1. Nov. 6 th, 2002ECON 1 – Section 19 – Page 1GSI: R. Estopina ECON 1 – Section 19 Demand and Output in the Short Run.

2. ECON 1 – Section 19 – Page 2GSI: R. EstopinaNov. 6 th, 2002 Contact Details GSI: Ramon Estopina Office Hours: No OH this Thursday !! Office: Evans 508-7 Email: estopina@haas.berkeley.eduestopina@haas.berkeley.edu Handouts (only sections 104 & 133) after class in: http://www.ocf.berkeley.edu/~jaychen/econ1/ http://www.ocf.berkeley.edu/~jaychen/econ1/ Please read: Read before downloading!.

3. ECON 1 – Section 19 – Page 3GSI: R. EstopinaNov. 6 th, 2002 Section 19 Agenda Administrative Stuff (10 min) Recap Quiz (10 min) Problem 25.6 (10 min) Problem 25.7 (10 min) Problem 25.9 (10 min) Re-cap (2 min)

4. ECON 1 – Section 19 – Page 4GSI: R. EstopinaNov. 6 th, 2002 Administrative Stuff PS #3 ready today from Econ-1 website !!! Due next Wednesday 13 th. Remember, no class next Monday!! -Veterans Day Holiday. Opportunity to catch-up and get ready for Midterm.

5. ECON 1 – Section 19 – Page 5GSI: R. EstopinaNov. 6 th, 2002 Review of Last Lecture - 11/4 th Chapter 25: AD: planned vs actual spending. Consumption Function and MPC Autonomous vs Induced spending Keynesian Model Assumptions Keynesian Cross Diagram Shifts in AD Equilibrium Output Potential Output Gaps (recessionary/expansionary) Paradox of thrift & multiplier

6. ECON 1 – Section 19 – Page 6GSI: R. EstopinaNov. 6 th, 2002 Recap Quiz - 1 Total planned spending on final goods and service is called 1) total spending. 2) total consumption. 3) aggregate expenditures. 4) aggregate consumption. 5) aggregate demand.

7. ECON 1 – Section 19 – Page 7GSI: R. EstopinaNov. 6 th, 2002 Recap Quiz - 2 A firm's actual investment will exceed its planned investment when 1) it sells less than it planned. 2) It sells more than it planned. 3) interest rates rise. 4) interest rates fall. 5) the economy experiences an unexpected expansion.

8. ECON 1 – Section 19 – Page 8GSI: R. EstopinaNov. 6 th, 2002 Recap Quiz - 3 The largest component of aggregate demand is 1) consumption. 2) investment. 3) government purchases. 4) exports. 5) imports.

9. ECON 1 – Section 19 – Page 9GSI: R. EstopinaNov. 6 th, 2002 Recap Quiz - 4 The objective of stabilization policies is to 1) affect aggregate supply. 2) eliminate output gaps. 3) increase potential GDP. 4) keep inflation constant. 5) cause business cycles

10. ECON 1 – Section 19 – Page 10GSI: R. EstopinaNov. 6 th, 2002 Recap Quiz - 5 The value of the MPC is assumed to be 1) less than 1. 2) greater than 1. 3) less than 0. 4) equal to 1. 5) constant.

11. ECON 1 – Section 19 – Page 11GSI: R. EstopinaNov. 6 th, 2002 Important to remember: Equation 1 of the day: Aggregate Demand (AD): total planned spending on final goods and services.

12. ECON 1 – Section 19 – Page 12GSI: R. EstopinaNov. 6 th, 2002 Important to remember (2) Remember: Planned may differ from actual for firms: difference is change in inventories. Firm sells less than expected: inventories grow (Increase in inventories is counted as actual investment)  I > I p Firm sells more than expected: inventories decline  I p > I

13. ECON 1 – Section 19 – Page 13GSI: R. EstopinaNov. 6 th, 2002 Important to remember (3) Components of AD. A) CONSUMPTION FUNCTION: = constant term capturing factors other than disposable income c = MPC (marginal propensity to consume): amount C raises when disposable income rises; assume 0 < c < 1

14. ECON 1 – Section 19 – Page 14GSI: R. EstopinaNov. 6 th, 2002 Important to remember (4) B) Rest of factors are exogenous.

