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Spending and
Output in the
Short Run
Instructor: Xi Wang
UMSL, Summer 2015
Learning Objectives
1. Identify the key assumptions of the basic Keynesian
model
2. Discuss the determination of planned investment and
aggregate consumption spending
3. Analyze how an economy reaches short-run
equilibrium in the basic Keynesian model
4. Show how a change in planned aggregate
expenditure can cause a change in the short-run
equilibrium output
5. Explain why the basic Keynesian model suggests that
fiscal policy is useful
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Introduction Suppose the stock market crashes; people lose their life
savings; they are forced to reduce spending.
GDP falls due to a reduction in aggregate spending.
A recessionary gap is created.
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Introduction Great Depression
Available resources are unemployed
Demand for goods and services not met
A decrease in spending leads to lower
production
Laid-off workers reduce their spending
Insufficient spending to support the normal level of production
No problem with productive capacity
Conventional economic policy of the 1920s
and 1930s would not solve this problem
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John Maynard Keynes John Maynard Keynes revolutionized economic
thought and public policy
For a brief history:
http://www.bbc.co.uk/history/historic_figures/keynes_j
ohn_maynard.shtml
Economist, diplomat, financier, journalist, and patron
of the arts
In The General Theory of Employment, Interest and
Money, he
Predicted that a decrease in aggregate spending could create a
recessionary gap
Suggested that government policy could be used to restore full
employment
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John Maynard Keynes Masters of Money Part 1
https://www.youtube.com/watch?v=CkHooEp3vRE
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The Keynesian Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
The Keyenisian Model is a building block for
current theories of short-run economic
fluctuations and stabilization policies
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 change
quantity to meet the demand at that price.
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The Keynesian Model’s Crucial Assumption:
Firms Meet Demand at Preset Prices
Meeting Demand at Preset Prices:
Is a logical management decision because of menu costs.
Prices should be changed only if the additional benefit exceeds the extra menu cost.
In the long run firms will change prices.
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Menu Costs
New technologies have certainly reduced (but not
eliminated) menu costs.
Example: bar codes on products; scanner technology, etc.
Pricing decisions also require time consuming market analysis,
strategic considerations, and cost analysis - these factors are
also components of menu costs.
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Planned Aggregate Expenditure
Keynesian theory hypothesizes that output at each point in time is determined by the total amount that people want to spend on final goods and services throughout the economy.
This is referred to as Planned Aggregate Expenditure (PAE)
The Components of PAE :
Consumer expenditure or Consumption (C)
Planned Investment expenditures (IP)
Government expenditures (G)
Expenditures on Net Exports (NX)
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Planned Aggregate Expenditure
Consumption Expenditure (C)
Household spending on durables, nondurables, and services
Planned Investment (IP)
Spending on New capital goods
Spending on New residential buildings
Increases in inventories
Government purchases (G)
Federal, state, and local spending on goods and services
Net exports (NX)
Exports - Imports
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Planned vs. Actual Aggregate
Expenditure Therefore, Planned Aggregate Expenditure is given as the
following sum:
This may or may not be equal to Actual Expenditures which equals
C + I + G + NX
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NX G I C PAE P
Planned Spending versus Actual
Spending
In the Keynesian model, output is determined
by PAE. However, Actual expenditures may
not equal PAE.
If inventories are larger than expected: Actual
Investment (I) > planned Investment (IP), and
Actual Expenditure > PAE
If inventories are smaller than expected: Actual Investment (I) <
planned Investment (IP), and
Actual Expenditure < PAE
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Planned Spending versus Actual
Spending
Example:
Fly-by-Night Kite Co. produces $5 million kites per year.
Expected sales = $4.8 million kites and planned inventory = $200,000
kites which it expects to store in the warehouse for future sale.
During the year, the company makes new Capital expenditure worth
$1 million, as part of an expansion plan.
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Planned Spending versus Actual
Spending
If actual sales are $4,600,000 (low demand)
IP = $1,000,000 + $200,000 = $1,200,000
I = $1,000,000 + $400,000 = $1,400,000
I > IP
If actual sales are $4,800,000 (demand exactly as expected)
IP = $1.2 m. = I If actual sales are $5,000,000 (high demand)
IP = $1,000,000 + $200,000 = $1,200,000
I = $1,000,000 + $200,000 - $200,000 = $1,000,000; I < IP
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Planned Aggregate Expenditure
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Since firms meet demand at preset
prices, they cannot control how much
they sell. So planned I may well be
different from actual I. For simplicity we
assume that C, G and NX always equal
their planned levels
The only way for PAE and Actual
Expenditures (Y) to be different is if IP
and I are different.
