1. Spending, Output, and Fiscal Policy
Chapter 22
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. Learning Objectives
Identify the key assumptions of the basic Keynesian model and explain how this affects the production decisions made by firms
Discuss the determinations of planned investment and aggregate consumption spending and how these concepts are used to develop a model of planned aggregate expenditure
Analyze, using graphs, how an economy reaches short-run equilibrium in the basic Keynesian model
Show how a change in planned aggregate expenditure can cause a change in short-run 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

3. Recessionary Gap Great Depression
Available resources are unemployed
Public’s willingness or ability to spend declines
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

4. 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

5. 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 costs are the costs 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

6. 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

7. Planned Aggregate Expenditure
Planned aggregate expenditure (PAE) is total 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) equals exports minus imports

8. 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

9. 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

10. Consumption Expenditures
Consumption (C) accounts for two-thirds of total spending
Powerful determinant of planned aggregate expenditure
Includes purchases of goods, services, and consumer durables, but not new houses
Rent is considered a service
C depends on disposable income, (Y – T)

11. Consumption in the U.S

12. Consumption Function
The consumption function is an equation relating planned consumption (C) to its determinants, notably disposable income (Y –T)
C = C + (mpc) (Y – T), where
C is autonomous consumption spending mpc is the change in consumption for a given change in disposable income
0 < mpc < 1
Autonomous consumption is spending not related to the level of disposable income
A change in C shifts the consumption function

13. Consumption Function C = C + (mpc) (Y – T)
The wealth effect is the tendency of changes in asset prices to affect household's wealth and thus their consumption spending
This effect is included in C
Autonomous consumption also captures the effects of interest rates on consumption
Higher rates increase the cost of using credit to purchase consumer durables and other items

14. 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 potentially 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

15. 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

16. More on the 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

17. Consumption Function C = C + (mpc) (Y – T) C Consumption spending (C)
Intercept
Slope = Δ C / Δ (Y – T)
slope
Consumption spending (C)
Δ C
Δ (Y – T)
Disposable income (Y – T)

18. Planned Aggregate Expenditure (PAE)
Two dynamic patterns in the economy
Declines in production lead to reduced spending
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

19. 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 = (Y – 250)
PAE = Y
C = 620
mpc = 0.8
T = 250
IP = 220
G = 330
NX = 20

20. Planned Spending Example
C = (Y – 250)
PAE = 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

21. Planned Expenditure Graph
Output (Y)
Planned aggregate expenditure (PAE)
960
PAE = Y
Slope = 0.8
4,800

22. 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 = Y
Y = Y
0.2 Y = 960
Y = $4,800

23. Short-Run Equilibrium Search
Output (Y)
PAE = Y
Y – PAE
Y = PAE?
4,000
4,160
–160 No
4,200
4,320
–120 No
4,400
4,480
–80
4,600
4,640
–40
4,800
Yes
5,000
4,960 40
5,200
5,120 80
Only when Y = 4,800 does planned spending equal output

24. Short-Run Equilibrium Graph
Y = PAE
PAE = Y
Slope = 0.8
4,800
Planned aggregate expenditure (PAE)
960
45o
Output (Y)

25. 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
Y = PAE
PAE = Y
PAE
960
45o
4,800
5,000
Output (Y)

26. 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
Y = PAE
PAE = Y
PAE
960
4,500
4,800
Output (Y)

27. A Fall in Planned Spending Leads to a Recession
Y = PAE
PAE = Y
PAE = Y
950 E
Planned aggregate expenditure (PAE) F
4,750
960
Recessionary gap
45o
4,800
Output Y Y*

28. New Equilibrium Autonomous consumption, C, decreases by 10–
Autonomous consumption, C, decreases by 10
Causes a downward shift in the planned aggregate expenditure curve
The economy eventually adjusts to a new lower level of equilibrium spending and 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

29. New Short-Run Equilibrium Search
Output (Y)
PAE = Y
Y – PAE
Y = PAE?
4,600
4,630
–30 No
4,650
4,670
–20
4,700
4,710
–10
4,750
Yes
4,800
4,790 10
4,850
4,830 20
4,900
4,870 30
4,950
4,910 40
5,000 50

30. 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 expenditure 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
U.S. recessions have similar effects on our major trading partners

31. What Caused U.S. Recession 2007 - 2009
Housing price bubble burst summer 2006
House prices increased an average of 8.2% per year from
Last period of high increase was 1976 – 1979
4.9% per year increase on average
Using the rule of 72, house prices would double in 10 years as compared to years
Housing prices declined 6% 2006 – 2007 and over 20% 2007 – 2009
Financial market crisis

32. What Caused the U.S. Recession 2007 - 2009
Decline in spending by businesses and households
Difficult to borrow
Uncertainty about the state of the economy
Decline in planned aggregate expenditure
Downward shift of the PAE line
Recessionary gap

33. Income-Expenditure Multiplier
The income – expenditure multiplier shows the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output
Initial planned expenditure = Y
New planned expenditure = Y
The 10-unit drop in C implied a 10 unit drop in autonomous expenditure
Equilibrium changed from $4,800 to $4,750
A $10 change in autonomous expenditures caused a $50 change in output
Multiplier = 5
The larger the mpc, the greater the multiplier

34. Stabilization Policy
Stabilization policies are government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps
Expansionary policies increase planned expenditure
Contractionary policies decrease planned expenditure
Fiscal policy uses changes in government spending, transfers, or taxes
Monetary policy uses changes in the money supply

35. Government Spending Y = 960 + 0.8 Y to Y = 950 + 0.8 Y
Government spending is part of planned spending
Changes in government spending will directly affect planned aggregate expenditures
Suppose planned spending decreases $10 from
Y = Y to
Y = 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

36. Planned aggregate expenditure (PAE)
$10 Fiscal Stimulus
Y = PAE
960
PAE = Y E
4,800 Y*
PAE = Y
Planned aggregate expenditure (PAE) F
950
45o
4,750
Output Y

37. U.S. 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

38. Taxes and Transfers
Net tax (T) = total taxes – transfer payments – government interest payments
Planned aggregate expenditures are influenced by changing total taxes and/or transfer payments
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

39. Using Tax Cuts to Close a Recessionary Gap – An Example
Original planned spending Y = Y
Autonomous spending decreases Y = 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 (Y – T)
4,750
250
4,500
4,210
237.5
4,512.5
4,220

40. U.S. 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
Successful policy

41. U.S. Fiscal Policy During the 2007 – 2009 Recession
Economic Stimulus Act of 2008
$100 billion in tax cuts
$60 billion government spending increase
American Recovery and Reinvestment Act of 2009
$200 billion in tax cuts
$600 billion government spending increase
Both were effective at raising consumption spending
Real GDP higher than it would have been otherwise

42. 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 can change potential output, Y*
Supply-side economists emphasize the supply-side effects of fiscal policy
Current thinking is more moderate
Demand-side effects of spending matter
Supply-side effects also matter

43. 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

44. 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

45. 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

46. Spending and Output in the Short Run
Short-Run Spending and Output
Keynesian Model
Multiplier
Output Gaps
Planned Aggregate Expenditures (PAE)
Short-Run Equilibrium
Fiscal Policy
Consumption Function
Changes in Equilibrium
Limitations