Spending and Output in the Short Run · Consumption and the Stock Market What effect did the...

Spending and

Output in the

Short Run

Instructor: Xi Wang

UMSL, Summer 2015

Learning Objectives

1. Identify the key assumptions of the basic Keynesian

model

2. Discuss the determination of planned investment and

aggregate consumption spending

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

5. Explain why the basic Keynesian model suggests that

fiscal policy is useful

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Introduction Suppose the stock market crashes; people lose their life

savings; they are forced to reduce spending.

GDP falls due to a reduction in aggregate spending.

A recessionary gap is created.

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Introduction Great Depression

Available resources are unemployed

Demand for goods and services not met

A decrease in spending leads to lower

production

Laid-off workers reduce their spending

Insufficient spending to support the normal level of production

No problem with productive capacity

Conventional economic policy of the 1920s

and 1930s would not solve this problem

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John Maynard Keynes John Maynard Keynes revolutionized economic

thought and public policy

For a brief history:

http://www.bbc.co.uk/history/historic_figures/keynes_j

ohn_maynard.shtml

Economist, diplomat, financier, journalist, and patron

of the arts

In The General Theory of Employment, Interest and

Money, he

Predicted that a decrease in aggregate spending could create a

recessionary gap

Suggested that government policy could be used to restore full

employment

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John Maynard Keynes Masters of Money Part 1

https://www.youtube.com/watch?v=CkHooEp3vRE

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The Keynesian Model’s Crucial Assumption:

Firms Meet Demand at Preset Prices

The Keyenisian Model is a building block for

current theories of short-run economic

fluctuations and stabilization policies

In the short run, firms meet the demand for

their products at preset prices.

Firms do not respond to every change in the demand for their

products by changing their prices.

Instead, they typically set a price for some period, then change

quantity to meet the demand at that price.

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The Keynesian Model’s Crucial Assumption:

Firms Meet Demand at Preset Prices

Meeting Demand at Preset Prices:

Is a logical management decision because of menu costs.

Prices should be changed only if the additional benefit exceeds the extra menu cost.

In the long run firms will change prices.

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Menu Costs

New technologies have certainly reduced (but not

eliminated) menu costs.

Example: bar codes on products; scanner technology, etc.

Pricing decisions also require time consuming market analysis,

strategic considerations, and cost analysis - these factors are

also components of menu costs.

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Planned Aggregate Expenditure

Keynesian theory hypothesizes that output at each point in time is determined by the total amount that people want to spend on final goods and services throughout the economy.

This is referred to as Planned Aggregate Expenditure (PAE)

The Components of PAE :

Consumer expenditure or Consumption (C)

Planned Investment expenditures (IP)

Government expenditures (G)

Expenditures on Net Exports (NX)

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Planned Aggregate Expenditure

Consumption Expenditure (C)

Household spending on durables, nondurables, and services

Planned Investment (IP)

Spending on New capital goods

Spending on New residential buildings

Increases in inventories

Government purchases (G)

Federal, state, and local spending on goods and services

Net exports (NX)

Exports - Imports

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Planned vs. Actual Aggregate

Expenditure Therefore, Planned Aggregate Expenditure is given as the

following sum:

This may or may not be equal to Actual Expenditures which equals

C + I + G + NX

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NX G I C PAE P

Planned Spending versus Actual

Spending

In the Keynesian model, output is determined

by PAE. However, Actual expenditures may

not equal PAE.

If inventories are larger than expected: Actual

Investment (I) > planned Investment (IP), and

Actual Expenditure > PAE

If inventories are smaller than expected: Actual Investment (I) <

planned Investment (IP), and

Actual Expenditure < PAE

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Planned Spending versus Actual

Spending

Example:

Fly-by-Night Kite Co. produces $5 million kites per year.

Expected sales = $4.8 million kites and planned inventory = $200,000

kites which it expects to store in the warehouse for future sale.

During the year, the company makes new Capital expenditure worth

$1 million, as part of an expansion plan.

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Planned Spending versus Actual

Spending

If actual sales are $4,600,000 (low demand)

IP = $1,000,000 + $200,000 = $1,200,000

I = $1,000,000 + $400,000 = $1,400,000

I > IP

If actual sales are $4,800,000 (demand exactly as expected)

IP = $1.2 m. = I If actual sales are $5,000,000 (high demand)

IP = $1,000,000 + $200,000 = $1,200,000

I = $1,000,000 + $200,000 - $200,000 = $1,000,000; I < IP

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Planned Aggregate Expenditure

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Since firms meet demand at preset

prices, they cannot control how much

they sell. So planned I may well be

different from actual I. For simplicity we

assume that C, G and NX always equal

their planned levels

The only way for PAE and Actual

Expenditures (Y) to be different is if IP

and I are different.