Consumption Function
Consumption (C) accounts for two
thirds of total spending
The primary determinant of C is
disposable income or Y - T
Consumption Function is the
relationship between consumption
spending and its determinants, in
particular, disposable (after-tax)
income
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Consumption Function
The consumption function:
C is a constant; it represents the non income determinants of C, like
Consumer optimism; Wealth; Real interest rates
c is the marginal propensity to consume; 0<c<1
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T)- c(Y C C
The U.S. Consumption
Function, 1960-2007
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Consumption and the Stock
Market
What 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
Historically, a $1 decrease in wealth reduces overall consumer spending C by 3 to 7 cents/year (i.e., 3% to 7%)
The $6.5 trillion loss could reduce Consumption between $195 and $455 billion
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Consumption and the Stock
Market
On the Contrary, Consumption Expenditures (C) continued to increase between 2000 and 2002. This is explained by
Higher housing prices (greater wealth)
Lower interest rates increased consumer spending on big ticket items, like automobiles etc.
Real after tax income (Y - T) continued to rise until Fall 2001 despite the recession that started in March 2001.
Look at Nature of 2001 Recession Handout
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A Consumption Function
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Disposable income Y-T
Co
nsu
mp
tio
n s
pe
nd
ing
C Consumption function
Slope = c = MPCC
T)- c(Y C C
Back to Planned Aggregate
Expenditure
Planned Aggregate Expenditure and Output
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NX G I C PAE P
T)- c(Y C C
PAE = C + c(Y – T) + IP + G + NX
Planned Aggregate Expenditure
Suppose:
C = 620; c = 0.8; T = 250; IP = 220;
G = 300; NX = 20
Then:
PAE = [620 + 0.8(Y - 250) + 220 + 300 + 20
= 620 - 200 + 220 + 300 + 20 = 0.8 Y
Therefore,
PAE = 960 + 0.8 Y
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Planned Aggregate Expenditure
Relationship between PAE and Output is given by:
PAE = 960 + 0.8 Y
The part of PAE that is independent of output is called Autonomous Expenditure (=960)
The part of PAE that depends on output Y is called Induced Expenditure (=0.8Y)
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Short Run Equilibrium Output
Keynesian Assumption
Producers meet demand at preset prices in the short-run
Short-run equilibrium is achieved when output (actual
expenditure) equals planned spending: Y = 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
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(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, Y<PAE
If Y=5,000, PAE = 960 + .8(5,000) = 4,960,
Y>PAE
Determination of Short-Run Equilibrium
Output (Keynesian Cross)
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Output Y
Pla
nn
ed
ag
gre
ga
te e
xp
en
ditu
re
PA
E
960
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
45o
Y = PAE
4,800
Equilibrium when PAE intersects
the 45o line @ 4,800
Disequilibrium
If Y < 4,800, PAE > Y
If Y > 4,800, PAE < Y
Short Run Equilibrium
Algebraically, we have short run
equilibrium when,
Y = PAE
Y = 960 + 0.8 Y
0.2 Y = 960
Y* = 960/0.2 = 960 x 5 = $4800
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Output Greater than Equilibrium
Suppose output
reaches 5,000
Planned spending is
less than total output
Unplanned inventory
increases
Businesses slow down
production
Output goes down
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Output Less than Equilibrium
Suppose output is only
4,700
Planned spending is more
than total output
Unplanned inventory
decreases
Businesses speed up
production
Output goes up
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PA
E
Output
(Y)
96
0
PAE = 960 +
0.8Y
Y = PAE
4,8004,700
Planned Aggregate Expenditure
Other factors remaining constant, a decline in autonomous spending causes short-run equilibrium output to fall and creates a recessionary gap.
Other factors remaining constant, an increase in autonomous spending causes short-run equilibrium output to rise and creates an expansionary gap.
A decrease (increase) in autonomous spending can be caused by a reduction (increase) in autonomous C, IP, G, and/or NX.
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Recessionary Gap: Demand Falls
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Determination of Short-Run
Equilibrium Output After A Fall In Spending
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(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 = 950 + 0.8Y
(3)
Y - PAE
(4)
Y – PAE?
Short Run Equilibrium
New equilibrium with reduced
planned expenditure
Y = 950 + 0.8 Y
0.2 Y = 950
Y = 950/0.2 = 950 x 5 = $4750
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Spending and Output in the Short Run; F&B 4th ed Slide 36
The Multiplier
Income-Expenditure Multiplier measures the effect of a 1-
unit increase in autonomous expenditure on short-run
equilibrium output
m = 1/(1-c) = 1/(1-0.8) = 5
Therefore, if autonomous expenditure rises (falls) by $4,
output will rise (fall) by $20 in the short run.
Spending and Output in the Short Run; F&B 4th ed Slide 37
Planned Aggregate Expenditure
Why is the change in equilibrium Y a multiple of the
change in autonomous spending?
Spending and Output in the Short Run; F&B 4th ed Slide 38
Tax Multiplier
Is c/(1-c) = 0.8/(1-0.8) = 4
Tax multiplier is less than govt. expenditure multiplier.
If Govt. expenditure rises by $Z, everything else remaining constant (including taxes), equilibrium GDP rises by 1/(1 – c) ×$Z.
If taxes FALL by $Z, everything else remaining constant (including govt. expenditure), equilibrium GDP rises by c/(1 – c) ×$Z.
