Download Ch. 13

Frank & Bernanke
3rd edition, 2007
Ch. 13: Spending and
Output in the Short Run
1
(Neo) Classical Theory
Markets always clear.
 When Supply does not equal to
Demand, price changes to equate the
two.
 Labor market works the same way, too.
 In the 19th century, general price levels
sometimes went up and sometimes
down but there hasn’t been any trend.

2
The Great Depression

Living through the Great Depression,
people rightfully questioned the
received wisdom of economists.


If markets tended to clear, why did the
labor market show up to 25%
unemployment?
The 1936 publication of The General
Theory of Employment, Interest and
Money by John Maynard Keynes
provided an explanation for markets not
to clear in the short run.
3
The Model by Keynes
Prices (including the price of labor wages) do not change in the short run.
 Firms respond to demand changes by
adjusting their production and keeping the
price constant.
 Demand changes occur all the time and
the structure of the economy changes as
the demand for say, horse carriages fell
and trains and cars rose. This would not
affect labor.

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The Model by Keynes
If the total spending (aggregate demand)
fell, then almost all markets would feel the
drop in demand.
 Production in general would fall.
 Recession (and depression) would be felt.
 To avoid this aggregate demand shortfall,
the government should step in and by the
use of monetary and fiscal policies, should
stimulate total spending.

5
Why Are Prices Constant in
the Short Run?
Menu costs.
 Fear of uncertainty.
 Contracts.
 Information lag.

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Keynesian Assumption: Firms Meet
Demand at Preset Prices

Will new technologies eliminate menu costs?



Keynesian theory assumes that menu cost prevent
firms from changing prices.
Many new technologies (bar codes) have reduced
menu cost and increased price flexibility.
Pricing decisions also require market analysis,
strategic considerations, and cost analysis.

These factors are a component of menu costs.
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Constant Price Means Wide
Output Fluctuations
P
S
Q1
Q2
Q
8
Circular Flow Explanation
Consumption Expenditures
Firms
Households
Wages, profits, rent, interest
If the upper flow (C+I+G+NX) is LESS THAN the lower flow
(Income = Value of Output), inventories will pile up (I>Ip) and the
firms will cut back in production. If the upper flow is MORE THAN
the lower flow, inventories will fall below the desired level (I<Ip) and
the firms will increase production.
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Circular Flow Explanation
Consumption Expenditures
Firms
Households
Wages, profits, rent, interest
The upper flow is the aggregate demand: C+I+G+NX. The lower flow
is Output: Y. When Aggregate Demand is <Y, Y falls. There is a
positive output gap (Y*-Y>0) and the economy has slowed down.
When I<Ip, C+I+G+NX is greater than Y, or Y>Y* and there is
an expansionary (negative) output gap.
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Aggregate Demand
Fluctuations

Consumption expenditures fluctuate.


Investment expenditures fluctuate.


Optimism/pessimism about the future; interest
rate changes.
Government expenditures change.


Confidence, fear levels, demography, wealth,
taxes, etc. change.
Budget items, wars…
Net Exports change.

Demand for our exports or exchange rates
change.
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Consumption

Relating Consumption to Income and
Other Determinants

The consumption function:
__
C  C  mpc(Y  T )

