customers.
Also, prices may be sticky because wages are
sticky.
ƒ Prices should be changed only if the benefit of
charging the “optimal price”
price” exceeds the cost
of “price adjustment.”
adjustment.”
ƒ In the long run firms will change prices.
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Chapter 26: Spending and Output in the
Short Run
6
1
The Keynesian Model’
Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
Economic Naturalist
Economic Naturalist
ƒ Will new technologies eliminate menu costs?
ƒ 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.
Copyright c 2004 by The McGraw-Hill
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The Keynesian Model’
Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
Chapter 26: Spending and Output in the
Short Run
7
Pricing decisions also require market analysis,
strategic considerations, and cost analysis
These factors are a component of menu costs,
which technology may reduce but not eliminate.
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Wage Stickiness may lead to
Price Stickiness
Chapter 26: Spending and Output in the
Short Run
8
Aggregate Expenditure
Aggregate Expenditure
After being laid off from her job as a manager at Ford Motor
Co.'s [Mexican] unit, [Karina] Maldonado searched
unsuccessfully for a job for months before settling on a
position selling cars at a Volkswagen AG dealership. Her
commute is two hours and her pay is half of what she
earned at Ford.
“At first I looked for something close to home and well paid,”
paid,” Maldonado, who ran the auto parts division at
Ford's Land Rover unit in Mexico … . “Then I said I'd take
something anywhere, as long as it was in planning. In the
end, I didn't care as long as it was a job.”
job.”
ƒ Total spending on final goods and services
AE = C + I + G + NX
AE = Planned AE + Unplanned AE
“Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 21, 2004”
2004”
(Bloomberg)
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
9
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Aggregate Expenditure
The Components of Aggregate
Expenditure
1. Consumer expenditure or Consumption (C
(C)
3. Government purchases
Household spending on durables, nondurables,
and services
Federal, state, and local spending on goods and
services
2. Investment (I
(I)
4. Net exports
New capital goods spending
New residential spending
Increases in inventories (planned or unplanned)
Chapter 26: Spending and Output in the
Short Run
10
Aggregate Expenditure
The Components of Aggregate
Expenditure
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Chapter 26: Spending and Output in the
Short Run
Exports - imports
11
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Chapter 26: Spending and Output in the
Short Run
12
2
Planned Aggregate
Expenditure
Aggregate Expenditure
Planned Spending Versus Actual
Spending
Actual expenditures may not equal PAE.
Planned Spending Versus Actual
Spending
Actual expenditures may not equal PAE.
ƒ Suppose a firm planned to sell 500,000 (and
keep some as inventory) but only sold
450,000
ƒ Then inventories are larger than expected:
ƒ I > planned Investment (I
(IP)
Chapter 26: Spending and Output in the
Short Run
Copyright c 2004 by The McGraw-Hill
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ƒ Suppose a firm planned to sell 500,000 (and
keep some as inventory) but sold 550,000
ƒ If inventories are smaller than expected:
ƒ I < IP
13
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Planned Aggregate
Expenditure
If actual sales are:
ƒ Flight Kite Co. produces $5 million of kites per year.
ƒ Expected sales = $4.8 million and planned inventory
accumulation = $200,000
ƒ Capital expenditure = $1 million
ƒ $4,600,000 instead of $4,800,000
IP = $1,000,000 + $200,000 = $1,200,000
I = IP + unplanned inventory accumulation
= $1,200,000 + $200,000
= $1,400,000
I > IP
If actual sales = $4.8 million
IP = $1,000,000 + $200,000 = $1,200,000
I = IP + unplanned inventory accumulation
= $1,200,000 + 0
= $1,200,000
I = IP
Chapter 26: Spending and Output in the
Short Run
14
Planned Aggregate
Expenditure
Actual and planned investment
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Chapter 26: Spending and Output in the
Short Run
15
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Planned Aggregate
Expenditure
Chapter 26: Spending and Output in the
Short Run
16
Planned Aggregate
Expenditure
If actual sales are:
Planned Aggregate Expenditure
ƒ $5,000,000
IP = $1,000,000 + $200,000 = $1,200,000
I = IP + unplanned inventory accumulation
PAE = C + I P + G + NX
= $1,200,000 – $200,000
= $1,000,000
ƒ I < IP
P
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Chapter 26: Spending and Output in the
Short Run
17
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Chapter 26: Spending and Output in the
Short Run
18
3
Planned Aggregate
Expenditure
Levels
U.S. Consumption
and
Output, 1960-2001
10000.0
C o n s u m p tio n (C )
Consumer Spending and the Economy
ƒ Consumption (C
(C) accounts for two thirds of
total spending.
ƒ What determines Consumption?
