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Chapter 21: Spending and
Output in the Short Run
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Learning Objectives
1. Identify the key assumptions of the basic
Keynesian model and explain how this affects
firms' production decisions
2. Discuss the determination of planned
investment and aggregate consumption
spending and how these are used to develop
the model of planned aggregate spending
3. Analyze, using graphs and numbers, how an
economy reaches short-run equilibrium in the
basic Keynesian model
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Learning Objectives
4. Show how a change in planned aggregate
expenditure can cause a change in shortrun equilibrium output and how this is
related to the income-expenditure
multiplier
5. Explain why the basic Keynesian model
suggests that fiscal policy is useful as a
stabilization policy, and discuss the
qualifications that arise in applying fiscal
policy in real-world situations
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Recessionary Gap
 Great Depression
 Available
resources are unemployed
 Demand for goods and services unmet
 A decrease in spending leads to lower
production
 Laid-off
workers reduce their spending
 Insufficient spending to support the normal level of
production
 Conventional economic policy of the 1920s
and 1930s would not solve this problem
 John
Maynard Keynes revolutionized economic
thought and public policy
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John Maynard Keynes (1883 – 1946)
 After World War I, Keynes recognized that
the terms of the peace would lead to another
war
 German
war reparations would prevent growth
and recovery
 The General Theory of Employment, Interest, and
Money (1936) is his best-known work
 Problem
was explaining why economies kept a
recessionary gap for long periods


Aggregate spending is too low for full employment
Stabilization policies use government spending or taxes
to substitute for spending in other sectors
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Keynesian Model
 Building block for current theories of shortrun economic fluctuations and stabilization
policies
 In the short run, firms meet demand at preset
prices
 Firms
typically set a price and meet the demand at
that price in the short run

Menu price is the cost of changing prices
• Determining the new price
• Incorporating prices into the business
• Informing consumers of new prices
 Firms change prices when the marginal
benefits exceed the marginal costs
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Technology of Changing Prices
 Technology has reduced menu costs
 Bar
codes and scanners reduce costs of changing
prices in the store
 Online surveys
 Highly segmented airline pricing
 Internet mechanisms for setting price
 eBay
■
Priceline
 Other costs remain
 Competitive
analysis
prices
 Informing consumers
■
Deciding the new
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Planned Aggregate Expenditure (PAE)
PAE is planned spending on final goods and
services
Four components of planned aggregate
expenditure
 Consumption
(C) by households
 Investment (I) is planned spending by domestic
firms on new capital goods
 Government purchases (G) are made by
federal state and local governments
 Net exports (NX) is exports minus imports
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Planned versus Actual Investment Example
 Suppose Khedr Papyrus Company produces $5
million of Egyptian papyrus paintings per year
 Expected
sales are $4.8 million and planned
inventory increase is $0.2 million
 Capital expenditure of $1 million is planned

Total planned investment is $1.2 million
 If actual sales are only $4.6 million
 Unplanned
inventory investment of $0.2 million
 Actual investment is $1.4 million
 If actual sales are $5.0 million


Unplanned inventory decrease of $0.2 million
Actual investment is $1.0 million
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Planned Aggregate Expenditure
 Actual spending equals planned spending for
 Consumption
 Government
 Net
purchases of final goods and services
exports
 Adjustments between actual and planned
spending are accomplished with changes in
inventories
 The general equation for planned aggregate
expenditures is
P
PAE = C + I + G + NX
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Consumption Spending and the Economy
Consumption (C) accounts for two-thirds
of total spending
 Powerful
determinant of planned aggregate
spending
 Includes purchases of goods, services, and
consumer durables, but not houses

Rent is considered a service
C depends on disposable income, (Y – T)
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The Egyptian Consumption Function, 20072011
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The Turkish Consumption Function, 20072011
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The UAE Consumption Function, 2007- 2011
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Consumption Function
The consumption function is an equation relating
planned consumption to its determinants,
notably disposable income (Y – T)
C = C + (mpc) (Y – T)
where C is autonomous consumption spending and
mpc is the change in consumption for a given
change in (Y – T)
 Autonomous consumption is spending not related to
the level of disposable income

