MBMC Spending and Output in the Short Run Spending and Output in the Short Run

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Spending and Output in the

Short Run

Spending and Output in the

Short Run

Chapter 13: Spending and Output in the Short Run Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Introduction

Spending, in the short run, may not be sufficient to support a normal level of output.

Therefore, recessionary gaps are caused by insufficient aggregate spending.


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Introduction

John Maynard KeynesEconomist, diplomat, financier, journalist,

and patron of the artsPublications include:

The Economic Consequences of the PeaceThe General Theory of Employment, Interest,

and Money


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Introduction

John Maynard KeynesThe General Theory:

Revolutionized economic policyPredicted that a decrease in aggregate

spending could create a recessionary gapSuggests that government policy could be used

to restore full employment


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The Keynesian Model’s Crucial Assumption: Firms Meet Demand at Preset Prices

In the short run, firms meet the demand for their products at preset prices.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.


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In the short run, firms meet the demand for their products at preset prices.By “meeting the demand,” we mean that

firms produce just enough to satisfy their customers at the prices that have been set.


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Meeting Demand at Preset Prices:Is a logical management decision because

of menu costs.Prices should be changed only if the

benefit exceeds the menu cost.In the long run firms will change prices.


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Economic NaturalistWill 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.


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Economic NaturalistWill new technologies eliminate menu

costs?Pricing decisions also require market analysis,

strategic considerations, and cost analysiso These factors are a component of menu costs.


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Planned Aggregate Expenditure

Planned Aggregate ExpenditureTotal planned spending on final goods and

services


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The Components of Planned Aggregate ExpenditureConsumer expenditure or Consumption (C)

Household spending on durables, nondurables, and services


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The Components of Planned Aggregate ExpenditureInvestment (I)

New capital goods spendingNew residential spendingIncreases in inventories


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The Components of Planned Aggregate ExpenditureGovernment purchases

Federal, state, and local spending on goods and services


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The Components of Planned Aggregate ExpenditureNet exports

Exports - imports

NX G I C PAE


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Planned Spending Versus Actual SpendingIn the Keynesian model, output is

determined by PAE.Actual expenditures may not equal PAE.

If inventories are larger than expected:o I > planned Investment (IP)

If inventories are smaller than expected:o I < IP


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ExampleActual and planned investment

Fly-by-Night Kite Co. produces $5 million of kites per year.

Expected sales = $4.8 million and planned inventory = $200,000

Capital expenditure = $1 million


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ExampleIf actual sales are:

$4,600,000 instead of $4,800,000o IP = $1,000,000 + $200,000 = $1,200,000o I = $1,200,000 + $200,000 = $1,400,000o I > IP

$4,800,000o IP = $1.2 m. = I


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ExampleIf actual sales are:

$5,000,000 o IP = $1,000,000 + $200,000 = $1,200,000o I = $1,200,000 - $200,000 = $1,000,000o I < IP


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NX G I C PAE P


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Hey Big Spender! Consumer Spending and the EconomyConsumption (C) accounts for two thirds of

total spendingThe primary determinant of C is

disposable income or Y - T


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Consumption FunctionThe relationship between consumption

spending and its determinants, in particular, disposable (after-tax) income


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Relating Consumption to Income and Other DeterminantsThe consumption function:

C = a constant; represents the non income determinants of C

Consumer optimismWealthReal interest rates

T)- c(Y C C


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Economic NaturalistWhat effect did the 2000-2002 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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$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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C rose from 2000-2002o Higher housing prices (greater wealth)o Lower interest rateso Increase in disposable income (Y – T)


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Consumption Function

c = marginal propensity to consume

c = the amount by which consumption rises when disposable income rises by $1; 0 < c < 1

T)- c(Y C C


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A Consumption Function

Disposable income Y-T

Co

nsu

mp

tio

n s

pen

din

g C

Consumption function

Slope = c = MPCC

T)- c(Y C C


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The U.S. Consumption Function, 1960-2001


