1.GT01003Macroeconomics

2. Learning Objectives1. Identify the key assumptions of the basic Keynesianmodel2. Explain how to develop a model of Planned AggregateExpenditure (PAE)3. Analyze how an economy reaches short-runequilibrium in the basic Keynesian model Do the analysis with both numbers and graphs 3. Learning Objectives4. Show how a change in planned aggregate expenditurecan cause a change in the short-run equilibriumoutput Explain how this is related to the income-expendituremodel5. Explain why the basic Keynesian model suggests thatfiscal policy is useful 4. John Maynard Keynes (1883 1946) The idea that a decline in aggregatespending may cause output to fallbelow potential output was one of thekey insights of John Maynard Keynes. The goal of this lecture is to present atheory/model of how recession andexpansion may arise fromfluctuations in planned aggregateexpenditure or total plannedspending. 5. Keynesian Model Building block for current theories of short-run economicfluctuations and stabilization policies In the short run, firms meet demand at preset prices Firms typically set a price and meet the demand at that pricein 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 themarginal costsKeyAssumption 6. Keynesian ModelWill new technologies make the Keynesian theory lessrelevant to the real world?? 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 Deciding the new prices Informing consumers 7. New Technologies 8. New Technologies 9. New Technologies 10. Planned Aggregate Expenditure (PAE) Planned aggregate expenditure is planned spending onfinal goods and services Four components of planned aggregate expenditure Consumption (C) by households Investment (I) is planned spending by domestic firmson new capital goods Government purchases (G) are made by federal stateand local governments Net exports (NX) is exports minus imports 11. Planned Aggregate Expenditure (PAE) Actual spending equals planned spending for Consumption Government purchases of final goods and services Net exports Adjustments between actual and planned spendingare accomplished with changes in inventories The general equation for planned aggregateexpenditures isPAE = C + IP + G + NX 12. Develop a Model of PAE:Consumption Expenditures Consumption (C) accounts for two-thirds of totalspending Powerful determinant of planned aggregate spending Includes purchases of goods, services, and consumerdurables, but not houses Rent is considered a service C depends on disposable income, (Y T) 13. Consumption, 1960 - 2007 14. Develop a Model of PAE:Consumption Function The consumption function is an equation relatingplanned consumption to its determinants, notablydisposable income (Y T)C = C + (mpc) (Y T)where C is autonomous consumption spendingmpc is the change in consumption for a givenchange in (Y T) Autonomous consumption is spending not related to thelevel of disposable income A change in C shifts the consumption function 15. Develop a Model of PAE:Consumption FunctionC = C + (mpc) (Y T) The wealth effect is the tendency of changes in assetprices to affect households wealth and thisconsumption spending This effect is included in C C also captures the effects of interest rates onconsumption Higher rates increase the cost of using credit to purchaseconsumer durables and other items 16. Develop a Model of PAE:Consumption FunctionC = C + (mpc) (Y T) Marginal propensity to consume (mpc) is theincrease in consumption spending when disposableincome increases by $1 mpc is between 0 and 1 for the economy If households receive an extra $1 in income, they spendpart (mpc) and save part (Y T) is disposable income Output plus government transfers minus taxes Main determinant of consumption spending 17. Develop a Model of PAE:Consumption FunctionDisposable income (Y T)Consumptionspending(C)CC = C + (mpc) (Y T) (Y T) CCInterceptSlope = C / (Y T)slope 18. Planned Aggregate Expenditure(PAE) Two dynamic patterns in the economy1. Declines in production lead to reduced spending2. Reductions in spending lead to declines in productionand income Consumption is the largest component of PAE Consumption depends on output, Y PAE depends on Y 19. Planned Spending ExamplePAE = C + IP + G + NXC = C + mpc (Y T)PAE = C + mpc (Y T) + IP + G + NX Suppose that planned spending components have thefollowing valuesPAE = 620 + 0.8 (Y 250) + 220 + 330 + 20PAE = 960 + 0.8 YC = 620 mpc = 0.8 T = 250IP = 220 G = 330 NX = 20 20. Planned Spending ExampleC = 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 thatis independent of output $960 in our example Induced expenditure, the part of spending thatdepends on output (Y) 0.8 Y in our example 21. Planned Expenditure GraphOutput (Y)Plannedaggregateexpenditure(PAE)960PAE = 960 + 0.8YSlope = 0.84,800 22. Short-Run Equilibrium Short-run