8000.0
6000.0
4000.0
2000.0
0.0
ƒ Check out “Explaining Consumption.xls”
Consumption.xls”
0.0
2000.0
4000.0
6000.0
8000.0 10000.0 12000.0 14000.0
Income (GDP)
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Chapter 26: Spending and Output in the
Short Run
19
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
0.08
% C h a n g e in C
Consumer Spending and the Economy
C = 0.0035 + 0.7839 Y
ƒ The primary determinant of C is disposable
income or Y – T
0.04
Consumption Function
0.02
0
-0.04
-0.02
-0.02
20
Planned Aggregate
Expenditure
% Changes
0.06
Chapter 26: Spending and Output in the
Short Run
0
0.02
0.04
0.06
0.08
ƒ The relationship between consumption
spending and its determinants, in particular,
disposable (after(after-tax) income
-0.04
% Change in GDP
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Chapter 26: Spending and Output in the
Short Run
21
Copyright c 2004 by The McGraw-Hill
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Planned Aggregate
Expenditure
C = C + c(Y - T)
ƒ The consumption function:
C = a constant; represents the nonnon-income
determinants of C. It is called autonomous
consumption
C = C + c(Y - T)
Consumption is a function of other factors (C) and disposable income (Y-T)
Chapter 26: Spending and Output in the
Short Run
22
Planned Aggregate
Expenditure
Relating Consumption to Income and Other
Determinants
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Chapter 26: Spending and Output in the
Short Run
ƒ
ƒ
ƒ
ƒ
23
Consumer optimism
Wealth
Real interest rates
Prices
Chapter 26: Spending and Output in the
Copyright c 2004 by The McGraw-Hill
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Short Run
24
4
Planned Aggregate
Expenditure
Planned Aggregate
Expenditure
Economic Naturalist
Economic Naturalist
ƒ What effect did the 20002000-2002 decline in the
U.S. stock market values have on
consumption spending?
From March 2000 to March 2002 the S&P 500 fell
49%.
Households lost $6.5 trillion of wealth in two years
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Chapter 26: Spending and Output in the
Short Run
25
ƒ $1 decrease in wealth reduces C
(autonomous consumption) by 3 to 7
cents/year
ƒ The $6.5 trillion loss could reduce C between
$195 and $455 billion
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Chapter 26: Spending and Output in the
Short Run
26
Planned Aggregate
Expenditure
Planned Aggregate
Expenditure
Economic Naturalist
ƒ C has risen since 2002
C = C + c(Y
Higher housing prices (greater wealth)
Lower interest rates
c = marginal propensity to consume
MPC is the amount by which consumption
rises when disposable income rises by $1;
0<c<1
ƒ The incomeincome-related (induced) part of C has
also risen
Increase in disposable income (Y
(Y – T)
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Chapter 26: Spending and Output in the
Short Run
27
Consumption spending C
A Consumption Function
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Chapter 26: Spending and Output in the
Short Run
28
What do we know so far?
Planned Aggregate Expenditure
= C + IP + G + NX
Actual expenditures may not equal PAE
Consumption
function
ƒ If so, unplanned inventory (de)accumulation
(de)accumulation
will occur.
C = C + c(Y - T)
C
- T)
Slope = c = MPC
Consumption depends positively on
disposable income
ƒ (Income after taxes)
Disposable income Y-T
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Chapter 26: Spending and Output in the
Short Run
29
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Chapter 26: Spending and Output in the
Short Run
30
5
Planned Aggregate
Expenditure
Planned Aggregate
Expenditure
Example
Planned Aggregate Expenditure and
Output
ƒ The relationship between changes in
production and income and PAE
A large part of PAE is C
C depends on Y
∴ PAE depends on Y
We still haven’t
shown this
connection
Copyright c 2004 by The McGraw-Hill
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From C to PAE,
algebraically
PAE = C + IP + G + NX
C
C = C + c(Y – T)
C
PAE
PAE = C + c(Y – T) + IP + G + NX
Y
For the moment we
assume that only C
depends on Y.
Assume all other
components of AE
are exogenous.
C = 620; c = 0.8; T = 250;
IP = 220; G = 300; NX = 20
PAE
Chapter 26: Spending and Output in the
Short Run
Y
31
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Chapter 26: Spending and Output in the
Short Run
32
Planned Aggregate
Expenditure
Planned Expenditures
Planned Aggregate
Expenditure
From C to PAE, numerically
ƒ Then:
PAE = [620 + 0.8(Y - 250)] + 220 + 300 + 20
From C to PAE, graphically
PAE
PAE = C + I P + G + NX
Consumption
function
PAE = [620 + 0.8Y - 0.8(250)] + 220 + 300 + 20
PAE = 620 + 0.8Y - 200 + 220 + 300 + 20
Slope = c = MPC
C+IP+G+NX
C = C + c(Y - T)
PAE = (620 - 200 + 220 + 300 + 20) + 0.8Y
PAE = 960 + 0.8Y
Slope = c = MPC
C
Output, Y
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Chapter 26: Spending and Output in the
Short Run
33
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Planned Aggregate
Expenditure
Chapter 26: Spending and Output in the
Short Run
34
Planned Aggregate
Expenditure
PAE = 960 + 0.8Y
There are two parts to PAE:
PAE = 960 + 0.8Y = C + I + G + NX
ƒ Autonomous expenditure (960)
Is independent of output: Does not vary
when output changes
It varies with prices, consumer confidence,
interest rates, wealth, etc.
