7–17–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 7 Spending and Output in the Short Run

7–27–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank An introduction to the Keynesian model Aggregate expenditure (AE) Planned aggregate expenditure and output Short-run equilibrium output Illustrating equilibrium using withdrawals and injections The 45-degree diagram Equilibrium and disequilibrium The four-sector model Planned spending and the output gap The multiplier Stabilising planned spending: the role of fiscal policy Fiscal policy as a stabilisation tool: three qualifications Chapter 7: Spending and Output in the Short Run

7–37–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Pre-Keynesian Dogma There will never be excess production because firms will cut prices to sell it There will never be persistent unemployment because workers will cut their wages to keep and get jobs Fluctuations in demand will be accommodated by flexible prices and wages without changes in output and employment

7–47–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Keynesian Ideas Pre-Keynesian dogma ignores the reality of depressions and long-term unemployment In the short run, unemployed workers do not cut their wages In the short run, firms accommodate a cut (rise) in demand by reducing (increasing) output and employment, not by reducing (increasing) prices

7–57–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Implication If private demand is insufficient for full employment, governments should fill the recessionary gap with public spending

7–67–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Why Prices are Not Fully Flexible Price rises involve ‘menu’ costs including loss of customer ‘goodwill’ Prices can’t be cut if wages aren’t Workers resist wage cuts because, in the absence of simultaneous price cuts, they reduce living standards, social status, and self respect

7–77–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Aggregate Expenditure (AE) AE = C + I + G + NX C = consumption spending by households I = investment spending by firms G = public spending by governments NX = foreign spending on our exports, net of our spending on imports

7–87–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inventory Investment When firms produce goods which they do not sell, this is an inventory investment expenditure by them This may be planned (desired) or unplanned (undesired)

7–97–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Planned vs Actual Spending Firms’ actual inventory investment Firms’ planned inventory investment Firms’ unplanned inventory investment Unplanned inventory investments signify excessive production and subsequent reductions in output

7–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Planned Aggregate Spending PAE = C + I P + G + NX I P stands for planned investment

7–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Determinants of Consumption Disposable income: [Y – T ] Other determinant: optimism/pessimism, wealth etc. which do not depend on income; denoted by C C = C + c [Y – T ] Exogenous and induced components of C c = the MPC = 1 – MPS

7–12 A Consumption Function

7–13 Australian Consumption Function

7–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Planned Aggregate Spending PAE = C + c [Y – T ] + I P + G + NX PAE = [C + I P + G + NX] + c [Y – T ] An exogenous component and an induced component Increase in Y of $1 induces an increase in PAE of $c through increased C

7–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Short-Run Equilibrium Y, Y e In equilibrium, supply = demand Supply: GDP = Y Demand: [C + I P + G + NX] + c [Y – T ] Set supply = demand and solve for Y = Y e Y e = [C + I P + G + NX – cT ] / [1 – c]

7–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Determinants of Y e Exogenous expenditures: C, I P, G, NX Exogenous Taxes: T The MPC: c Know these, know Y e

7–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Illustration on 45 o Diagram Need to find the level of Y or GDP which generates demand equal to the level of GDP (supply) itself This occurs where the PAE line cuts the 45 o line This line marks equal distances along the axis for GDP and the axis for PAE, so we know where they are equal

7–18 Short-Run Equilibrium

7–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Disequilibrium To the left of the intersection: –PAE > Y –excess demand –unplanned inventory loss (disinvestment) –Y rises To the right of the intersection: –PAE > Y –excess supply –unplanned gain in inventories –Y falls

7–20 Numerical Illustration

7–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Fall in PAE Reduces Y e Shift down in PAE gives lower Y e Fall in C, I P, G, NX Conversely for a shift up in PAE

7–22 Reduction in PAE Lowers Y e

7–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Withdrawals and Injections Y = C + I P + G + NX Y = C + S + T Therefore S + T = I P + G + NX LHS are withdrawals from spending – income from GDP not spent RHS are injections of spending

7–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Paradox of Thrift Increased desire to save (consume less) shifts down PAE and reduces Y e S + T = I P + G + NX So S = I P + G + NX – T S remains constant because [I P + G + NX – T ] is constant So aggregate saving has not increased

7–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Paradox of Thrift Despite people wanting to save a bigger proportion of their income, aggregate saving has not risen because income has fallen 20% of 100 is the same as 10% of 200!

7–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Expenditure Multiplier Shifts in PAE change Y e by a multiple of shift in PAE Shift in PAE changes exogenous spending and Y, which induces further changes in C and Y The size of the multiplier increases with MPC

7–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Fiscal Policy to Raise Y e Increase G, shifting PAE directly Lower T, raise disposable income and increase C by the MPC, shifting PAE indirectly Increase social security benefits (negative tax), raise disposable income and increase C by the MPC, shifting PAE indirectly

7–28 Increased G Eliminates Recessionary Gap

7–29 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Changed Role of Fiscal Policy When Keynes was writing, monetary policy was ineffective because of extreme pessimism associated with the Great Depression In these circumstances, expansionary fiscal policy was the only option to raise PAE In normal times, monetary policy is effective in stabilisation, so discretionary fiscal policy is less called for

7–30 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Modern Fiscal Stabilisation In recession, when income-tax collections automatically fall, let the budget move into deficit In booms, when income-tax collections automatically rise, let the budget move into surplus This provides automatic stabilisation and a budget which is in long-run balance

7–31 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Persistent Budget Deficits Assume that the G which it finances is not wasteful Then deficits are caused by low T Low T means disposable income is higher than it would be without deficit This means C is higher than it would be This means I is lower than it would be

7–32 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Annual Budget Balancing Is destabilising and undesirable because: –In recession, T falls automatically –Budget balance requires reduce G also –This deepens recession –Conversely in boom We should aim for balance OVER CYCLE