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Planned Aggregate Expenditure and OutputThe relationship between changes in

production and income and PAEC is a large part of PAEC depends on YPAE depends on Y


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ExamplePAE = C + IP + G + NXC = C + c(Y – T)PAE = C + c(Y – T) + IP + G + NXC = 620; c = 0.8; T = 250; IP = 220; G

= 330; NX = 20


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ExampleThen:

20 330 220 250) - 0.8( 620 Y PAE

20 330 220 0.8(250) - 0.8 620 Y PAE

20 330 220 2000.8 620 - Y PAE

Y- PAE 0.8 20) 330 220 200(620

Y PAE 0.8 960


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Example

If Y increases by $1, C will increase by 80 cents (c = 0.80)

C is part of PAEPAE increases by 80 cents ($1 X 0.80)

NX G I C Y PAE 0.8 960


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Example

There are two parts to PAE:Autonomous expenditure (960)

o Is independent of outputo Does not vary when output changes

Induced expenditure (0.8Y)o Depends on output (Y)

Y PAE 0.8 960


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Example

PAE = autonomous expenditure + induced expenditure

Y PAE 0.8 960


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Short-run Equilibrium OutputKeynesian Assumption

Producers meet demand at preset prices in the short-run

Short-run equilibrium: Y = PAE


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Short-run Equilibrium OutputThe level of output at which output Y

equals planned aggregate expenditure PAE

Short-run equilibrium output is the level of output that prevails during the period in which prices are predetermined


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Numerical Determination of Short-Run Equilibrium Output

(1) Output

Y

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

(2) Planned aggregate expenditure

PAE = 960 + 0.8Y

(3)

Y - PAE

(4)

Y = PAE?

•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)

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

Expenditure line PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium• PAE intersects the 45o line @ 4,800Disequilibrium• < 4,800, PAE > Y• > 4,800, PAE < Y


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A Decline In Planned Spending Leads To A Recession

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

E


45o

Y = PAE

4,800Y*

Recessionary gap

F


A decline in autonomous aggregate expenditure (C) shifts the expenditure line down

950

4,750


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Determination of Short-Run Equilibrium Output After A Fall In Spending

(1) Output

Y

4,600 4,630 -30 No

4,650 4,670 -20 No

4,700 4,710 -10 No

4,750 4,750 0 Yes

4,800 4,790 10 No

4,850 4,830 20 No

4,900 4,870 30 No

4,950 4,910 40 No

5,000 4,950 50 No

(2) Planned aggregate expenditure

PAE = 960 + 0.8Y

(3)

Y - PAE

(4)

Y – PAE?

•If Y = 4,800 > PAE = 4,790•Y = PAE @ 4,750•Output Gap: Y* (4,800) > Y (4,750)


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ObservationsOther factors remaining constant, a decline

in autonomous spending causes short-run equilibrium output to fall and creates a recessionary gap.

A decrease in autonomous spending can be caused by a reduction in C, IP, G, and/or NX.


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Economic NaturalistWhat caused the 1990-1991 recession?

Decline in consumer confidenceCredit crunch


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Economic NaturalistWhy was the deep Japanese recession of

the 1990s bad news for the rest of East Asia?

Recession in Japan reduced Japanese importsThe decline in East Asian exports to Japan

reduced domestic spending in non-export sectors


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Economic NaturalistWhat caused the 2001 recession in the

United States?Reduction in investment spending


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Income-Expenditure MultiplierThe effect of a 1-unit increase in

autonomous expenditure on short-run equilibrium output

For example, a multiplier of 5 means that a 10-unit decrease in autonomous expenditure reduces short-run equilibrium output by 50 units


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The MultiplierRecall

PAE = 960 + 0.8Y, equilibrium Y = 4,800C fell by 10PAE = 950 + 0.8Y, equilibrium Y = 4,750


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The Multiplier EffectThe decrease in the equilibrium Y was 5

times the fall in C.The income-expenditure multiplier

equaled 5.The size of the multiplier is influenced by

the MPC.