ƒ If Y increases by $1, C will increase by 80
cents (c
(c = 0.80)
ƒ And because C is part of PAE, …
ƒ PAE increases by 80 cents ($1 X 0.80)
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Chapter 26: Spending and Output in the
Short Run
ƒ Induced expenditure (0.8Y
(0.8Y)
Depends on output (Y
(Y)
35
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Chapter 26: Spending and Output in the
Short Run
36
6
Planned Aggregate
Expenditure
Graphing the Expenditures
Function
PAE = 960 + 0.8Y
PAE
PAE
400
380
310
Slope = 0.6
140
(a)
expenditure
PAE
Autonomous expenditure
expenditure
expenditure
Induced
expenditure
200 400 600
Real output
Autonomous
expenditure
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c 2004 by The McGraw-Hill
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Slope = 0.5
Slope = 0.6
200
190
200
400 600
Real output
(b)
200
ƒ Is the part of expenditure that does not
depend on output
Induced expenditure
ƒ Is the part of expenditure that depends
on output (Y
(Y)
400 600
Real output
(c)
Chapter 26: Spending and Output in the
Short Run
37
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Chapter 26: Spending and Output in the
Short Run
Short-run Equilibrium Output
Short-run Equilibrium Output
The Key Keynesian Assumption:
Producers meet demand at preset prices
in the shortshort-run.
Therefore,
38
Y = PAE
ƒ Suppose planned demand for goods is higher
than production:
ƒ Instead of raising prices, firms will increase
production, until Y = PAE.
is a condition for economic equilibrium
(in the short run)
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Chapter 26: Spending and Output in the
Short Run
39
Short-run Equilibrium Output
ShortShort-run equilibrium:
Short-run Equilibrium Output
Y = PAE
Induced
Expenditure
Chapter 26: Spending and Output in the
Short Run
40
ƒ The level of output at which output Y equals
planned aggregate expenditure PAE
ƒ ShortShort-run equilibrium output: the level of
output that prevails as long as prices are
predetermined.
PAE = C – cT + IP + G + NX + cY
Autonomous
Expenditure
Chapter 26: Spending and Output in the
Short Run
ShortShort-run Equilibrium Output
Y = PAE
PAE = C + c(Y – T) + IP + G + NX
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41
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Chapter 26: Spending and Output in the
Short Run
42
7
Planned Aggregate
Expenditure
The Equilibrium Level of
Aggregate Income
ShortShort-run Equilibrium Output
Suppose PAE > Y
1. Y = PAE
2. PAE = C + c(Y – T) + IP + G + NX
⇒Sales > Production
⇒Inventories fall
⇒Businesses produce more: Y ↑
ƒ
Suppose PAE < Y
ƒ
⇒Sales < Production
⇒Inventories rise
⇒Businesses produce less: Y ↓
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Y = C + c(Y – T) + IP + G + NX
Chapter 26: Spending and Output in the
Short Run
43
Numerical Determination of
ShortShort-Run Equilibrium Output
(2)
Planned aggregate expenditure
PAE = 960 + 0.8Y
(3)
(4)
Y - PAE
Y = PAE?
4,000
4,160
-160
No
4,200
4,320
-120
No
4,400
4,480
-80
No
4,600
4,640
4,800
4,960
5,120
-40
0
40
80
No
Yes
No
No
4,800
5,000
5,200
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Chapter 26: Spending and Output in the
Short Run
44
Determination of ShortShort-Run Equilibrium
Output (Keynesian Cross)
Y = PAE
45o
•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
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Chapter 26: Spending and Output in the
Short Run
Planned aggregate expenditure
PAE
(1)
Output
Y
This is a system with two equations and two
unknowns.
