Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Aggregate Demand and Output in the Short Run

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide John Maynard Keynes  Most influential economist of the 20 th century  Published The General Theory of Employment, Interest, and Money in 1936  Keynes’ idea was that  A decline in aggregate spending may cause output to fall below potential output for long periods of time  Government spending would increase aggregate demand and restore full employment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Modeling Fluctuations  Goal of this chapter  To develop a model of how recessions and expansions may arise from fluctuations in aggregate spending following Keynes  Basic Keynesian model or the Keynesian Cross  The diagram used to illustrate the theory is not complete or entirely realistic model

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Assumptions  Aggregate demand fluctuates  Total planned spending changes  In the short run, firms meet the demand for their products at preset prices  Do not respond to every change in demand by changing their prices  Set a price for some period and meet the demand at that price  Produce just enough to satisfy their customers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Meet the Demand  Menu costs: The costs of changing prices  Firms do not change their prices frequently  Or, in the short run  Firms will eventually change prices if there is a large imbalance between sales and potential output

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Aggregate Demand  Aggregate demand (AD)  Total planned spending on final goods and services  Four components  Consumer expenditure (C)  Investment (I)  Government purchases (G)  Net exports (NX)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Planned vs. Actual  Aggregate demand is planned spending  Planned may differ from actual for firms  When a firm sells either less or more of its product than expected  For households, governments, and foreign purchasers we can reasonably assume that actual equals planned

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Unplanned Investment  Suppose a firm’s actual sales are less then expected  Warehouses fill up  Actual investment is greater than planned investment  The extra inventory becomes part of actual investment  I > I p  I p planned investment  I actual investment  If a firm sells more than expected  I < I p  The firm planned on increasing inventories more than it actually did

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Definition of Aggregate Demand  Aggregate demand equals the economy’s total planned spending AD = C + I p + G + NX

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Consumption  C is nearly 2/3 rds of AD  Many determinants of consumption spending  Prices, incomes, tastes, etc.  Disposable income  After-tax income is particularly important  National income (Y) minus net taxes (T)  As disposable income rises, consumption (C) rises

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Consumption Function  The relationship between consumption spending and its determinants, such as disposable (after-tax) income  constant term capturing factors other than disposable income  c is the MPC (Marginal propensity to consume)  The amount by which consumption rises when disposable income rises by $1  We assume that 0 < c < 1

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Consumption Function

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The U.S. Consumption Function,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and Output  How is AD affected by changes in Y  Recall, Y is aggregate income  C depends on Y  C is a large part of AD  AD depends on Y

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and Output  For now assume that I p, G, NX, and T are fixed, so that

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and Output  Substituting and rearranging,  Shows if Y increases by one unit, then AD increases by c units  Positive relationship between Y and AD  c is the MPC

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Autonomous AD  Autonomous aggregate demand  The portion of aggregate demand that is determined outside the model  Induced aggregate demand  The portion of aggregate demand that is determined within the model [cY]

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide SR Equilibrium Output  Short-run equilibrium output  The level of output at which output Y equals aggregate demand AD  The level of output that prevails during the period in which prices are predetermined Y = AD Y – AD = 0

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Numerical SR Equilibrium  Using Example 25.2 and Table 25.1  SR equilibrium occurs when Y = 4,800  If output Y was 4,000  Firms are not producing enough  Inventories are being depleted, I < I p  Firms respond by increasing production  If output Y was 5,000  Firms are producing too enough  Inventories are piling up, I > I p  Firms respond by decreasing production

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Determination of Short-Run Equilibrium Output (Keynesian Cross)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and Gaps  Using Example 25.2 and adding the assumption that potential output also equals 4,800,  We can see how a fall in AD can lead to a recession

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Decline in Spending Leads to a Recession

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide The Multiplier  Income-expenditure multiplier  The effect of a one-unit increase in autonomous aggregate demand on short- run equilibrium output  An initial change in spending  leads to a larger change in short-run equilibrium output  Simplified form:

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Stabilization  The Keynesian model says that recessions are caused by insufficient aggregate spending  Implying that policymakers must find ways to increase aggregate demand  Stabilization policies  Government policies that are used to affect aggregate demand, with the objective of eliminating output gaps  Monetary policy  Fiscal policy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Government Policy  Monetary policy  Decisions on the size of the money supply  Fiscal policy  Decisions about the government’s budget  Government spending  Government revenues

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Government Purchases and AD  Keynes thought that changes in G would be the most effective tool for reducing output gaps  Increased government purchases can eliminate a recessionary gap

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig An Increase in Government Purchases Eliminates a Recessionary Gap

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig U.S. Military Expenditures as a Share of GDP,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Taxes, Transfers and AD  Fiscal policymakers also determine the level of  Tax collections  Payments from the private sector to the government  Transfer payments  Payments from the government to the private sector (e.g., welfare, social security payments)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Taxes, Transfers, and AD  Using taxes and/or transfers affects AD indirectly by changing disposable income  Increase in disposable income  Decrease taxes  Increase transfers  Decrease in disposable income  Increase taxes  Decrease transfers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Qualifications of Fiscal Policy  The real world is more complicated than the basic Keynesian model  1. Fiscal policy may affect potential output Y* as well as AD  Investments in public capital increase growth and potential output Y*  Roads, airports, schools, etc.  Taxes and transfers affect incentives  People save less with higher taxes on saving  Tax break on new investment encourages firms to make more investment  Policymakers should take both the demand side and supply side effects into account

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Qualifications of Fiscal Policy  2. Fiscal policy is not always flexible enough to be useful for stabilization  Changes in government spending or taxes are slow  usually a lengthy legislative process ensues  Budget changes proposed by the president must be submitted to Congress 18 or more months before they go into effect  Policymakers may have goals other than stabilizing AD  Adequate national defense  Income support for the poor  Reelection

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Automatic Stabilizers  Automatic stabilizers  Provisions in the law that imply automatic increases in government spending or decreases in taxes when real output declines  “Recession aid” flows out when the unemployment rate reaches a certain amount  Transfer payments increase and tax revenues decline during a recession