A change in C shifts the consumption function
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Consumption Function
C = C + (mpc) (Y – T)
The wealth effect is the tendency of
changes in asset prices to affect household's
wealth and this consumption spending
 This
effect is included in C
C also captures the effects of interest rates
on consumption
 Higher
rates increase the cost of using credit
to purchase consumer durables and other
items
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Consumption Function
C = C + (mpc) (Y – T)
Marginal propensity to consume (mpc)
is the increase in consumption spending
when disposable income increases by $1
 mpc
is between 0 and 1 for the economy
 If households receive an extra $1 in income,
they spend part (mpc) and save part
(Y – T) is disposable income
 Output
plus government transfers minus taxes
 Main determinant of consumption spending
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Consumption spending (C)
Consumption Function
C = C + (mpc) (Y – T)
Intercept
C
slope
ΔC
C
Δ (Y – T)
Slope = Δ C / Δ (Y – T)
Disposable income (Y – T)
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Planned Aggregate Expenditure And Output
Two dynamic patterns in the economy
Declines in production lead to reduced
spending
2. Reductions in spending lead to declines in
production and income
1.
Consumption is the largest component of
PAE
 Consumption
depends on output, Y
 PAE depends on Y
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Linking Planned Aggregate Expenditure To
Output
PAE = C + IP + G + NX
C = C + mpc (Y – T)
PAE = C + mpc (Y – T) + IP + G + NX
 Suppose that planned spending components
have the following values
C = 620
IP = 220
mpc = 0.8
G = 330
T = 250
NX = 20
PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20
PAE = 960 + 0.8 Y
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Linking Planned Aggregate Expenditure To
Output
C = 620 + 0.8 (Y – 250)
PAE = 960 + 0.8 Y
 If Y increases by $1, C will increase by $0.80
 PAE
increases by 80 cents
 Planned aggregate expenditure has two parts
 Autonomous
expenditure, the part of spending
that is independent of output

$960 in our example
 Induced
expenditure, the part of spending that
depends on output (Y)

0.8 Y in our example
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Planned aggregate expenditure (PAE)
Planned Expenditure Graph
PAE = 960 + 0.8Y
960
Slope = 0.8
4,800
Output (Y)
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Short-Run Equilibrium
 Short-run equilibrium is the level of output at
which planned spending is equal to output
 No
change in output as long as prices are constant
 Our equilibrium condition can be written
Y = PAE
 Using our previous example,
PAE = 960 + 0.8 Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
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Short-Run Equilibrium Search
Output (Y) PAE = 960 + 0.8 Y
4,000
4,160
4,200
4,400
4,600
4,800
5,000
5,200
Y – PAE
–160
Y = PAE?
No
–120
–80
–40
0
40
80
No
No
No
Yes
No
No
4,320
4,480
4,640
4,800
4,960
5,120
 Only when Y = 4,800 does planned spending equal
output
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Planned aggregate expenditure (PAE)
Short-Run Equilibrium Graph
Y = PAE
PAE = 960 + 0.8Y
Slope = 0.8
960
45o
4,800
Output (Y)
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Output Greater than Equilibrium
Y = PAE
PAE = 960 +
0.8Y
PAE
 Suppose output reaches
5,000
 Planned spending is less
than total output
 Unplanned inventory
increases
 Businesses slow down
production
 Output goes down
96
0
45o
4,800
5,000
Output (Y)
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Output Less than Equilibrium
Y = PAE
PAE = 960 +
0.8Y
PAE
 Suppose output is only
4,500
 Planned spending is
more than total output
 Unplanned inventory
decreases
 Businesses speed up
production
 Output goes up
96
0
4,700 4,800
Output (Y)
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Planned aggregate expenditure
(PAE)
Lower Equilibrium
Y = PAE
PAE = 960 + 0.8Y
PAE = 950 + 0.8Y
E
F
960
950
45o
Recessionary gap
4,750 4,800
Y* Output Y
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New Equilibrium
–
 Autonomous consumption, C, decreases by 10
 Causes
a downward shift in the planned aggregate
expenditures curve
 The economy eventually adjusts to a new lower
level of equilibrium spending an output, $4,750
 Suppose that the original equilibrium level,
$4,800, represented potential output, Y*
A
recessionary gap develops
 Size of the recessionary gap is 4,800 – 4,750 = $50
 Entire decrease is in Consumption spending
 Same process applies to a decrease in IP, G, or
NX
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New Short-Run Equilibrium Search
Output
(Y)
4,600
4,650
4,700
PAE = 950 + 0.8 Y
Y – PAE
Y = PAE?
4,630
4,670
4,710
–30
–20
–10
No
No
No
4,750
4,800
4,850
4,900
4,750
4,790
4,830
4,870
0
10
20
30
Yes
No
No
No
4,950
5,000
4,910
4,950
40
50
No
No
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Japan's Recession and East Asia
 Japanese recession in 1990s reduced Japanese
imports
 East Asian economies developed by promoting
exports
 The
decrease in exports to Japan decreased
planned aggregate expenditures in these countries
 The decrease in planned spending caused the
economies to contract to a new, lower level of
planned spending and output