Solve it by putting equation 2 into equation 1:
Output Y
45
Determination of ShortShort-Run Equilibrium
Output (Keynesian Cross)
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Chapter 26: Spending and Output in the
Short Run
46
Determination of ShortShort-Run Equilibrium
Output (Keynesian Cross)
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
960
Planned aggregate expenditure PAE
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
4,800
Slope = 0.8
Equilibrium
• PAE intersects the 45o line @ 4,800
960
45o
4,800
Output Y
Output Y
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Chapter 26: Spending and Output in the
Short Run
47
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Chapter 26: Spending and Output in the
Short Run
48
8
The Equilibrium Level of
Aggregate Income
The Equilibrium Level of
Aggregate Income
Suppose PAE > Y
Remember Inventories are a kind of
investment:
⇒Sales > Production
⇒Inventories fall
⇒Businesses produce more: Y ↑
ƒ Planned changes in inventory are part of IP.
ƒ Unplanned changes in inventory are part of I
(but not of IP).
Suppose PAE < Y
Unplanned inventory changes make sure actual
aggregate expenditures = income all the time.
When PAE=Y, unplanned inventory changes = 0.
⇒Sales < Production
⇒Inventories rise
⇒Businesses produce less: Y ↓
Chapter 26: Spending and Output in the
Short Run
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49
Determination of ShortShort-Run Equilibrium
Output (Keynesian Cross)
Chapter 26: Spending and Output in the
Short Run
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A Decline In Planned
Spending Leads To A Recession
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
4,800
Disequilibrium
• If PAE > 4,800,
PAE > Y Inventories fall
• If PAE < 4,800,
PAE < Y Inventories rise
PAE>Y
Planned aggregate expenditure PAE
Planned aggregate expenditure PAE
Y = PAE
PAE<Y
960
Expenditure line
PAE = 960 + 0.8Y
E
Suppose the economy starts
from short-run equilibrium,
And suppose that Y = Y*,
actual equilibrium output =
potential output.
(This isn’t always so).
960
45o
45o
4,800
Output Y
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50
4,800
Y*
Chapter 26: Spending and Output in the
Short Run
51
Output Y
Chapter 26: Spending and Output in the
Short Run
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52
Planned Aggregate
Expenditure
A Decline In Planned
Spending Leads To A Recession
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Expenditure line
PAE = 950 + 0.8Y
960
ƒ The Central Bank raises interest rates.
∆ IP < 0, investment falls.
ƒ Prices rise.
Recessionary gap
45o
Copyright c 2004 by The McGraw-Hill
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Makes exports more expensive, ∆NX < 0.
∆G < 0 ∆T > 0, government expenditure falls or taxes
rise.
A decline in autonomous
aggregate expenditure (PAE)
shifts the expenditure line
down
950
4,750 4,800
Y*
ƒ The exchange rate appreciates.
ƒ The government cuts the budget deficit.
E
F
Autonomous Spending can fall because…
because…
The purchasing power of consumers’
consumers’ wealth falls,
∆ C < 0, autonomous consumption falls.
Output Y
Chapter 26: Spending and Output in the
Short Run
53
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Chapter 26: Spending and Output in the
Short Run
54
9
ShortShort-Run
Equilibrium Output After A Fall In Spending
Original Aggregate Expenditure
(1)
Output
Y
(2)
Planned aggregate expenditure
PAE = 960 + 0.8Y
(3)
(4)
Y - PAE
Y = PAE?
4,000
4,160
-160
No
4,200
4,320
-120
No
4,400
4,480
-80
No
4,600
4,640
4,800
4,960
5,120
-40
0
40
80
No
Yes
No
No
4,800
5,000
5,200
(1)
Output
Y
4,600
4,650
4,700
4,750
4,800
4,850
4,900
4,950
5,000
•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
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Chapter 26: Spending and Output in the
Short Run
(2)
Planned aggregate expenditure
PAE = 950 + 0.8Y
4,630
4,670
4,710
4,750
4,790
4,830
4,870
4,910
4,950
(3)
(4)
Y - PAE
Y = PAE?
-30
-20
-10
0
10
20
30
40
50
No
No
No
Yes
No
No
No
No
No
•If Y = 4,800 then PAE = 4,790 < Y
•Y = PAE @ 4,750
•Output Gap: Y* (4,800) > Y (4,750)
55
Chapter 26: Spending and Output in the
Short Run
Copyright c 2004 by The McGraw-Hill
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Planned Aggregate
Expenditure
56
An Increase In Planned
Spending Leads To An Expansion
Y = PAE
Planned aggregate expenditure PAE
Other factors remaining constant, a
decline in autonomous spending causes
shortshort-run equilibrium output to fall.
ƒ If the economy started at full employment, this
creates a recessionary gap.
A decrease in autonomous spending can
be caused by a reduction in C, IP, G,
and/or NX.
