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McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 11 Spending and Output in the Short Run

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11-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23- All Learning Objectives 1.Identify the key assumptions of the basic Keynesian model 2.Discuss the determination of planned investment and planned aggregate expenditure 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

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11-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 1 Keynesian Model Key assumption: 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 Eventually, firms change prices when the marginal benefits exceed the marginal costs Basic Keynesian model developed here ignores this fact.

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11-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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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11-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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 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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11-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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 + I P + G + NX

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11-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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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11-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 Consumption, 1960 - 2007

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11-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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 spending mpc 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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11-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 Consumption Function C = C + (mpc) (Y – T) C captures wealth effect The effect of changes in asset prices on consumption spending 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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11-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 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 minus net taxes

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11-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 2 Consumption Function Disposable income (Y – T) Consumption spending (C) C C = C + (mpc) (Y – T) Δ (Y – T) Δ C C Intercept Slope = Δ C / Δ (Y – T) slope

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11-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Planned Spending Example PAE = C + I P + G + NX C = C + mpc (Y – T) PAE = C + mpc (Y – T) + I P + 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 = 620mpc = 0.8T = 250 I P = 220G = 330NX = 20

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11-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 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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11-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Planned Expenditure Graph Output (Y) Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y Slope = 0.8 4,800

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11-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Short-Run Equilibrium Short-run equilibrium is the level of output at which planned spending is equal to output 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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11-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Short-Run Equilibrium Graph Output (Y) Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y 45 o Y = PAE 4,800 Slope = 0.8

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11-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 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 PAE Output (Y) 96 0 PAE = 960 + 0.8Y 45 o Y = PAE 4,8005,000

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11-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 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 PAE Output (Y) 96 0 PAE = 960 + 0.8Y Y = PAE 4,8004,700

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11-20 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 Lower Equilibrium Output Y Planned aggregate expenditure (PAE) 960 E PAE = 960 + 0.8Y 45 o Y = PAE 4,800 Y* Recessionary gap PAE = 950 + 0.8Y 950 F 4,750

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11-21 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 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 I P, G, or NX –

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11-22 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 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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11-23 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 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

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11-24 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 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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11-25 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 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 Yto 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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11-26 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 $10 Fiscal Stimulus Output Y Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y 45 o Y = PAE F PAE = 950 + 0.8Y 950 4,750 E 4,800 Y*

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11-27 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 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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11-28 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 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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11-29 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 5 Tax Cuts Stimulate – An Example Original planned spending PAE = 960 + 0.8 Y Autonomous consumption, C, decreases by 10. Recessionary gap is $50. PAE = C + 0.8 (Y – T) + I P + G + NX 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

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McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 23 Appendix A An Algebraic Solution of the Basic Keynesian Model

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11-31 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 The Basic Keynesian Model PAE = C + I P + 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 I P, G, T and NX are given – I = Iplanned investmentT = Tnet taxes G = Ggovernment purchasesNX = NXnet exports – – – –

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11-32 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Find Short-Run Equilibrium Output PAE = C + mpc (Y – T) + I + G + NX PAE = C – mpc T + I + G + NX + mpc Y Equilibrium 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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11-33 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 3 Short-Run Equilibrium Example C = 620I = 220 G = 300NX = 20 T = 250mpc = 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) –––––– – – – –

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McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 23 Appendix B The Multiplier in the Basic Keynesian Model

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11-35 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 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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11-36 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 23 - 4 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 (1 / 0.2) = 10 (5) = 50 In this case, the multiplier is 5 1 (1 – x) 1 + x + x 2 + x 3 + x 4 + … == multiplier 1 (1 – x) 1 (1 – 0.8)

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