Spending and Output in the Short Run; F&B 4th ed Slide 39
Balanced Budget
Multiplier Govt. budget is G – T. Suppose govt. expenditure and
taxes both rise by $Z. The balanced budget multiplier is
1/(1-c) – c/(1-c) = 1
Equilibrium GDP will rise by $Z.
The Case of Japan
Japanese Govt. built a 160 mile toll road in
Hokkaido that is not used very much. Why?
Application of keyenesian fiscal policy – spend about $1 trillion in
public works projects
The policy was not been successful
too little too late
more productive investments may have helped more by raising
consumer confidence and increasing the long run productive
capacity of the nation
Consumers realize that eventually taxpayers will have to foot the bill
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Causes of Recent Recessions
What caused the 1990-1991 recession in the
US?
Decline in consumer confidence following Iraq-Kuwait War and the
associated rise in oil prices
Credit crunch following large real estate loans by US banks that
could not be recovered (the Savings and Loan debacle)
Robust investment spending, 1995 – 2000
High growth economy
New technologies: internet, fiber optics, genetic engineering
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Causes of Recent Recessions
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What caused the 2001 recession in the United
States?
Reduction in investment spending - an adjustment
to the over-optimistic investments earlier
Recession caused by a decline in autonomous
spending
Less investment in 2001
Terrorist attack 9/11
Travel spending decreased
Recovery began 2002 – in the form of a housing boom
Stabilizing Planned
Spending: The Role of
Fiscal Policy In the Keynesian Model:
Recessionary and expansionary gaps are caused by
inadequate or excessive spending, respectively.
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Stabilization Policies are
Government policies that are used to affect
planned aggregate expenditure, with the
objective of eliminating output gaps
Two kinds of Stabilization
Policies Expansionary Policies
Government policy actions intended to increase planned
spending and output and eliminate recessionary gap
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Contractionary Policies
Government policy actions designed to
reduce planned spending and output and
eliminate expansionary gap
Tools of Stabilization
Policies Tools of Stabilization Policy
Fiscal Policy
Government Expenditures -
direct effect on PAE
Taxes and Transfer Payments -
indirect effect of PAE
Monetary policy
Money Supply and rate of
interest
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Taxes and the Short run
Equilibrium Example
Using a tax cut to close a recessionary gap
Assume
Recessionary gap = 50 ($4750
instead of $4800)
MPC = 0.8; multiplier = 5
Need to raise PAE by $10
Use a tax cut to eliminate the gap
The tax cut must increase PAE by $10
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Stabilizing Planned
Spending: The Role of
Fiscal PolicyFor every dollar reduction in taxes,
consumption will increase by 80
cents (MPC = 0.8); so PAE will
increase by 80 cents So to raise PAE by $10 we need a tax cut of 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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Recent Tax Rebates
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.
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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Spending and Output in the Short Run; F&B 4th ed Slide 49
The Case of Japan
Why was the deep Japanese recession
of the 1990s bad news for the rest of
East Asia?
Recession in Japan reduced
Japanese imports (East Asian
exports)
Wages and profits declined in East
Asian export industries which spilled
over to the non-export sectors
Fiscal Policy as a Stabilization
Tool: Three Qualifications 1. Fiscal Policy and the Supply Side
Keyenesian Model assumes fiscal policy affects PAE only
Supply side argument - tax breaks give individuals incentive to invest, take risks and create capital, thereby raising potential output; no effect on PAE is expected
In reality, fiscal policy may affect potential output as well as PAE. Government expenditures on public capital (roads, airports), R&D, and human capital (education) will affect potential output
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Fiscal Policy as a Stabilization
Tool: Three Qualifications
2. The Problem of Rising Budget Deficits
Sustained government deficits reduce saving and
investment in new capital goods – crowding out.
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 as a Stabilization
Tool: Three Qualifications 3. A lack of flexibility may reduce the effectiveness of
fiscal policy
Two limits to fiscal policy flexibility
The problem of time lags and the
legislative process
Competing political objectives
Fiscal policy is therefore less useful for
stabilizing aggregate spending than the
basic Keyenesian model suggests.
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Fiscal Policy and Automatic
Stabilizers Automatic stabilizers help offset the inflexibility
of fiscal policy. These are provisions in the law
that imply automatic increases in government
spending or decreases in taxes when real
output declines (unemployment benefits,
taxes are hooked to incomes). These change
automatically without the delays of the
legislative process.
Fiscal policy may be useful to address prolonged periods of recession
- Great Depression
In the US, monetary policy has been used more frequently.
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Some Interesting Videos
Round 1:
https://www.youtube.com/watch?v=d0nERTFo-Sk
Round 2:
https://www.youtube.com/watch?v=GTQnarzmTOc
Keynes vs. Hayek Rap Video, Round 2: Q&A with Russ Roberts on top-down and bottom-up economics
https://www.youtube.com/watch?v=5NIyCJC9ehQ
Lyrics
http://genius.com/John-papola-and-russ-roberts-fear-the-boom-
and-bust-hayek-vs-keynes-lyrics
http://genius.com/John-papola-fight-of-the-century-keynes-vs-hayek-round-two-lyrics
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End of
Chapter
Summary
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