Japan exported its recession to its neighbors
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The Multiplier
 The income – expenditure multiplier shows
the effect of a one-unit increase in
autonomous expenditure on short-run
equilibrium output
 Previous





example
Initial planned expenditure = 960 + 0.8 Y
New planned expenditure = 950 + 0.8 Y
Equilibrium changed from $4,800 to $4,750
A $10 change in autonomous expenditures caused a $50
change in output
Multiplier = 5
 The
larger mpc, the greater the multiplier
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Stabilizing Planned Spending: The Role of
Fiscal Policy
 Stabilization policies are government
actions to affect planned spending with the
intention of eliminating output gaps
 Expansionary
policies increase planned
spending
 Contractionary policies decrease planned
spending
 Two major stabilization tools are fiscal policy and
monetary policy


Fiscal policy uses changes in government spending,
transfers, or taxes
Monetary policy uses changes in the money supply
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Government Purchases and Planned Spending
 Government spending is part of planned spending

Changes in government spending will directly affect
planned aggregate expenditures
 Suppose planned spending decreases $ 10 from
Y = 960 + 0.8 Y
to
Y = 950 + 0.8 Y

Equilibrium Y decreases from $4,800 to $4,750

Recessionary gap is $50
 Stabilization policy indicates a $10 increase in
government spending will restore the economy to
Y* at $4,800
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Planned aggregate expenditure
(PAE)
$10 Fiscal Stimulus
Y = PAE
PAE = 960 + 0.8Y
PAE = 950 + 0.8Y
E
F
960
95
0
45o
4,750 4,800
Y* Output Y
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Japanese Spending
 In the 1990s Japan spent over $1 trillion on
public works
 Highways,
subways, and transportation projects
 Concert halls
 Re-laying cobblestone sidewalks
 Projects did not end the recession
 Prevented
larger decrease in income
 Eroded consumer confidence because there was
little demand

Consumers reduced spending in anticipation of higher
taxes in the future
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Taxes, Transfers and Aggregate Spending
Planned aggregate expenditures are affected
by taxes and transfers
 The
effect is indirect, channeled through the
effects on disposable income


Lower taxes or higher transfers increase disposable
income
Increases in disposable income lead to higher C
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Tax Cuts Stimulate – An Example
 Original planned spending Y = 960 + 0.8 Y
 Autonomous spending decreases Y = 950 + 0.8 Y
 Recessionary gap is $50
 Tax cut to close the gap must be bigger than $10
 Increase
disposable income to cause initial increase in
spending to be $10