Consumption Function

Consumption (C) accounts for two

thirds of total spending

The primary determinant of C is

disposable income or Y - T

Consumption Function is the

relationship between consumption

spending and its determinants, in

particular, disposable (after-tax)

income

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Consumption Function

The consumption function:

C is a constant; it represents the non income determinants of C, like

Consumer optimism; Wealth; Real interest rates

c is the marginal propensity to consume; 0<c<1

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T)- c(Y C C

The U.S. Consumption

Function, 1960-2007

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Consumption and the Stock

Market

What effect did the 2000-2002 decline in the U.S. stock market values have on consumption spending?

From March 2000 to March 2002 the S&P 500 fell 49%.

Households lost $6.5 trillion of wealth in two years

Historically, a $1 decrease in wealth reduces overall consumer spending C by 3 to 7 cents/year (i.e., 3% to 7%)

The $6.5 trillion loss could reduce Consumption between $195 and $455 billion

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Consumption and the Stock

Market

On the Contrary, Consumption Expenditures (C) continued to increase between 2000 and 2002. This is explained by

Higher housing prices (greater wealth)

Lower interest rates increased consumer spending on big ticket items, like automobiles etc.

Real after tax income (Y - T) continued to rise until Fall 2001 despite the recession that started in March 2001.

Look at Nature of 2001 Recession Handout

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A Consumption Function

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Disposable income Y-T

Co

nsu

mp

tio

n s

pe

nd

ing

C Consumption function

Slope = c = MPCC

T)- c(Y C C

Back to Planned Aggregate

Expenditure

Planned Aggregate Expenditure and Output

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NX G I C PAE P

T)- c(Y C C

PAE = C + c(Y – T) + IP + G + NX

Planned Aggregate Expenditure

Suppose:

C = 620; c = 0.8; T = 250; IP = 220;

G = 300; NX = 20

Then:

PAE = [620 + 0.8(Y - 250) + 220 + 300 + 20

= 620 - 200 + 220 + 300 + 20 = 0.8 Y

Therefore,

PAE = 960 + 0.8 Y

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Planned Aggregate Expenditure

Relationship between PAE and Output is given by:

PAE = 960 + 0.8 Y

The part of PAE that is independent of output is called Autonomous Expenditure (=960)

The part of PAE that depends on output Y is called Induced Expenditure (=0.8Y)

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Short Run Equilibrium Output

Keynesian Assumption

Producers meet demand at preset prices in the short-run

Short-run equilibrium is achieved when output (actual

expenditure) equals planned spending: Y = PAE

Short-run equilibrium output is the level of output that

prevails during the period in which prices are

predetermined

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Numerical Determination of

Short-Run Equilibrium Output

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(1)

Output

Y

4,000 4,160 -160 No

4,200 4,320 -120 No

4,400 4,480 -80 No

4,600 4,640 -40 No

4,800 4,800 0 Yes

5,000 4,960 40 No

5,200 5,120 80 No

(2)

Planned aggregate expenditure

PAE = 960 + 0.8Y

(3)

Y - PAE

(4)

Y = PAE?

Equilibrium: Y = PAE; Y (4,800) = PAE (4,800)

If Y=4,000, PAE = 960 + .8(4000) = 4,160, Y<PAE

If Y=5,000, PAE = 960 + .8(5,000) = 4,960,

Y>PAE

Determination of Short-Run Equilibrium

Output (Keynesian Cross)

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Output Y

Pla

nn

ed

ag

gre

ga

te e

xp

en

ditu

re

PA

E

960

Expenditure line

PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium when PAE intersects

the 45o line @ 4,800

Disequilibrium

If Y < 4,800, PAE > Y

If Y > 4,800, PAE < Y

Short Run Equilibrium

Algebraically, we have short run

equilibrium when,

Y = PAE

Y = 960 + 0.8 Y

0.2 Y = 960

Y* = 960/0.2 = 960 x 5 = $4800

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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

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Output Less than Equilibrium

Suppose output is only

4,700

Planned spending is more

than total output

Unplanned inventory

decreases

Businesses speed up

production

Output goes up

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PA

E

Output

(Y)

96

0

PAE = 960 +

0.8Y

Y = PAE

4,8004,700

Planned Aggregate Expenditure

Other factors remaining constant, a decline in autonomous spending causes short-run equilibrium output to fall and creates a recessionary gap.

Other factors remaining constant, an increase in autonomous spending causes short-run equilibrium output to rise and creates an expansionary gap.

A decrease (increase) in autonomous spending can be caused by a reduction (increase) in autonomous C, IP, G, and/or NX.

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Recessionary Gap: Demand Falls

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Determination of Short-Run

Equilibrium Output After A Fall In Spending

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(1)

Output

Y

4,600 4,630 -30 No

4,650 4,670 -20 No

4,700 4,710 -10 No

4,750 4,750 0 Yes

4,800 4,790 10 No

4,850 4,830 20 No

4,900 4,870 30 No

4,950 4,910 40 No

5,000 4,950 50 No

(2)

Planned aggregate expenditure

PAE = 950 + 0.8Y

(3)

Y - PAE

(4)

Y – PAE?