C = a constant; represents the non income
determinants of C
 Consumer
optimism
 Wealth
 Real
interest rates
12
The U.S. Consumption Function,
1960-2004
13
Algebraic Short Run Equilibrium
Y = C + I + G + NX (Output=Aggregate Demand)
C = a +c (Y-T)
(Consumption=Autonomous+c*Disposable Income)
c = MPC = Change in Consumption/Change in Disposable Income
Y = a +cY -cT + I + G + NX
Y = (a + I +G + NX - cT) + cY
Aggregate Demand Function is comprised of autonomous
and induced parts.
Y = [1/(1-c)][a+I+G+NX-cT]
Equilibrium income is multiplier times autonomous expenditures.14
Numerical Determination of
Short-Run Equilibrium Output
(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
-40
No
4,800
4,800
0
Yes
5,000
4,960
40
No
5,200
5,120
80
No
•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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Determination of Short-Run Equilibrium
Output (Keynesian Cross)
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
960
Equilibrium
• PAE intersects the 45o line @ 4,800
Disequilibrium
• < 4,800, PAE > Y
• > 4,800, PAE < Y
45o
4,800
Output Y
16
Determination of Short-Run Equilibrium
Output (Keynesian Cross)
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
960
Equilibrium Algebraically
• At equilibrium: PAE = C + Ip + G + NX
• Y = 960 + 0.8Y
• 0.2Y = 960
• Y = 960/0.2 = 4,800 = equilibrium
45o
4,800
Output Y
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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
E
F
960
A decline in autonomous
aggregate expenditure (C)
shifts the expenditure line
down
950
Recessionary gap
45o
4,750 4,800
Y*
Output Y
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Determination of Short-Run
Equilibrium Output After a Fall In Spending
(1)
Output
Y
(2)
Planned aggregate expenditure
PAE = 950 + 0.8Y
4,600
4,650
4,700
4,750
4,800
4,850
4,900
4,950
5,000
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 > PAE = 4,790
•Y = PAE @ 4,750
•Output Gap: Y* (4,800) > Y (4,750)
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Japanese Recession

Why was the deep Japanese recession of the
1990s bad news for the rest of East Asia?
 Recession
in Japan reduced Japanese imports
 The decline in East Asian exports to Japan
reduced domestic spending in non-export sectors
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2000-2002 Decline in the
U.S. Stock Market
From March 2000 to March 2002 the S&P
500 fell 49%.
 Households lost $6.5 trillion of wealth in
two years
 $1 decrease in wealth reduces C by 3 to 7
cents/year
 The $6.5 trillion loss could reduce C
between $195 and $455 billion

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2000-2002 Stock Market

C rose from 2000-2002
Higher housing prices (greater wealth)
 Lower interest rates
 Lowering taxes

 Increase

in disposable income (Y – T)
What caused the 2001 recession in the
United States?

Reduction in investment spending
22
Fiscal Policy

Why did the federal government send out
millions of $300 and $600 checks to
households in 2001?
 In
the spring 2001, the U.S. economy was slowing.
 Summer 2001, families received $38 billion in tax
rebates.
 A recent study indicated that two-thirds of the
rebates were spent by households within six
months.
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Multiplier
If a and I drops, what will happen to Y?
 Y = [1/(1-c)][a+I+G+NX-cT]
 One can plug in the new values and find
Y.
 One can take the “Change in Y” to be
equal to [1/(1-c)]*Change in a+I.
 One can show the effect graphically by
shifting AD downward.

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Multiplier
Suppose a dropped from 400 to 350,
and I dropped from 300 to 250. Find
the new equilibrium Y.
 Y = [1/(1-c)][a+I+G+NX-cT]
 Y = 5 (700) = 3500
 DY = 5 (-100) = -500

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Graphical Short Run Equilibrium
AD
AD
800
700
3500
4000
What is the value of the multiplier? What is mpc equal to?
Y
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Role of Fiscal Policy
In the Keynesian system, it is obvious
that in response to changes in C, I, and
NX, government can counter them by
changing G or T.
 If a+I fell by 100, how much G should
change to keep Y=4000?
 If a+I fell by 100, how much T should
change to keep Y=4000?

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The Problem of Deficits
Sustaining government deficits reduce saving
and investment in new capital goods.
 The goal of keeping deficits low may reduce
the incentive to use fiscal policy to control a
recessionary gap.

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Fiscal Policy and the Supply Side

Fiscal policy may affect potential output as
well as Aggregate Expenditures.
Public capital
R&D
 Human Capital
 Transfer payments

29
Limits on Fiscal Policy
The problem of time lags and the legislative
process
 Competing political objectives
 Automatic stabilizers help offset the
inflexibility of fiscal policy

 Transfer
payments
 Income tax collections

Fiscal policy may be useful to address
prolonged periods of recession
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Automatic Stabilizers

Without any act by the Congress, fiscal
measures kick in to keep Y close to Y*.
Income taxes.
 Unemployment insurance.
 Welfare payments.
 Recession aid transfers.

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Does military spending
stimulate the economy?
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