McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Chapter 23

Spending and Output in the Short Run

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Learning Objectives

1. Identify the key assumptions of the basic Keynesian model Explain how this affects firms' production decisions

2. Discuss the determination of planned investment and aggregate consumption spending Explain how to develop the model of planned

aggregate spending

3. Analyze how an economy reaches short-run equilibrium in the basic Keynesian model Do the analysis with both numbers and graphs

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Learning Objectives

4. Show how a change in planned aggregate expenditure can cause a change in the short-run equilibrium output Explain how this is related to the income-expenditure

model

5. Explain why the basic Keynesian model suggests that fiscal policy is useful 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 short-run 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 ■ Deciding the new

prices Informing consumers

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Planned Aggregate Expenditure

Planned aggregate expenditure 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 Investment Example

Fly-by-Night Kite produces $5 million of kites 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 (PAE)

Actual spending equals planned spending for Consumption Government purchases of final goods and services Net exports

Adjustments between actual and planned spending are accomplished with changes in inventories

The general equation for planned aggregate expenditures is

PAE = C + IP + G + NX

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Consumption Expenditures

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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Consumption, 1960 - 2007

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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 spendingmpc 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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2000 – 2002 Stock Market Decline

Stock prices fell 49% between March 2000 and October 2002 Households owned $13.3 trillion in stocks in 2000

Stock market decline could have destroyed $6.5 trillion of household wealth

A $1 decrease in wealth decreases consumption by 3 – 7 ¢ Suggests a decrease in consumer spending of

$195 – 455 billion would occur Consumption spending continued to increase

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2000 – 2002 Consumer Spending

Consumer spending increased despite sharp fall in stock prices After-tax income increased Interest rates decreased

Spurred spending on durables Housing wealth increased

Housing prices increased 20% in the period Partially offset lost wealth from stock market

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More 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 Function

Disposable income (Y – T)

Con

sum

ptio

n sp

endi

ng (

C)

CC = C + (mpc) (Y – T)

C

Intercept

Slope = Δ C / Δ (Y – T)

slope

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Planned Aggregate Expenditure (PAE)

Two dynamic patterns in the economy

1. Declines in production lead to reduced spending

2. Reductions in spending lead to declines in production and income

Consumption is the largest component of PAE Consumption depends on output, Y PAE depends on Y

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Planned Spending Example

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

PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20

PAE = 960 + 0.8 Y

C = 620 mpc = 0.8 T = 250

IP = 220 G = 330 NX = 20

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Planned Spending Example

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 Expenditure Graph

Output (Y)Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

Slope = 0.8

4,800

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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 Y – PAE Y = PAE?

4,000 4,160 –160 No

Only when Y = 4,800 does planned spending equal output

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

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Short-Run Equilibrium Graph

Output (Y)Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

45o

Y = PAE

4,800

Slope = 0.8

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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

PA

E

Output (Y)

960

PAE = 960 + 0.8Y

45o

Y = PAE

4,800 5,000

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Output Less than Equilibrium

Suppose output is only 4,500 Planned spending is

more than total output Unplanned inventory

decreases Businesses speed up

production Output goes up

PA

E

Output (Y)

960

PAE = 960 + 0.8Y

Y = PAE

4,8004,700

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Lower Equilibrium

Output Y

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

E

PAE = 960 + 0.8Y

45o

Y = PAE

4,800Y*

Recessionary gap

PAE = 950 + 0.8Y

950

F

4,750

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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) PAE = 950 + 0.8 Y Y – PAE Y = PAE?

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

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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

US recessions have similar effects on our major trading partners

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US Recession 2001

Robust investment spending, 1995 – 2000 High growth economy New technologies: internet, fiber optics, genetic

engineering Not as promising as anticipated

Recession caused by a decline in autonomous spending Less investment in 2001 Terrorist attack 9/11

Travel spending decreased Recovery began 2002

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Income-Expenditure 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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Stabilization 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 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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$10 Fiscal Stimulus

Output Y

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

960

PAE = 960 + 0.8Y

45o

Y = PAE

F

PAE = 950 + 0.8Y

950

4,750

E

4,800Y*

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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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US Military Spending

Military spending as a share of GDP decreased sharply after World War II Peaks for wars and Reagan military buildup

Added demand from military spending helped end the Great Depression Recessions

associated with declines in military spending

Increases in G help stimulate the economy

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Taxes and Transfers

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)

Consumption610 + 0.8 (Y – T)

4,750 250 4,500 4,210

4,750 237.5 4,512.5 4,220

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Federal Tax Rebates -- 2001

Economy showed signs of slowing in early 2001 Federal government rebated $300 to individual and

$600 to couples Total rebates were about $38 billion

Also made cuts in tax rates Two-thirds of the rebates were spent by households

within six months Weakening economy in 2007 led to a replay in 2008

$150 billion in rebates

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Supply-Side Effects of Fiscal Policy

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 Medicare and income support

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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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Spending and Output in the Short Run

Short-Run Spending and Output

Planned Aggregate

Expenditures (PAE)

Consumption Function

Short-Run Equilibrium

Changes in Equilibrium

Output Gaps

Multiplier

Fiscal Policy

Limitations

Keynesian Model

McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Chapter 23Appendix A

An Algebraic Solution of the Basic Keynesian Model

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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 T = T net taxes

G = G government purchases NX = NX net exports

–

–

–

––

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Find Short-Run Equilibrium Output

PAE = C + mpc (Y – T) + I + G + NX

PAE = C – mpc T + I + G + NX + mpc YEquilibrium 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

––– – ––

––– – ––

––– – ––

––– – ––

Y = C – mpc T + I + G + NX(1 – mpc)

––– – ––

––– – ––

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Short-Run Equilibrium Example

C = 620 I = 220

G = 300 NX = 20

T = 250 mpc = 0.8

Y = 620 – 0.8 (250) + 220 + 300 +20(1 – 0.8)

Y = 960 / 0.2 = 4,800

––

Y = C – mpc T + I + G + NX(1 – mpc)

––– – ––

–

–

–

–

McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Chapter 23Appendix B

The Multiplier in the Basic Keynesian Model

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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

In our case, x = 0.8

10 [1 + 0.8 + (0.8)2 + (0.8)3…]

= 10 = 10

= 10 (1 / 0.2) = 10 (5) = 50 In this case, the multiplier is 5

1(1 – x)

1 + x + x2 + x3 + x4 + … = = multiplier

1(1 – x)

1(1 – 0.8)