15. ECON 1 – Section 19 – Page 15GSI: R. EstopinaNov. 6 th, 2002 Important to remember (5) Combining all equations: Composed of: Autonomous AD & Induced AD

16. ECON 1 – Section 19 – Page 16GSI: R. EstopinaNov. 6 th, 2002 Important to remember (6) In equilibrium Y = AD, so: Multiplier:

17. ECON 1 – Section 19 – Page 17GSI: R. EstopinaNov. 6 th, 2002 Box 25.2 (F&B page 667) From Example 25.2 (F&B page 664) we have: =620 /c = 0.8 / = 220 / =300 / =20 / =250 We know the definition of Aggregate Demand is: AD = C + I p + G + NX And, in the SHORT RUN:

18. ECON 1 – Section 19 – Page 18GSI: R. EstopinaNov. 6 th, 2002 Box 25.2 (Conclusion) Substituting the components: AD = [620 + 0.8(Y-250)] + 220 + 200 + 20 And finally: AD = 960 + 0.8Y In addition, from the short term equilibrium: Y=AD So the previous equation will be: Y = 960 + 0.8Y Solving for Y: Y = 960 / 0.2 = 4,800

19. ECON 1 – Section 19 – Page 19GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (F&B page 684) For the following economy, find Autonomous aggregate demand The multiplier SR equilibrium output Output gap.

20. ECON 1 – Section 19 – Page 20GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) A) The relationship between aggregate demand and output is given by: Autonomous aggregate demand equals 6200, the part of aggregate demand that does not depend on output.

21. ECON 1 – Section 19 – Page 21GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) To find short-run equilibrium output, use the equation Y=AD and solve for Y: What is the Output Gap? Remember last class: Y*-Y

22. ECON 1 – Section 19 – Page 22GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) So we have: SR equilibrium output (Y) = 12,400 Potential output (Y*)= 12,000 Output gap is = – 400. Is this a recessionary or expansionary gap? Expansionary, Y > Y*

23. ECON 1 – Section 19 – Page 23GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) The multiplier can be found by the formula of the multiplier (obviously) = 1/(1-c) There is another way to solve it (more complicated), but I know you are curious.

24. ECON 1 – Section 19 – Page 24GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) Imagine that autonomous aggregate demand rises from 6200 to 6300. Now the equation Y=AD becomes Y= 6,300 + 0.5Y Solving for output yields Y = 12,600, an increase of 200 over the solution found before. We have shown that an increase in autonomous aggregate demand of 100 raises short-run equilibrium output by 200. Therefore the multiplier must equal 2.

25. ECON 1 – Section 19 – Page 25GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (Conclusion) By how much would autonomous AD have to change to eliminate the output gap? As the multiplier is 2, to eliminate the output gap of – 400, autonomous aggregate demand would have to change by – 200, that is, autonomous aggregate demand would have to fall. If autonomous aggregate demand falls from 6200 to 6000, then short-run equilibrium output equals 12,000 and the output gap is eliminated.

26. ECON 1 – Section 19 – Page 26GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (F&B page 685) Following with the previous problem but now = 0. A) What would be the SR equilibrium output? We proceed as before:

27. ECON 1 – Section 19 – Page 27GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (cont ’ d) Then we apply the definition of short-run equilibrium output, Y = AD.

28. ECON 1 – Section 19 – Page 28GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (cont ’ d) B) Economic recovery abroad increases the demand for the country ’ s exports. As a result = 100. What happens to the SR Equilibrium Output?

29. ECON 1 – Section 19 – Page 29GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (cont ’ d) An increase of by 100 implies that autonomous aggregate demand rises by 100, so now we have: So the increase in net exports of 100 has increased output by 200.

30. ECON 1 – Section 19 – Page 30GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (cont ’ d) C) Now assume foreign economies are slowing and the demand for the country ’ s exports is reduced. As a result = -100. What happens to the SR Equilibrium Output?

