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What causes fluctuations? Spending and Output in the Short Run What caused the 2001 recession? Lower consumer spending Lower investment Principles of Macroeconomics Why was it so mild? 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 Companies, Inc. All rights reserved. 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 Firms do not respond to every change in the demand for their products by changing their prices. 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 Companies, Inc. All rights reserved. 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. By “meeting the demand,” demand,” we mean that firms produce just enough to satisfy their customers at the prices that have been set. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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: Is a logical management decision because of menu costs or contracts with customers. Also, prices may be sticky because wages are sticky. Prices should be changed only if the benefit of charging the “optimal price” price” exceeds the cost of “price adjustment.” adjustment.” In the long run firms will change prices. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Will new technologies eliminate menu costs? 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 Companies, Inc. All rights reserved. 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. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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.” 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 Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run Exports - imports 11 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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. Suppose a firm planned to sell 500,000 (and keep some as inventory) but only sold 450,000 Then inventories are larger than expected: I > planned Investment (I (IP) Chapter 26: Spending and Output in the Short Run Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Suppose a firm planned to sell 500,000 (and keep some as inventory) but sold 550,000 If inventories are smaller than expected: I < IP 13 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Planned Aggregate Expenditure If actual sales are: Flight Kite Co. produces $5 million of kites per year. Expected sales = $4.8 million and planned inventory accumulation = $200,000 Capital expenditure = $1 million $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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 15 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Planned Aggregate Expenditure Chapter 26: Spending and Output in the Short Run 16 Planned Aggregate Expenditure If actual sales are: Planned Aggregate Expenditure $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 I < IP P Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 17 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Consumption (C (C) accounts for two thirds of total spending. What determines Consumption? 8000.0 6000.0 4000.0 2000.0 0.0 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) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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 The relationship between consumption spending and its determinants, in particular, disposable (after(after-tax) income -0.04 % Change in GDP Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 21 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Planned Aggregate Expenditure C = C + c(Y - T) 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 23 Consumer optimism Wealth Real interest rates Prices Chapter 26: Spending and Output in the Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Short Run 24 4 Planned Aggregate Expenditure Planned Aggregate Expenditure Economic Naturalist Economic Naturalist 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 25 $1 decrease in wealth reduces C (autonomous consumption) by 3 to 7 cents/year The $6.5 trillion loss could reduce C between $195 and $455 billion Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 26 Planned Aggregate Expenditure Planned Aggregate Expenditure Economic Naturalist 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 The incomeincome-related (induced) part of C has also risen Increase in disposable income (Y (Y – T) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 27 Consumption spending C A Consumption Function Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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 (Income after taxes) Disposable income Y-T Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 29 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 30 5 Planned Aggregate Expenditure Planned Aggregate Expenditure Example Planned Aggregate Expenditure and Output 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 Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 32 Planned Aggregate Expenditure Planned Expenditures Planned Aggregate Expenditure From C to PAE, numerically 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 33 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Autonomous expenditure (960) Is independent of output: Does not vary when output changes It varies with prices, consumer confidence, interest rates, wealth, etc. If Y increases by $1, C will increase by 80 cents (c (c = 0.80) And because C is part of PAE, … PAE increases by 80 cents ($1 X 0.80) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run Induced expenditure (0.8Y (0.8Y) Depends on output (Y (Y) 35 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill McGraw-Hill/Irwin Companies, Inc. All rights reserved. Slope = 0.5 Slope = 0.6 200 190 200 400 600 Real output (b) 200 Is the part of expenditure that does not depend on output Induced expenditure 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Suppose planned demand for goods is higher than production: Instead of raising prices, firms will increase production, until Y = PAE. is a condition for economic equilibrium (in the short run) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 The level of output at which output Y equals planned aggregate expenditure PAE 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 41 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 ↑ Suppose PAE < Y ⇒Sales < Production ⇒Inventories rise ⇒Businesses produce less: Y ↓ Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 47 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 ↑ Planned changes in inventory are part of IP. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 49 Determination of ShortShort-Run Equilibrium Output (Keynesian Cross) Chapter 26: Spending and Output in the Short Run Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 The Central Bank raises interest rates. ∆ IP < 0, investment falls. Prices rise. Recessionary gap 45o Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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* The exchange rate appreciates. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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. 