Expenditure line
PAE = 960 + 0.8Y
Expenditure line
PAE = 980 + 0.8Y
F
E
An increase in autonomous
aggregate expenditure shifts
the expenditure line up
980
960
Expansionary gap
45o
4,800 4,900
Output Y
Y*
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Chapter 26: Spending and Output in the
Short Run
57
Planned Aggregate
Expenditure
Chapter 26: Spending and Output in the
Short Run
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58
120
February
2005
100
Economic Naturalist
September
2005
80
ƒ What caused the 19901990-1991 recession?
Decline in consumer confidence (C fell)
January
1990
60
• Between January and October 1990, the U of M’
M’s index
of consumer confidence fell by 31%.
August
1990
40
Credit crunch (caused IP to fall)
20
Chapter 26: Spending and Output in the
Short Run
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Jan-91
Cons Confidence 90-91
59
Feb-91
Dec-90
Oct-90
Nov-90
Sep-90
Jul-90
Aug-90
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Jan-90
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0
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Chapter 26: Spending and Output in the
Short Run
60
10
Planned Aggregate
Expenditure
Planned Aggregate
Expenditure
Economic Naturalist
Economic Naturalist
ƒ 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 on all other goods.
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
ƒ What caused the 2001 recession in the United
States?
Reduction in investment spending
61
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Chapter 26: Spending and Output in the
Short Run
62
What do we know so far?
Investment / GDP
18%
Expenditure is of two kinds:
autonomous and induced.
Producers meet demand
at preset prices in the
shortshort-run, so Y=PAE
indicates equilibrium.
If PAE > Y, production increases.
Changes in autonomous PAE change
equilibrium Y.
17%
PA
E
PAE
16%
Y = PAE
15%
45o
14%
Y
13%
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
63
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
64
The Multiplier
The Multiplier
Now, wait a minute!
In the example, autonomous consumption (C) fell
by 10 billion, but equilibrium output fell by 50
billion!
ƒ When Bob’
Bob’s C fell, he stopped buying from Lucas, who
stopped buying from Pedro, who stopped buying from
Alexandra, who stopped buying from you…
you…
ƒ In the example, the incomeincome-expenditure multiplier
equaled 5.
ƒ The size of the multiplier is influenced by the MPC.
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
66
11
The First Five Steps of a
Multiplier
The Multiplier
G increases by 100: they buy $100
worth of staples from Bob.
Bob’s income increases by 100. He
spends 40% of it on Kate’s bikes,
according to his MPC = 0.4.
IncomeIncome-Expenditure Multiplier
MPC = 0.4
100
ƒ The effect of a 11-unit increase in autonomous
expenditure on shortshort-run equilibrium output.
ƒ For example, a multiplier of 5 means: “a 1010unit decrease in autonomous expenditure
reduces shortshort-run equilibrium output by 50
units”
units”.
Kate’s income rises by 40, so she
spends 40% of it on Jason’s burgers.
Jason’s income rises by 16, so he
spends 40% of it on Susan’s vinyl
siding.
Susan’s income increases by 6.4, so
she spends 40% of it on Peter’s travel
agency services.
Peter’s income rises by 2.56, so …
Copyright c 2004 by The McGraw-Hill
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40
16
6.4 2.56
Multiplier = 1/(1-0.4) = 1.7
Chapter 26: Spending and Output in the
Short Run
67
Chapter 26: Spending and Output in the
Short Run
Copyright c 2004 by The McGraw-Hill
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The Multiplier
The Multiplier
Recall
Recall
1. Y = PAE
2. PAE = C + c(Y – T) + IP + G + NX
1. Y = PAE
2. PAE = C + c(Y – T) + IP + G + NX
ƒ Solution
Y = C + c(Y – T) + IP + G + NX
Y = C + cY – cT + IP + G + NX
Y - cY = C–
C– cT + IP + G + NX
Y (1–
(1– c) = C–
C– cT + IP + G + NX
Y=
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Chapter 26: Spending and Output in the
Short Run
69
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The Multiplier
Y=
68
(
)
Y=
Chapter 26: Spending and Output in the
Short Run
70
(
1
C − cT + I P + G + NX
1− c
The Multiplier
Autonomous
Expenditure
Because 0<c<1 (c is positive and less than one),
the multiplier is always positive and bigger than
one.
Copyright c 2004 by The McGraw-Hill
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)
Chapter 26: Spending and Output in the
Short Run
The Multiplier
1
C − cT + I P + G + NX
1− c
The Multiplier
(
1
C − cT + I P + G + NX
1− c
71
)
Autonomous
Expenditure
A change in autonomous spending increases Y
by 1/(11/(1-c).
