Download Document

ECON 1 – Section 19
Demand and Output
in the Short Run.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 1
GSI: R. Estopina
Contact Details





GSI: Ramon Estopina
Office Hours: No OH this Thursday !!
Office: Evans 508-7
Email: [email protected]
Handouts (only sections 104 & 133) after
class in: http://www.ocf.berkeley.edu/~jaychen/econ1/

Please read: Read before downloading!.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 2
GSI: R. Estopina
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)
Nov. 6th, 2002
ECON 1 – Section 19 – Page 3
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 4
GSI: R. Estopina
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
Nov. 6th, 2002
ECON 1 – Section 19 – Page 5
GSI: R. Estopina
Recap Quiz - 1
Total planned spending on final goods and
service is called

1) total spending.
2) total consumption.
3) aggregate expenditures.
4) aggregate consumption.
5) aggregate demand.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 6
GSI: R. Estopina
Recap Quiz - 2

A firm's actual investment will exceed its planned
investment when
1) it sells less than it planned.
2) It sells more than it planned.
3) interest rates rise.
4) interest rates fall.
5) the economy experiences an unexpected
expansion.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 7
GSI: R. Estopina
Recap Quiz - 3

The largest component of aggregate
demand is
1) consumption.
2) investment.
3) government purchases.
4) exports.
5) imports.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 8
GSI: R. Estopina
Recap Quiz - 4

The objective of stabilization policies is to
1) affect aggregate supply.
2) eliminate output gaps.
3) increase potential GDP.
4) keep inflation constant.
5) cause business cycles
Nov. 6th, 2002
ECON 1 – Section 19 – Page 9
GSI: R. Estopina
Recap Quiz - 5

The value of the MPC is assumed to be
1) less than 1.
2) greater than 1.
3) less than 0.
4) equal to 1.
5) constant.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 10
GSI: R. Estopina
Important to remember:


Equation 1 of the day:
Aggregate Demand (AD): total planned
spending on final goods and services.
AD  C  I  G  NX
p
Nov. 6th, 2002
ECON 1 – Section 19 – Page 11
GSI: R. Estopina
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
Nov. 6th, 2002
ECON 1 – Section 19 – Page 12
GSI: R. Estopina
Important to remember (3)


Components of AD.
A) CONSUMPTION FUNCTION:
C  C  c(Y  T)


C = 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
Nov. 6th, 2002
ECON 1 – Section 19 – Page 13
GSI: R. Estopina
Important to remember (4)

B) Rest of factors are exogenous.
p
I I
GG
NX  N X
TT
Nov. 6th, 2002
ECON 1 – Section 19 – Page 14
GSI: R. Estopina
Important to remember (5)

Combining all equations:
AD  C  I  G  NX
p
AD  C  c(Y  T )  I  G  NX
AD ( C - cT  I  G  N X)  cY

Composed of:

Autonomous AD & Induced AD
Nov. 6th, 2002
ECON 1 – Section 19 – Page 15
GSI: R. Estopina
Important to remember (6)

In equilibrium Y = AD, so:
Y ( C - cT  I  G  N X)  cY
1
Y 
( C - cT  I  G  N X )
1 c

Multiplier:
1
1
Mult. 

1  c 1  MPC
Nov. 6th, 2002
ECON 1 – Section 19 – Page 16
GSI: R. Estopina
Box 25.2 (F&B page 667)



From Example 25.2 (F&B page 664) we have:
 C=620 /c = 0.8 / I = 220 / G =300 /N X=20 / T=250
We know the definition of Aggregate Demand is:
AD = C + Ip + G + NX
And, in the SHORT RUN:
C  C  c(Y  T) 620  0.8(Y  T)
Ip  I  220
G  G  300
NX  N X  20
T  T  250
Nov. 6th, 2002
ECON 1 – Section 19 – Page 17
GSI: R. Estopina
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
Nov. 6th, 2002
ECON 1 – Section 19 – Page 18
GSI: R. Estopina
Problem 25.6 (F&B page 684)

For the following
economy, find




Autonomous
aggregate demand
The multiplier
SR equilibrium
output
Output gap.
Nov. 6th, 2002
C  3,000 0.5(Y  T)
p
I  I  1,500
G  G  2,500
NX  N X  200
T  T  2,000
Y *  12,000
ECON 1 – Section 19 – Page 19
GSI: R. Estopina
Problem 25.6 (cont’d)
A) The relationship between aggregate demand
and output is given by:

AD  C  I p  G  NX
AD  3000  0.5(Y  2000)  1500  2500  200
AD  6200  0.5Y

Autonomous aggregate demand equals 6200,
the part of aggregate demand that does not
depend on output.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 20
GSI: R. Estopina
Problem 25.6 (cont’d)

To find short-run equilibrium output, use
the equation Y=AD and solve for Y:
Y  AD
Y  6200  0.5Y
0.5Y  6200
Y  12,400


What is the Output Gap?
Remember last class: Y*-Y
Nov. 6th, 2002
ECON 1 – Section 19 – Page 21
GSI: R. Estopina
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*
Nov. 6th, 2002
ECON 1 – Section 19 – Page 22
GSI: R. Estopina
Problem 25.6 (cont’d)

The multiplier can be found by the
formula of the multiplier (obviously) =
1/(1-c)
1
1

2
1  c 1  0.5

There is another way to solve it (more
complicated), but I know you are curious.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 23
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 24
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 25
GSI: R. Estopina
Problem 25.7 (F&B page 685)


Following with the previous problem but now
N X = 0.
A) What would be the SR equilibrium output?

We proceed as before:
AD  C  I  G  NX
p
AD  3000  0.5(Y  2000)  1500  2500  0
AD  6000  0.5Y
Nov. 6th, 2002
ECON 1 – Section 19 – Page 26
GSI: R. Estopina
Problem 25.7 (cont’d)

Then we apply the definition of short-run
equilibrium output, Y = AD.
Y  AD
Y  6000  0.5Y
0.5Y  6000
Y  12,000
Nov. 6th, 2002
ECON 1 – Section 19 – Page 27
GSI: R. Estopina
Problem 25.7 (cont’d)


B) Economic recovery abroad increases the
demand for the country’s exports. As a
result N X = 100.
What happens to the SR Equilibrium
Output?
Nov. 6th, 2002
ECON 1 – Section 19 – Page 28
GSI: R. Estopina
Problem 25.7 (cont’d)

An increase of N X by 100 implies that
autonomous aggregate demand rises by 100, so
now we have:
AD  6100  0.5Y
Y  AD
Y  6100  0.5Y
0.5Y  6100
Y  12,200
 So the increase in net exports of 100 has
increased output by 200.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 29
GSI: R. Estopina
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 N X = -100.
What happens to the SR Equilibrium
Output?
Nov. 6th, 2002
ECON 1 – Section 19 – Page 30
GSI: R. Estopina
Problem 25.7 (cont’d)

A decrease of N X by 100 implies that autonomous
aggregate demand falls by 100, so now we have:
AD  5900  0.5Y
Y  AD
Y  5900  0.5Y
0.5Y  5900
Y  11,800

So the decline in net exports of 100 lowers
output by 200.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 31
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 32
GSI: R. Estopina
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).
Nov. 6th, 2002
C  40  0.8(Y  T)
p
I  I  70
G  G  120
NX  N X  10
T  T  150
Y *  580
ECON 1 – Section 19 – Page 33
GSI: R. Estopina
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:
AD  C  I  G  NX
p
AD  40  0.8(Y  150)  70  120  10
AD  120  0.8Y
Nov. 6th, 2002
ECON 1 – Section 19 – Page 34
GSI: R. Estopina
Problem 25.9 (cont’d)


Second, use the condition Y = AD to
solve for short-run equilibrium output:
Y  AD
Y  120  0.8Y
0.2Y  120
Y  600
The output gap is Y*-Y = 580-600 = -20,
so there is an expansionary gap of 20.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 35
GSI: R. Estopina
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:
1
1

5
1  c 1  0.8
Nov. 6th, 2002
ECON 1 – Section 19 – Page 36
GSI: R. Estopina
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
G =116 and re-solving for short-run
equilibrium output.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 37
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 38
GSI: R. Estopina
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 T =115 and solving
for short-run equilibrium output.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 39
GSI: R. Estopina
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 G
shifts the expenditure
line upwards.
600
Nov. 6th, 2002
Y*=630
ECON 1 – Section 19 – Page 40
Output
GSI: R. Estopina
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*.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 41
GSI: R. Estopina
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.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 42
GSI: R. Estopina
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 !!.
Nov. 6th, 2002
ECON 1 – Section 19 – Page 43
GSI: R. Estopina