Taxes will have to go down by $12.5
Output
(Y)
Net Taxes
(T)
Disposable
Income (Y – T)
Consumption
610 + 0.8 (Y – T)
4,750
250
4,500
4,210
4,750
237.5
4,512.5
4,220
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Fiscal Policy as A Stabilization Tool: Three
Qualifications
 Fiscal policy may affect potential output as well
as potential spending
 Investment
in infrastructure increases Y*
 Taxes and transfers affect incentives and could
decrease potential output, Y*
 Supply-side economists argue the primacy of
supply-side effects of fiscal policy
 Current thinking is more moderate
 Demand-side
effect of spending matter
 Supply-side effects also matter
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Fiscal Policy and Deficit Spending
 Government deficit is the difference between
government spending and net taxes, (G – T)
 Large
and persistent budget deficits reduce
national saving

Less saving means less investment which means less
growth
 Managing the impact of the deficit limits the
government's ability to use fiscal policy as a
stimulus
 Political
considerations make it difficult to use
contractionary fiscal policy
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Fiscal Policy Flexibility
Two limits to fiscal policy flexibility
 The

legislative process requires time
Change in fiscal policy may be slow
 Competing


political objectives
National defense
Entitlements such as unemployment benefits and
welfare payments
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Fiscal Policy Can Be Effective
Automatic stabilizers increase
government spending or decrease taxes
when real output declines
 Built
into laws so no decision is required
 Unemployment compensation, progressive
income tax
Fiscal policy may be useful to address
prolonged periods of recession
 Monetary
policy is more often used to stabilize
the economy
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Chapter 21
Appendix A
An Algebraic Solution
of the Basic Keynesian Model
The Basic Keynesian Model
PAE = C + IP + G + NX
–
C = C + mpc (Y – T)
The consumption function is defined by
 C,
autonomous consumption
 mpc, the marginal propensity to consume, a number
between 0 and 1
IP, G, T and NX are given
–
I=I
planned investment
–
G=G
government purchases
–
T =T
–
NX = NX
–
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net taxes
net exports
44
Find Short-Run Equilibrium Output
–
– – – ––
PAE = C + mpc (Y – T) + I + G + NX
–
– – – ––
PAE = C – mpc T + I + G + NX + mpc Y
Equilibrium condition is PAE = Y
–
– – – ––
Y = C – mpc T + I + G + NX + mpc Y
–
– – – ––
Y – mpc Y = C – mpc T + I + G + NX
–
– – – ––
(1 – mpc) Y = C – mpc T + I + G + NX
–
– – – ––
C – mpc T + I + G + NX
Y=
(1 – mpc)
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Short-Run Equilibrium Example
–
– – – ––
C – mpc T + I + G + NX
Y=
(1 – mpc)
–
C = 620
–
G = 300
–
T = 250
Y=
–
I = 220
––
NX = 20
mpc = 0.8
620 – 0.8 (250) + 220 + 300 +20
(1 – 0.8)
Y = 960 / 0.2 = 4,800
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Chapter 21
Appendix B
The Multiplier in
the Basic Keynesian Model
The Income and Expenditure Multiplier
Suppose autonomous spending decreases
$10 and mpc is 0.8
 First

decrease in spending is $10
Leads to a decrease in output of $10
 Second
decrease in spending is $8
 Third decrease is $6.40, etc.
Sum of the decreases in spending
10 + 8 + 6.4 + 5.12 + …
= 10 [1 + 0.8 + (0.8)2 + (0.8)3…]
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Income and Expenditure Multiplier
 To find the sum of the series, we need a relationship
when x is between 0 and 1
x2
x3
1+x+ + +
 In our case, x = 0.8
x4 +
1
…=
= multiplier
(1 – x)
10 [1 + 0.8 + (0.8)2 + (0.8)3…]
= 10
1
1
= 10
(1 – 0.8)
(1 – x)
= 10 (1 / 0.2) = 10 (5) = 50
 In this case, the multiplier is 5
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