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What Do You Think?Why is the change in equilibrium Y a

multiple of the change in autonomous spending?


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Stabilizing Planned Spending: The Role of Fiscal Policy

In the Keynesian Model:Recessionary and expansionary gaps are

caused by inadequate or excessive spending, respectively.

Stabilization policies are used to affect planned aggregate expenditures to eliminate output gaps.


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Stabilization PoliciesGovernment policies that are used to affect

planned aggregate expenditure, with the objective of eliminating output gaps


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Expansionary PoliciesGovernment policy actions intended to

increase planned spending and output


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Contractionary PoliciesGovernment policy actions designed to

reduce planned spending and output


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Tools of Stabilization PolicyMonetary policyFiscal policy


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Tools of fiscal policyGovernment spending

Direct effect on PAE

TaxationIndirect effect on PAE

Transfer paymentsIndirect effect on PAE


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An Increase In Government Purchases Eliminates A Recessionary Gap

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960


E

An increase in G shifts the expenditure line upward

Output Y

Y = PAE

F

45o

4,800

Recessionary gap


950

4,750

Y*


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Economic NaturalistWhy is Japan building roads nobody wants

to use?Japan has a recessionary gap$1 trillion spending on public worksThe policy has not been successful to date

o Was not large enougho Wasteful spending may have demoralized

consumers


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Economic NaturalistDoes military spending stimulate the

economy?


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U.S. Military Expenditures as a Share of GDP, 1940-2001


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Taxes, Transfers, and Aggregate SpendingTaxes and transfers affect PAE indirectly


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ExampleUsing a tax cut to close a recessionary gap


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ExampleAssume

Recessionary gap = 50MPC = 0.8

Use a tax cut to eliminate the gapThe tax cut must increase PAE by 10For every dollar reduction in taxes,

consumption will increase by 80 cents (MPC = 0.8)


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ExampleAssume

Recessionary gap = 50MPC = 0.8

Use a tax cut to eliminate the gapChange in spending (10) = tax cut x MPC (0.8)

o Tax cut = change in spending/MPC = 10/0.8 = 12.5

An increase in transfers of 12.5 will also raise PAE by 10 (12.5 x 0.8) = 10


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Economic NaturalistWhy 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.


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Economic NaturalistWhy did the federal government send out

millions of $300 and $600 checks to households in 2001?

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.


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Fiscal Policy as a Stabilization Tool: Three Qualifications

Fiscal Policy and the Supply SideFiscal policy may affect potential output as

well as PAE.Government spending and potential output

o Public capitalo R & Do Human Capital


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Fiscal Policy and the Supply SideFiscal policy may affect potential output as

well as PAE.Taxation and potential output

o Tax break for new investmento Tax break on interest income may stimulate saving

Fiscal policy affects both PAE and Y*.


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The Problem of DeficitsSustaining government deficits reduce

saving and investment in new capital goods.


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The Problem of DeficitsThe goal of keeping deficits low may

reduce the incentive to use fiscal policy to control a recessionary gap.


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The Relative Inflexibility of Fiscal PolicyA lack of flexibility may reduce the

effectiveness of fiscal policyTwo limits to fiscal policy flexibility

o The problem of time lags and the legislative processo Competing political objectives


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The Relative Inflexibility of Fiscal PolicyA lack of flexibility may reduce the

effectiveness of fiscal policyAutomatic stabilizers help offset the inflexibility

of fiscal policyo Transfer paymentso Income tax collections

Fiscal policy may be useful to address prolonged periods of recession


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Automatic StabilizersProvisions in the law that imply automatic

increases in government spending or decreases in taxes when real output declines

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End ofChapterEnd of

Chapter

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MBMC Spending and Output in the Short Run Spending and Output in the Short Run