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* Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 57 Planned Aggregate Expenditure Chapter 26: Spending and Output in the Short Run Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 58 120 February 2005 100 Economic Naturalist September 2005 80 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Dec-91 Oct-91 Nov-91 Sep-91 Jul-91 Aug-91 Jun-91 Apr-91 May-91 Mar-91 Jan-91 Cons Confidence 90-91 59 Feb-91 Dec-90 Oct-90 Nov-90 Sep-90 Jul-90 Aug-90 Jun-90 May-90 Apr-90 Mar-90 Jan-90 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Feb-90 0 Cons Confidence 2005 Chapter 26: Spending and Output in the Short Run 60 10 Planned Aggregate Expenditure Planned Aggregate Expenditure Economic Naturalist Economic Naturalist 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 Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run What caused the 2001 recession in the United States? Reduction in investment spending 61 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 63 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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! 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… In the example, the incomeincome-expenditure multiplier equaled 5. The size of the multiplier is influenced by the MPC. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 The effect of a 11-unit increase in autonomous expenditure on shortshort-run equilibrium output. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 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= Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 69 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. ) 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) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. ( 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 75 The Multiplier Process 76 The process ends when aggregate production equals aggregate expenditures. Businesses reduce production levels, Which reduces income, which reduces expenditures, Which reduces production, which reduces income, 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 Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 When autonomous expenditures shift, the multiplier process is called into play. 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 Companies, Inc. All rights reserved. $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 Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 80 Shifts in the Planned Aggregate Expenditure Curve PAE=5000+0.5Y 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 Companies, Inc. All rights reserved. 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? Because C, IP, G, T, or NX change exogenously. What happens if autonomous spending falls by X? Carlos has X less income, so he spends less (by the amount of cX) cX) Rosa has cX less income, so she spends ccX less. Pedro has c2X less income, so he spends c3X less. Victoria has c3X less income, so she spends c4X less. Marcos has c4X less income, so he spends c5X less … … Eventually income falls by (1/1(1/1-c)X PAE=4800+0.75Y 42.19 56.25 75 100 400 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 83 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 85 Stabilizing Planned Spending: The Role of Fiscal Policy In the Keynesian Model: Stabilization Policies 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 Companies, Inc. All rights reserved. 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 Stabilization policies are used to affect planned aggregate expenditures to eliminate output gaps. These are government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps. They are Monetary and Fiscal policies. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 88 Stabilizing Planned Spending: The Role of Fiscal Policy Tools of fiscal policy Expansionary Policies: Policies: Government policy actions intended to increase planned spending and output Contractionary Policies: Policies: Government policy actions designed to reduce planned spending and output Government spending Direct effect on PAE Taxation Indirect effect on PAE • Through C, which is part of PAE. PAE. Transfer payments Indirect effect on PAE Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 89 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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* Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 91 Stabilizing Planned Spending: The Role of Fiscal Policy Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 92 U.S. Military Expenditures as a Share of GDP, 19401940-2001 Economic Naturalist Does military spending stimulate the economy? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 93 Stabilizing Planned Spending: The Role of Fiscal Policy Taxes and Aggregate Spending Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. ∆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 Taxes affect PAE indirectly Lower taxes increase disposable income (Y(Y-T). T). The Consumption Function is C=C+c(Y C=C+c(Y--T) A tax cut of X increases C by cX. cX. Therefore autonomous spending increases by cX when T falls by X. ∆C cX < X. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. = − mpc 95 Assume Recessionary gap = 50 MPC = 0.8 Multiplier = 1/(11/(1-0.8) = 1/0.2 = 5 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) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Y* – Y = 50, multiplier = 5. ∴The tax cut must cause ∆C = 10. ∆C = 10 = tax cut x MPC = tax cut x 0.8 Tax cut = ∆C /MPC = 10/0.8 = 12.5 A tax cut of 12.5 increases C by 10 which increases Y by 50. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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 Companies, Inc. All rights reserved. ∆Y Fiscal Policy and the Supply Side Why did the federal government send out millions of $300 and $600 checks to households in 2001? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. A tax cut of 12.5 increases C by 10 which increases Y by 50. What increase in G is necessary to achieve the same increase in output? 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Fiscal policy may affect potential output as well as PAE. 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*. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 101 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 A lack of flexibility may reduce the effectiveness of fiscal policy Two limits to fiscal policy flexibility: 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 Fiscal policy may be useful to address prolonged periods of recession, but not to “finefine-tune” tune” the economy. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 103 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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. If so, unplanned inventory changes will occur. This will lead to changes in output and PAE. PAE. PAE depends positively on income. Higher income causes PAE to rise, but only by a proportion = mpc < 1. 1. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 105 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run Changes in autonomous PAE cause ∆Y 1 changes in Y. = = multiplier ∆PAE0 1 − mpc 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 Companies, Inc. All rights reserved. Y Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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. Potential output is determined by the productivity and availability of labor, capital, etc. ShortShort-run equilibrium output is determined by planned aggregate expenditures. There’ There’s no reason for these two to be equal. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run Y Y* 109 But it may respond slowly or inadequately. Because there’ there’s no reason for shortshort-run Y to be equal to Y*, Governments can choose to intervene to make them equal. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 110 In the long run, is he dead? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 26: Spending and Output in the Short Run 111 19