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

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

11-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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.

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

11-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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)

11-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Consumption,

11-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

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

11-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

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

11-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

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

11-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 = Y Y = Y 0.2 Y = 960 Y = $4,800

11-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Short-Run Equilibrium Graph Output (Y) Planned aggregate expenditure (PAE) 960 PAE = Y 45 o Y = PAE 4,800 Slope = 0.8

11-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 = Y 45 o Y = PAE 4,8005,000

11-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 = Y Y = PAE 4,8004,700

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

11-21 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 –

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

11-23 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 = Y  New planned expenditure = Y  Equilibrium changed from $4,800 to $4,750  A $10 change in autonomous expenditures caused a $50 change in output  Multiplier = 5

11-24 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-25 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 = Yto 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

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

11-27 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-28 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

11-29 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Tax Cuts Stimulate – An Example  Original planned spending PAE = Y  Autonomous consumption, C, decreases by 10. Recessionary gap is $50. PAE = C (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

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

11-31 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 – – – –

11-32 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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) –––––– ––––

11-33 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Short-Run Equilibrium Example C = 620I = 220 G = 300NX = 20 T = 250mpc = 0.8 Y = 620 – 0.8 (250) (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 23 Appendix B The Multiplier in the Basic Keynesian Model

11-35 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 [ (0.8) 2 + (0.8) 3 …]

11-36 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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) 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)