2. 1 Frank & Bernanke 3 rd edition, 2007 Ch. 13: Spending and Output in the Short Run

3. 2 (Neo) Classical Theory Markets always clear. Markets always clear. When Supply does not equal to Demand, price changes to equate the two. When Supply does not equal to Demand, price changes to equate the two. Labor market works the same way, too. Labor market works the same way, too. In the 19th century, general price levels sometimes went up and sometimes down but there hasn’t been any trend. In the 19th century, general price levels sometimes went up and sometimes down but there hasn’t been any trend.

4. 3 The Great Depression Living through the Great Depression, people rightfully questioned the received wisdom of economists. Living through the Great Depression, people rightfully questioned the received wisdom of economists. If markets tended to clear, why did the labor market show up to 25% unemployment? If markets tended to clear, why did the labor market show up to 25% unemployment? The 1936 publication of The General Theory of Employment, Interest and Money by John Maynard Keynes provided an explanation for markets not to clear in the short run. The 1936 publication of The General Theory of Employment, Interest and Money by John Maynard Keynes provided an explanation for markets not to clear in the short run.

5. 4 The Model by Keynes Prices (including the price of labor - wages) do not change in the short run. Prices (including the price of labor - wages) do not change in the short run. Firms respond to demand changes by adjusting their production and keeping the price constant. Firms respond to demand changes by adjusting their production and keeping the price constant. Demand changes occur all the time and the structure of the economy changes as the demand for say, horse carriages fell and trains and cars rose. This would not affect labor. Demand changes occur all the time and the structure of the economy changes as the demand for say, horse carriages fell and trains and cars rose. This would not affect labor.

6. 5 The Model by Keynes If the total spending (aggregate demand) fell, then almost all markets would feel the drop in demand. If the total spending (aggregate demand) fell, then almost all markets would feel the drop in demand. Production in general would fall. Production in general would fall. Recession (and depression) would be felt. Recession (and depression) would be felt. To avoid this aggregate demand shortfall, the government should step in and by the use of monetary and fiscal policies, should stimulate total spending. To avoid this aggregate demand shortfall, the government should step in and by the use of monetary and fiscal policies, should stimulate total spending.

7. 6 Why Are Prices Constant in the Short Run? Menu costs. Menu costs. Fear of uncertainty. Fear of uncertainty. Contracts. Contracts. Information lag. Information lag.

8. 7 Keynesian Assumption: Firms Meet Demand at Preset Prices Will new technologies eliminate menu costs? Will new technologies eliminate menu costs? Keynesian theory assumes that menu cost prevent firms from changing prices. Keynesian theory assumes that menu cost prevent firms from changing prices. Many new technologies (bar codes) have reduced menu cost and increased price flexibility. Many new technologies (bar codes) have reduced menu cost and increased price flexibility. Pricing decisions also require market analysis, strategic considerations, and cost analysis. Pricing decisions also require market analysis, strategic considerations, and cost analysis. These factors are a component of menu costs. These factors are a component of menu costs.

9. 8 Constant Price Means Wide Output Fluctuations P Q S Q1 Q2

10. 9 Circular Flow Explanation Firms Households Consumption Expenditures Wages, profits, rent, interest If the upper flow (C+I+G+NX) is LESS THAN the lower flow (Income = Value of Output), inventories will pile up (I>I p ) and the firms will cut back in production. If the upper flow is MORE THAN the lower flow, inventories will fall below the desired level (I<I p ) and the firms will increase production.

11. 10 Circular Flow Explanation Firms Households Consumption Expenditures Wages, profits, rent, interest The upper flow is the aggregate demand: C+I+G+NX. The lower flow is Output: Y. When Aggregate Demand is <Y, Y falls. There is a positive output gap (Y*-Y>0) and the economy has slowed down. When I Y* and there is an expansionary (negative) output gap.