31. ECON 1 – Section 19 – Page 31GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (cont ’ d) A decrease of by 100 implies that autonomous aggregate demand falls by 100, so now we have: So the decline in net exports of 100 lowers output by 200.

32. ECON 1 – Section 19 – Page 32GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (Conclusion) How these results help explain the tendency of recessions and expansions to spread across countries? The example shows that a weak economy in one country, by reducing that country ’ s imports from a second country, can create economic weakness in the second country as well. Similarly, an expansion that increases a country ’ s purchases of foreign products strengthens the economies of its trade partners.

33. ECON 1 – Section 19 – Page 33GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (F&B page 685) For the following economy, find how much would Gov. purchases have to change to eliminate any output gap (this is fiscal policy).

34. ECON 1 – Section 19 – Page 34GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) We solve for short-run equilibrium output via the usual two steps. First, find the relationship of aggregate demand to output:

35. ECON 1 – Section 19 – Page 35GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) Second, use the condition Y = AD to solve for short-run equilibrium output: The output gap is Y*-Y = 580-600 = -20, so there is an expansionary gap of 20.

36. ECON 1 – Section 19 – Page 36GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) To answer the question about the effects of fiscal policy we need to know the multiplier for this economy. In this case:

37. ECON 1 – Section 19 – Page 37GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) Now we can find the appropriate fiscal policies to eliminate the output gap. Because actual output exceeds potential output by 20, and the multiplier is 5, a decrease of 4 in government purchases (from 120 to 116) will eliminate the output gap. You can verify this directly by setting =116 and re-solving for short-run equilibrium output.

38. ECON 1 – Section 19 – Page 38GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) By how much would taxes have to change? (Assume MPC = 0.8) For the case of a tax change we have to be careful. A change in taxes of ΔT does not change autonomous aggregate demand by ΔT, because consumers do not spend 100% of any tax cut (or reduce spending by 100% of any tax increase). A change in taxes of ΔT instead changes autonomous aggregate demand by cΔT, where c is the marginal propensity to consume (MPC) out of disposable income.

39. ECON 1 – Section 19 – Page 39GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) In the case of government spending, eliminating the output gap requires reducing autonomous aggregate demand by 4. To reduce autonomous aggregate demand by 4 via a tax change, Gov. will increase taxes by 5. Since the MPC = 0.8, a tax increase of 5 will lead consumers to reduce their spending by 4, as desired. You can also verify it by setting =115 and solving for short-run equilibrium output.

40. ECON 1 – Section 19 – Page 40GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) What happens if now Y*=630? If potential output is 630, then the output gap is Y*-Y=30, that is, there is a recessionary gap of 30. As the multiplier is 5, this gap can be eliminated by raising government purchases by 6. An increase in shifts the expenditure line upwards. AD OutputY*=630 600 Y=AD AD=120+0.8Y AD=126+0.8Y

41. ECON 1 – Section 19 – Page 41GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (Conclusion) Alternatively, cut taxes by 6/0.8 = 7.5. Because the MPC is 0.8, a cut in taxes of 7.5 will also stimulate autonomous aggregate demand by 6 and output by 6*5 = 30. The Keynesian cross diagram in this case shows the expenditure line rising too, rather than falling, to restore Y=Y*.

42. ECON 1 – Section 19 – Page 42GSI: R. EstopinaNov. 6 th, 2002 Problems for next sections !!! For next section: Chapter 26: Problems 3, 8, 9. Remember: This is not mandatory. It won ’ t be graded. Only for those of you that need improvement in Exam grades.

43. ECON 1 – Section 19 – Page 43GSI: R. EstopinaNov. 6 th, 2002 Next class Next Class: Section 20 – Wednesday, Nov 13 th No class next Monday. Veterans Day Holiday. Due PS#4 !!!! If you want more practice, work on Next Sections Problems (although you probably have enough). Read ch. 26 & 27. You can download handouts this afternoon. Thank you for coming on time !!! Enjoy the long weekend & C-U Wednesday !!.