∆Y = Multiplier * ∆(autonomous
∆(autonomous AE)
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Chapter 26: Spending and Output in the
Short Run
72
12
The Multiplier
Y=
The Multiplier
(
1
C − cT + I P + G + NX
1− c
The Multiplier
)
Y=
C = 620; c = 0.8; T = 250;
IP = 220; G = 300; NX = 20
Plugging this in we get
∆Y
Y=
∆(autonomous
∆(autonomous AE)
Chapter 26: Spending and Output in the
Short Run
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(
1
C − cT + I P + G + NX
1− c
1
(620 − 0.8(250) + 220 + 300 + 20) = 4800
1 − 0 .8
Which takes a lot less work than Table 26.1
73
The Multiplier
Y=
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
74
The Multiplier Equation
)
As the MPC increases, the multiplier
increases:
Suppose now
C = 820; c = 0.7; T = 600;
IP = 600; G = 600; NX = 200
MPC
Multiplier =
1/(1-MPC)
MPC
Multiplier =
1/(1-MPC)
Plugging this in we get
0.3
1.4
0.75
4
0.4
1.7
0.8
5
0.5
2.0
0.9
10
Y=
)
Previously we assumed
Autonomous
Expenditure
Multiplier =
(
1
C − cT + I P + G + NX
1− c
1
(820 − 0.7(600) + 600 + 600 + 200) = 6000
1 − 0 .7
Which takes a lot less work than Exercise 26.1
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
75
The Multiplier Process
76
The process ends when aggregate
production equals aggregate expenditures.
ƒ Businesses reduce production levels,
ƒ Which reduces income, which reduces
expenditures,
ƒ Which reduces production, which reduces
income,
ƒ Which reduces . . . etc.
Chapter 26: Spending and Output in the
Short Run
Chapter 26: Spending and Output in the
Short Run
The Multiplier Process
When aggregate production > aggregate
expenditures:
Copyright c 2004 by The McGraw-Hill
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Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Firms are selling all they produce, so they
have no reason to change their production
levels.
77
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Chapter 26: Spending and Output in the
Short Run
78
13
The Multiplier Process
Autonomous spending is determined
outside the model and is not affected by
changes in income.
income.
Y=PAE
$7,000
Real expenditures
The Multiplier Model in Action
A1
5,500
4,750
4,000
PAE
ƒ When autonomous expenditures shift, the
multiplier process is called into play.
ƒ The multiplier model illustrates how a change
in autonomous spending changes the
equilibrium level of income.
A2
2,500
2,000
B1
B2
$1,000
B
Copyright c 2004 by The McGraw-Hill
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$4,000
C
Real income (in dollars)
$7,000
A
Chapter 26: Spending and Output in the
Short Run
79
The Steps of the Multiplier
Process
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
80
Shifts in the Planned Aggregate
Expenditure Curve
PAE=5000+0.5Y
ƒ The income adjustment process is directly
related to the multiplier.
Any initial shock (a change in autonomous
PAE)
PAE) is multiplied in the multiplier process.
The multiplier process repeats itself again
and again until a new equilibrium level is
finally reached.
Y=PAE
1
∆(C + I P + G + NX)
1- c
1
∆Y =
(−200)
1 - 0.5
= −400
∆Y =
200
200
PAE=4800+0.5Y
100
50
25
400
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
81
Shifts in the Planned Aggregate
Expenditure Curve
Y=PAE
1
∆Y =
∆(C + I P + G + NX)
1- c
1
∆Y =
(100)
1 - 0.75
= 400
PAE=4900+0.75Y
Chapter 26: Spending and Output in the
Short Run
82
Shifts in the PAE curve
Why does the PAE curve shift?
ƒ Because C, IP, G, T, or NX change exogenously.
What happens if autonomous spending falls by X?
ƒ Carlos has X less income, so he spends less (by the
amount of cX)
cX)
ƒ Rosa has cX less income, so she spends ccX less.
ƒ Pedro has c2X less income, so he spends c3X less.
ƒ Victoria has c3X less income, so she spends c4X less.
ƒ Marcos has c4X less income, so he spends c5X less …
ƒ … Eventually income falls by (1/1(1/1-c)X
PAE=4800+0.75Y
42.19
56.25
75
100
400
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Chapter 26: Spending and Output in the
Short Run
83
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Chapter 26: Spending and Output in the
Short Run
84
14
What do we know so far?
Changes in autonomous PAE cause a
“multiplied”
multiplied” change in equilibrium Y.
The size of the multiplier is influenced by
the MPC.
Stabilizing the Economy:
Fiscal Policy
PAE=5000+0.5Y
Y=PAE
Y=
(
1
C − cT + I P + G + NX
1− c
)
200
200
PAE=4800+0.5Y
100
50
25
400
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Chapter 26: Spending and Output in the
Short Run
85
Stabilizing Planned Spending: The
Role of Fiscal Policy
In the Keynesian Model:
Stabilization Policies
ƒ Recessionary and expansionary gaps are
caused by insufficient or excessive spending,
respectively.