12. 11 Aggregate Demand Fluctuations Consumption expenditures fluctuate. Consumption expenditures fluctuate. Confidence, fear levels, demography, wealth, taxes, etc. change. Confidence, fear levels, demography, wealth, taxes, etc. change. Investment expenditures fluctuate. Investment expenditures fluctuate. Optimism/pessimism about the future; interest rate changes. Optimism/pessimism about the future; interest rate changes. Government expenditures change. Government expenditures change. Budget items, wars… Budget items, wars… Net Exports change. Net Exports change. Demand for our exports or exchange rates change. Demand for our exports or exchange rates change.

13. 12 Consumption Relating Consumption to Income and Other Determinants Relating Consumption to Income and Other Determinants The consumption function: The consumption function: C = a constant; represents the non income determinants of C C = a constant; represents the non income determinants of C Consumer optimism Consumer optimism Wealth Wealth Real interest rates Real interest rates

14. 13 The U.S. Consumption Function, 1960-2004

15. 14 Algebraic Short Run Equilibrium Y = C + I + G + NX (Output=Aggregate Demand) C = a +c (Y-T) (Consumption=Autonomous+c*Disposable Income) c = MPC = Change in Consumption/Change in Disposable Income Y = a +cY -cT + I + G + NX Y = (a + I +G + NX - cT) + cY Aggregate Demand Function is comprised of autonomous and induced parts. Y = [1/(1-c)][a+I+G+NX-cT] Equilibrium income is multiplier times autonomous expenditures.

16. 15 Numerical Determination of Short-Run Equilibrium Output (1) Output Y 4,0004,160-160No 4,2004,320-120No 4,4004,480-80No 4,6004,640-40No 4,8004,8000Yes 5,0004,96040No 5,2005,12080No (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 If Y = 5,000 > PAE = 960 +.8(5,000) = 4,960

17. 16 Determination of Short-Run Equilibrium Output (Keynesian Cross) Output Y Planned aggregate expenditure PAE 960 Expenditure line PAE = 960 + 0.8Y Slope = 0.8 45 o Y = PAE 4,800 Equilibrium PAE intersects the 45 o line @ 4,800 Disequilibrium Y > 4,800, PAE < Y

18. 17 Determination of Short-Run Equilibrium Output (Keynesian Cross) Output Y Planned aggregate expenditure PAE 960 Expenditure line PAE = 960 + 0.8Y Slope = 0.8 45 o Y = PAE 4,800 Equilibrium Algebraically At equilibrium: PAE = C + I p + G + NX Y = 960 + 0.8Y 0.2Y = 960 Y = 960/0.2 = 4,800 = equilibrium

19. 18 A Decline In Planned Spending Leads to a Recession Output Y Planned aggregate expenditure PAE 960 E Expenditure line PAE = 960 + 0.8Y 45 o Y = PAE 4,800 Y* Recessionary gap F Expenditure line PAE = 950 + 0.8Y A decline in autonomous aggregate expenditure (C) shifts the expenditure line down 950 4,750

20. 19 Determination of Short-Run Equilibrium Output After a Fall In Spending (1) Output Y 4,6004,630-30No 4,6504,670-20No 4,7004,710-10No 4,7504,7500Yes 4,8004,79010No 4,8504,83020No 4,9004,87030No 4,9504,91040No 5,0004,95050No (2) Planned aggregate expenditure PAE = 950 + 0.8Y (3) Y - PAE (4) Y – PAE? If Y = 4,800 > PAE = 4,790 Y = PAE @ 4,750 Output Gap: Y* (4,800) > Y (4,750)

21. 20 Japanese Recession Why was the deep Japanese recession of the 1990s bad news for the rest of East Asia? Why was the deep Japanese recession of the 1990s bad news for the rest of East Asia? Recession in Japan reduced Japanese imports Recession in Japan reduced Japanese imports The decline in East Asian exports to Japan reduced domestic spending in non-export sectors The decline in East Asian exports to Japan reduced domestic spending in non-export sectors

22. 21 2000-2002 Decline in the U.S. Stock Market From March 2000 to March 2002 the S&P 500 fell 49%. From March 2000 to March 2002 the S&P 500 fell 49%. Households lost $6.5 trillion of wealth in two years Households lost $6.5 trillion of wealth in two years $1 decrease in wealth reduces C by 3 to 7 cents/year $1 decrease in wealth reduces C by 3 to 7 cents/year The $6.5 trillion loss could reduce C between $195 and $455 billion The $6.5 trillion loss could reduce C between $195 and $455 billion

