1. ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 21: Spending and Output in the Short Run

2. ©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Identify the key assumptions of the basic Keynesian model and explain how this affects firms' production decisions 2.Discuss the determination of planned investment and aggregate consumption spending and how these are used to develop the model of planned aggregate spending 3.Analyze, using graphs and numbers, how an economy reaches short-run equilibrium in the basic Keynesian model

3. ©2012 The McGraw-Hill Companies, All Rights Reserved 3 Learning Objectives 4.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

4. ©2012 The McGraw-Hill Companies, All Rights Reserved 4 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

5. ©2012 The McGraw-Hill Companies, All Rights Reserved 5 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

6. ©2012 The McGraw-Hill Companies, All Rights Reserved 6 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

7. ©2012 The McGraw-Hill Companies, All Rights Reserved 7 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

8. ©2012 The McGraw-Hill Companies, All Rights Reserved 8 Planned Aggregate Expenditure (PAE) PAE 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

9. ©2012 The McGraw-Hill Companies, All Rights Reserved 9 Planned versus Actual Investment Example Suppose Khedr Papyrus Company produces $5 million of Egyptian papyrus paintings 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

10. ©2012 The McGraw-Hill Companies, All Rights Reserved 10 Planned Aggregate Expenditure 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

11. ©2012 The McGraw-Hill Companies, All Rights Reserved 11 Consumption Spending and the Economy 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)

12. ©2012 The McGraw-Hill Companies, All Rights Reserved 12 The Egyptian Consumption Function, 2007- 2011

13. ©2012 The McGraw-Hill Companies, All Rights Reserved 13 The Turkish Consumption Function, 2007- 2011

14. ©2012 The McGraw-Hill Companies, All Rights Reserved 14 The UAE Consumption Function, 2007- 2011

15. ©2012 The McGraw-Hill Companies, All Rights Reserved 15 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 and 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

16. ©2012 The McGraw-Hill Companies, All Rights Reserved 16 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

17. ©2012 The McGraw-Hill Companies, All Rights Reserved 17 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

18. ©2012 The McGraw-Hill Companies, All Rights Reserved 18 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

19. ©2012 The McGraw-Hill Companies, All Rights Reserved 19 Planned Aggregate Expenditure And Output 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

20. ©2012 The McGraw-Hill Companies, All Rights Reserved 20 Linking Planned Aggregate Expenditure To Output 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

21. ©2012 The McGraw-Hill Companies, All Rights Reserved 21 Linking Planned Aggregate Expenditure To Output 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

22. ©2012 The McGraw-Hill Companies, All Rights Reserved 22 Planned Expenditure Graph Output (Y) Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y Slope = 0.8 4,800

23. ©2012 The McGraw-Hill Companies, All Rights Reserved 23 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

24. ©2012 The McGraw-Hill Companies, All Rights Reserved 24 Short-Run Equilibrium Search Output (Y)PAE = 960 + 0.8 YY – PAEY = PAE? 4,0004,160–160No 4,2004,320–120No 4,4004,480–80No 4,6004,640–40No 4,800 0Yes 5,0004,96040No 5,2005,12080No  Only when Y = 4,800 does planned spending equal output

25. ©2012 The McGraw-Hill Companies, All Rights Reserved 25 Short-Run Equilibrium Graph Output (Y) Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y 45 o Y = PAE 4,800 Slope = 0.8

26. ©2012 The McGraw-Hill Companies, All Rights Reserved 26 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

27. ©2012 The McGraw-Hill Companies, All Rights Reserved 27 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

28. ©2012 The McGraw-Hill Companies, All Rights Reserved 28 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

29. ©2012 The McGraw-Hill Companies, All Rights Reserved 29 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 –

30. ©2012 The McGraw-Hill Companies, All Rights Reserved 30 New Short-Run Equilibrium Search Output (Y) PAE = 950 + 0.8 YY – PAEY = PAE? 4,6004,630–30No 4,6504,670–20No 4,7004,710–10No 4,750 0Yes 4,8004,79010No 4,8504,83020No 4,9004,87030No 4,9504,91040No 5,0004,95050No

31. ©2012 The McGraw-Hill Companies, All Rights Reserved 31 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

32. ©2012 The McGraw-Hill Companies, All Rights Reserved 32 The 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

33. ©2012 The McGraw-Hill Companies, All Rights Reserved 33 Stabilizing Planned Spending: The Role of Fiscal 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

34. ©2012 The McGraw-Hill Companies, All Rights Reserved 34 Government Purchases and Planned 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

35. ©2012 The McGraw-Hill Companies, All Rights Reserved 35 $10 Fiscal Stimulus Output Y Planned aggregate expenditure (PAE) 960 PAE = 960 + 0.8Y 45 o Y = PAE F PAE = 950 + 0.8Y 95 0 4,750 E 4,800 Y*

36. ©2012 The McGraw-Hill Companies, All Rights Reserved 36 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

37. ©2012 The McGraw-Hill Companies, All Rights Reserved 37 Taxes, Transfers and Aggregate Spending 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

38. ©2012 The McGraw-Hill Companies, All Rights Reserved 38 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) Consumption 610 + 0.8 (Y – T) 4,7502504,5004,210 4,750237.54,512.54,220

39. ©2012 The McGraw-Hill Companies, All Rights Reserved 39 Fiscal Policy as A Stabilization Tool: Three Qualifications 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

40. ©2012 The McGraw-Hill Companies, All Rights Reserved 40 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

41. ©2012 The McGraw-Hill Companies, All Rights Reserved 41 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 unemployment benefits and welfare payments

42. ©2012 The McGraw-Hill Companies, All Rights Reserved 42 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

43. Chapter 21 Appendix A An Algebraic Solution of the Basic Keynesian Model

44. ©2012 The McGraw-Hill Companies, All Rights Reserved 44 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 – – – –

45. ©2012 The McGraw-Hill Companies, All Rights Reserved 45 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) –––––– ––––

46. ©2012 The McGraw-Hill Companies, All Rights Reserved 46 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) –––––– – – – –

47. Chapter 21 Appendix B The Multiplier in the Basic Keynesian Model

48. ©2012 The McGraw-Hill Companies, All Rights Reserved 48 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 …]

49. ©2012 The McGraw-Hill Companies, All Rights Reserved 49 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)