equilibrium is the level of output at whichplanned spending is equal to output No change in output as long as prices are constant Our equilibrium condition can be writtenY = PAE Using our previous example, PAE = 960 + 0.8 YY = 960 + 0.8 Y0.2 Y = 960Y = $4,800 23. Short-Run Equilibrium SearchOutput (Y) PAE = 960 + 0.8 Y Y PAE Y = PAE?4,000 4,160 160 No4,200 4,320 120 No4,400 4,480 80 No4,600 4,640 40 No4,800 4,800 0 Yes5,000 4,960 40 No5,200 5,120 80 No Only when Y = 4,800 does planned spending equaloutput 24. Short-Run Equilibrium GraphOutput (Y)Plannedaggregateexpenditure(PAE)960PAE = 960 + 0.8Y45oY = PAE4,800Slope = 0.8 25. Output Greater than Equilibrium Suppose output reaches5,000 Planned spending isless than total output Unplanned inventoryincreases Businesses slow downproduction Output goes downPAEOutput (Y)960PAE = 960 +0.8Y45oY = PAE4,800 5,000 26. Output Less than Equilibrium Suppose output is only4,500 Planned spending ismore than totaloutput Unplanned inventorydecreases Businesses speed upproduction Output goes upPAEOutput (Y)960PAE = 960 +0.8YY = PAE4,8004,700 27. Planned Spending andthe Output GapOutput YPlannedaggregateexpenditure(PAE)960EPAE = 960 + 0.8Y45oY = PAE4,800Y*Recessionary gapPAE = 950 + 0.8Y950F4,750 28. Planned Spending andthe Output Gap Autonomous consumption, C, decreases by 10 Causes a downward shift in the planned aggregateexpenditures curve The economy eventually adjusts to a new lower level ofequilibrium spending an output, $4,750 Suppose that the original equilibriumlevel, $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 29. Planned Spending andthe Output Gap Japanese recession in 1990s reduced Japanese imports East Asian economies developed by promotingexports The decrease in exports to Japan decreased plannedaggregate expenditures in these countries The decrease in planned spending caused the economiesto contract to a new, lower level of planned spending andoutput Japan exported its recession to its neighbors US recessions have similar effects on its major tradingpartners 30. Planned Spending andthe Output Gap: US Recession 2001 Robust investment spending, 1995 2000 High growth economy New technologies: internet, fiber optics, geneticengineering Not as promising as anticipated Recession caused by a decline in autonomousspending Less investment in 2001 Terrorist attack 9/11 Travel spending decreased Recovery began 2002 31. Income-Expenditure Multiplier The income expenditure multiplier shows the effectof a one-unit increase in autonomous expenditure onshort-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 $50change in output Multiplier = 5 The larger mpc, the greater the multiplier 32. Stabilization Policy Stabilization policies are government actions toaffect planned spending with the intention ofeliminating output gaps Expansionary policies increase planned spending Contractionary policies decrease planned spending Two major stabilization tools are fiscal policy andmonetary policy Fiscal policy uses changes in governmentspending, transfers, or taxes Monetary policy uses changes in the money supply 33. Fiscal Policy and Recessions Government spending is part of planned spending Changes in government spending will directly affect plannedaggregate expenditures Suppose planned spending decreases $ 10 fromY = 960 + 0.8 Y toY = 950 + 0.8 Y Equilibrium Y decreases from $4,800 to $4,750 Recessionary gap is $50 Stabilization policy indicates a $10 increase in governmentspending will restore the economy to Y* at $4,800 34. How can the Government eliminatean Output Gap?Output YPlannedaggregateexpenditure(PAE)960PAE = 960 + 0.8Y45oY = PAEFPAE = 950 + 0.8Y9504,750E4,800Y* 35. Example: Japanese Spending In the 1990s Japan spent over $1 trillion on publicworks Highways, subways, and transportation projects Concert halls Re-laying cobblestone sidewalks 36. Taxes and Transfers Planned aggregate expenditures are affected by taxesand transfers The effect is indirect, channeled through the effects ondisposable income Lower taxes or higher transfers increase disposableincome Increases in disposable income lead to higher C 37. Fiscal Policy as a Stabilization Tool:Three Qualifications The use of fiscal policy to stabilize the economy ismore complicated than suggested by the basicKeynesian model. Three qualifications must be made to the use of fiscalpolicy as a stabilization tool.1. Fiscal policy may affect potential output as well aspotential spending2. Large and persistent government budget deficitsreduce national saving and growth3. The relative inflexibility of fiscal policy 38. Spending and Output in the ShortRunShort-Run Spending and OutputPlannedAggregateExpenditures(PAE)ConsumptionFunctionShort-RunEquilibriumChanges inEquilibriumOutput GapsMultiplierFiscal PolicyLimitationsKeynesian Model