23. 22 2000-2002 Stock Market C rose from 2000-2002 C rose from 2000-2002 Higher housing prices (greater wealth) Higher housing prices (greater wealth) Lower interest rates Lower interest rates Lowering taxes Lowering taxes Increase in disposable income (Y – T) Increase in disposable income (Y – T) What caused the 2001 recession in the United States? What caused the 2001 recession in the United States? Reduction in investment spending Reduction in investment spending

24. 23 Fiscal Policy Why did the federal government send out millions of $300 and $600 checks to households in 2001? 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. In the spring 2001, the U.S. economy was slowing. Summer 2001, families received $38 billion in tax rebates. Summer 2001, families received $38 billion in tax rebates. A recent study indicated that two-thirds of the rebates were spent by households within six months. A recent study indicated that two-thirds of the rebates were spent by households within six months.

25. 24 Multiplier If a and I drops, what will happen to Y? If a and I drops, what will happen to Y? Y = [1/(1-c)][a+I+G+NX-cT] Y = [1/(1-c)][a+I+G+NX-cT] One can plug in the new values and find Y. One can plug in the new values and find Y. One can take the “Change in Y” to be equal to [1/(1-c)]*Change in a+I. One can take the “Change in Y” to be equal to [1/(1-c)]*Change in a+I. One can show the effect graphically by shifting AD downward. One can show the effect graphically by shifting AD downward.

26. 25 Multiplier Suppose a dropped from 400 to 350, and I dropped from 300 to 250. Find the new equilibrium Y. Suppose a dropped from 400 to 350, and I dropped from 300 to 250. Find the new equilibrium Y. Y = [1/(1-c)][a+I+G+NX-cT] Y = [1/(1-c)][a+I+G+NX-cT] Y = 5 (700) = 3500 Y = 5 (700) = 3500  Y = 5 (-100) = -500  Y = 5 (-100) = -500

27. 26 Graphical Short Run Equilibrium 800 4000 Y AD AD 700 3500 What is the value of the multiplier? What is mpc equal to?

28. 27 Role of Fiscal Policy In the Keynesian system, it is obvious that in response to changes in C, I, and NX, government can counter them by changing G or T. In the Keynesian system, it is obvious that in response to changes in C, I, and NX, government can counter them by changing G or T. If a+I fell by 100, how much G should change to keep Y=4000? If a+I fell by 100, how much G should change to keep Y=4000? If a+I fell by 100, how much T should change to keep Y=4000? If a+I fell by 100, how much T should change to keep Y=4000?

29. 28 The Problem of Deficits Sustaining government deficits reduce saving and investment in new capital goods. Sustaining government deficits reduce saving and investment in new capital goods. The goal of keeping deficits low may reduce the incentive to use fiscal policy to control a recessionary gap. The goal of keeping deficits low may reduce the incentive to use fiscal policy to control a recessionary gap.

30. 29 Fiscal Policy and the Supply Side Fiscal policy may affect potential output as well as Aggregate Expenditures. Fiscal policy may affect potential output as well as Aggregate Expenditures. Public capital Public capital R & D R & D Human Capital Human Capital Transfer payments Transfer payments

31. 30 Limits on Fiscal Policy The problem of time lags and the legislative process The problem of time lags and the legislative process Competing political objectives Competing political objectives Automatic stabilizers help offset the inflexibility of fiscal policy Automatic stabilizers help offset the inflexibility of fiscal policy Transfer payments Transfer payments Income tax collections Income tax collections Fiscal policy may be useful to address prolonged periods of recession Fiscal policy may be useful to address prolonged periods of recession

32. 31 Automatic Stabilizers Without any act by the Congress, fiscal measures kick in to keep Y close to Y*. Without any act by the Congress, fiscal measures kick in to keep Y close to Y*. Income taxes. Income taxes. Unemployment insurance. Unemployment insurance. Welfare payments. Welfare payments. Recession aid transfers. Recession aid transfers.

33. 32 Does military spending stimulate the economy?