Recessionary gaps are marked by excessive
unemployment.
Expansionary gaps, by inflation
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
Stabilizing Planned Spending: The
Role of Fiscal Policy
87
Stabilizing Planned Spending: The
Role of Fiscal Policy
Stabilization Policies
ƒ Stabilization policies are used to affect
planned aggregate expenditures to eliminate
output gaps.
ƒ These are government policies that are used
to affect planned aggregate expenditure, with
the objective of eliminating output gaps.
ƒ They are Monetary and Fiscal policies.
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
88
Stabilizing Planned Spending: The
Role of Fiscal Policy
Tools of fiscal policy
ƒ Expansionary Policies:
Policies: Government policy
actions intended to increase planned
spending and output
ƒ Contractionary Policies:
Policies: Government policy
actions designed to reduce planned spending
and output
ƒ Government spending
Direct effect on PAE
ƒ Taxation
Indirect effect on PAE
• Through C, which is part of PAE.
PAE.
ƒ Transfer payments
Indirect effect on PAE
Copyright c 2004 by The McGraw-Hill
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Chapter 26: Spending and Output in the
Short Run
89
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Chapter 26: Spending and Output in the
Short Run
90
15
An Increase In Government
Purchases Eliminates A Recessionary Gap
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Expenditure line
PAE = 950 + 0.8Y
E
Economic Naturalist
ƒ Why is Japan building roads nobody wants to
use?
Japan has a recessionary gap
$1 trillion spending on public works
The policy has not been successful to date
An increase in G shifts the
expenditure line upward
F
Stabilizing Planned Spending: The
Role of Fiscal Policy
960
• Was not large enough
• Wasteful spending may have demoralized consumers
950
Recessionary gap
45o
4,750 4,800
Output Y
Y*
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Chapter 26: Spending and Output in the
Short Run
91
Stabilizing Planned Spending: The
Role of Fiscal Policy
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Chapter 26: Spending and Output in the
Short Run
92
U.S. Military Expenditures as a
Share of GDP, 19401940-2001
Economic Naturalist
ƒ Does military spending stimulate the
economy?
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Chapter 26: Spending and Output in the
Short Run
93
Stabilizing Planned Spending: The
Role of Fiscal Policy
Taxes and Aggregate Spending
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∆T
Chapter 26: Spending and Output in the
Short Run
Chapter 26: Spending and Output in the
Short Run
94
Stabilizing Planned Spending: The
Role of Fiscal Policy
Example: Using a tax cut to close a recessionary gap
ƒ Taxes affect PAE indirectly
ƒ Lower taxes increase disposable income (Y(Y-T).
T).
ƒ The Consumption Function is
C=C+c(Y
C=C+c(Y--T)
ƒ A tax cut of X increases C by cX.
cX.
ƒ Therefore autonomous spending increases by
cX when T falls by X.
∆C
cX < X.
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= − mpc
95
ƒ Assume
Recessionary gap = 50
MPC = 0.8
Multiplier = 1/(11/(1-0.8) = 1/0.2 = 5
ƒ Use a tax cut (∆
(∆T<0) to eliminate the gap
The tax cut must increase PAE by 10
• 10 x 5 = 50 = the output gap.
For every dollar T ↓ ,
(MPC = 0.8)
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C ↑ by 80 cents
Chapter 26: Spending and Output in the
Short Run
∆C
= − mpc
∆T
96
16
Stabilizing Planned Spending: The
Role of Fiscal Policy
Stabilizing Planned Spending: The
Role of Fiscal Policy
Example
Example
ƒ Y* – Y = 50, multiplier = 5.
ƒ ∴The tax cut must cause ∆C = 10.
ƒ ∆C = 10 = tax cut x MPC = tax cut x 0.8
ƒ Tax cut = ∆C /MPC
= 10/0.8 = 12.5
ƒ A tax cut of 12.5 increases C by 10 which
increases Y by 50.
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Chapter 26: Spending and Output in the
Short Run
∆(autonomous
∆(autonomous AE) =
97
Stabilizing Planned Spending: The
Role of Fiscal Policy
Economic Naturalist
∆(autonomous
∆(autonomous AE)
Multiplier
Chapter 26: Spending and Output in the
Short Run
98
Fiscal Policy as a Stabilization
Tool: Three Qualifications
ƒ Fiscal policy may affect potential output as
well as PAE.
In the spring 2001, the U.S. economy was slowing.
Summer 2001, families received $38 billion in tax
rebates.
Survey indicated that only 22% of the households
anticipated spending most of their rebates.
Tax cuts were accompanied by increases in
government spending to stimulate PAE.
Chapter 26: Spending and Output in the
Short Run
Copyright c 2004 by The McGraw-Hill
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∆Y
Fiscal Policy and the Supply Side
ƒ Why did the federal government send out
millions of $300 and $600 checks to
households in 2001?
Copyright c 2004 by The McGraw-Hill
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ƒ A tax cut of 12.5 increases C by 10 which
increases Y by 50.
ƒ What increase in G is necessary to achieve the
same increase in output?
ƒ If the desired ∆Y = 50 and the multiplier = 5,
∆Y
∆G = 10.
Multiplier =
99
Fiscal Policy as a Stabilization
Tool: Three Qualifications
Government spending and potential output
• Public capital
• R&D
• Human Capital
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Chapter 26: Spending and Output in the
Short Run
100
Fiscal Policy as a Stabilization
Tool: Three Qualifications
Fiscal Policy and the Supply Side
The Problem of Deficits
ƒ Fiscal policy may affect potential output as
well as PAE.
ƒ Sustaining government deficits reduce saving
and investment in new capital goods.
Taxation and potential output
If a society has a goal of keeping deficits low, it
may have less of an incentive to use fiscal policy to
control a recessionary gap.
• Tax break for new investment
• Tax break on interest income may stimulate saving
• Tax break on income may stimulate more work.
Fiscal policy may affect both PAE and Y*.
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Chapter 26: Spending and Output in the
Short Run
101
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Chapter 26: Spending and Output in the
Short Run
102
17
Fiscal Policy as a Stabilization
Tool: Three Qualifications
Fiscal Policy as a Stabilization
Tool: Three Qualifications
The Relative Inflexibility of Fiscal Policy
Automatic stabilizers help offset the
inflexibility of fiscal policy
ƒ A lack of flexibility may reduce the
effectiveness of fiscal policy
ƒ Two limits to fiscal policy flexibility:
ƒ Income tax collections
Government takes in more money (automatically)
when there is an expansionary gap.
Suppose T = tY.
tY. Then ∆T = t∆Y
Higher taxes reduce discretionary income
(∆(Y–
(Y–T)=–
T)=–∆T), reducing autonomous expenditure
(∆C=–
C=–c∆T), and thus closing the expansionary
gap.
The problem of time lags and the legislative
process
Competing political objectives
ƒ Fiscal policy may be useful to address
prolonged periods of recession, but not to
“finefine-tune”
tune” the economy.
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Chapter 26: Spending and Output in the
Short Run
103
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Chapter 26: Spending and Output in the
Short Run
104
What we’ve learned
What we’ve learned
Planned Aggregate Expenditure
= C + IP + G + NX
Actual expenditures may not equal PAE
In the short run, planned aggregate
expenditures determine income and output.
Differences between PAE and Y cause
unplanned changes in inventory, which
cause output to change.
The process stops
PAE
when PAE=Y.
ƒ If so, unplanned inventory changes will occur.
ƒ This will lead to changes in output and PAE.
PAE.
PAE depends positively on income.
ƒ Higher income causes PAE to rise, but only
by a proportion = mpc < 1.
1.
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Chapter 26: Spending and Output in the
Short Run
105
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Chapter 26: Spending and Output in the
Short Run
Changes in autonomous PAE cause
∆Y
1
changes in Y.
=
= multiplier
∆PAE0 1 − mpc
ƒ The economic
process by which this happens is that as one
person’
person’s expenditures rise, someone else’
else’s
income rise, raising his expenditure, etc.
Y=PAE
∆Y
=1
∆PAE
200
∆PAE
= mpc
∆Y
107
PAE=5000+0.5Y
PAE=4800+0.5Y
200
100
400
Chapter 26: Spending and Output in the
Short Run
106
Shifts in the Planned Aggregate
Expenditure Curve
What we’ve learned
Copyright c 2004 by The McGraw-Hill
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Y
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Chapter 26: Spending and Output in the
Short Run
∆Y
1
=
∆PAE0 1 − mpc
108
18
What we’ve learned
What we’ve learned
There’
There’s no reason for shortshort-run equilibrium
output to equal potential output.
Fiscal policy (changes in G or T) can be
used to close output gaps.
ƒ Potential output is determined by the productivity
and availability of labor, capital, etc.
ƒ ShortShort-run equilibrium output
is determined by planned
aggregate expenditures.
ƒ There’
There’s no reason for
these two to be equal.
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Chapter 26: Spending and Output in the
Short Run
Y
Y*
109
ƒ But it may respond slowly or inadequately.
ƒ Because there’
there’s no reason for shortshort-run Y to
be equal to Y*,
ƒ Governments can choose to intervene to
make them equal.
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Chapter 26: Spending and Output in the
Short Run
110
In the long run, is he dead?
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Chapter 26: Spending and Output in the
Short Run
111
19