Short Run Equilibrium

New equilibrium with reduced

planned expenditure

Y = 950 + 0.8 Y

0.2 Y = 950

Y = 950/0.2 = 950 x 5 = $4750

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Spending and Output in the Short Run; F&B 4th ed Slide 36

The Multiplier

Income-Expenditure Multiplier measures the effect of a 1-

unit increase in autonomous expenditure on short-run

equilibrium output

m = 1/(1-c) = 1/(1-0.8) = 5

Therefore, if autonomous expenditure rises (falls) by $4,

output will rise (fall) by $20 in the short run.

Spending and Output in the Short Run; F&B 4th ed Slide 37

Planned Aggregate Expenditure

Why is the change in equilibrium Y a multiple of the

change in autonomous spending?

Spending and Output in the Short Run; F&B 4th ed Slide 38

Tax Multiplier

Is c/(1-c) = 0.8/(1-0.8) = 4

Tax multiplier is less than govt. expenditure multiplier.

If Govt. expenditure rises by $Z, everything else remaining constant (including taxes), equilibrium GDP rises by 1/(1 – c) ×$Z.

If taxes FALL by $Z, everything else remaining constant (including govt. expenditure), equilibrium GDP rises by c/(1 – c) ×$Z.

Spending and Output in the Short Run; F&B 4th ed Slide 39

Balanced Budget

Multiplier Govt. budget is G – T. Suppose govt. expenditure and

taxes both rise by $Z. The balanced budget multiplier is

1/(1-c) – c/(1-c) = 1

Equilibrium GDP will rise by $Z.

The Case of Japan

Japanese Govt. built a 160 mile toll road in

Hokkaido that is not used very much. Why?

Application of keyenesian fiscal policy – spend about $1 trillion in

public works projects

The policy was not been successful

too little too late

more productive investments may have helped more by raising

consumer confidence and increasing the long run productive

capacity of the nation

Consumers realize that eventually taxpayers will have to foot the bill

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Causes of Recent Recessions

What caused the 1990-1991 recession in the

US?

Decline in consumer confidence following Iraq-Kuwait War and the

associated rise in oil prices

Credit crunch following large real estate loans by US banks that

could not be recovered (the Savings and Loan debacle)

Robust investment spending, 1995 – 2000

High growth economy

New technologies: internet, fiber optics, genetic engineering

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Causes of Recent Recessions

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What caused the 2001 recession in the United

States?

Reduction in investment spending - an adjustment

to the over-optimistic investments earlier

Recession caused by a decline in autonomous

spending

Less investment in 2001

Terrorist attack 9/11

Travel spending decreased

Recovery began 2002 – in the form of a housing boom

Stabilizing Planned

Spending: The Role of

Fiscal Policy In the Keynesian Model:

Recessionary and expansionary gaps are caused by

inadequate or excessive spending, respectively.

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Stabilization Policies are

Government policies that are used to affect

planned aggregate expenditure, with the

objective of eliminating output gaps

Two kinds of Stabilization

Policies Expansionary Policies

Government policy actions intended to increase planned

spending and output and eliminate recessionary gap

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Contractionary Policies

Government policy actions designed to

reduce planned spending and output and

eliminate expansionary gap

Tools of Stabilization

Policies Tools of Stabilization Policy

Fiscal Policy

Government Expenditures -

direct effect on PAE

Taxes and Transfer Payments -

indirect effect of PAE

Monetary policy

Money Supply and rate of

interest

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Taxes and the Short run

Equilibrium Example

Using a tax cut to close a recessionary gap

Assume

Recessionary gap = 50 ($4750

instead of $4800)

MPC = 0.8; multiplier = 5

Need to raise PAE by $10

Use a tax cut to eliminate the gap

The tax cut must increase PAE by $10

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Stabilizing Planned

Spending: The Role of

Fiscal PolicyFor every dollar reduction in taxes,

consumption will increase by 80

cents (MPC = 0.8); so PAE will

increase by 80 cents So to raise PAE by $10 we need a tax cut of 10/0.8 = $12.5

An increase in transfers of 12.5 will also raise PAE by 10 (12.5 x

0.8) = 10

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Recent Tax Rebates

Why did the federal government send out millions of $300 and $600 checks to households in 2001?

In the spring 2001, the U.S. economy was slowing.

Summer 2001, families received $38 billion in tax rebates.

Survey indicated that only 22% of the households anticipated spending most of their rebates.

Tax cuts were accompanied by increases in government spending to stimulate PAE.

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Spending and Output in the Short Run; F&B 4th ed Slide 49

The Case of Japan

Why was the deep Japanese recession

of the 1990s bad news for the rest of

East Asia?

Recession in Japan reduced

Japanese imports (East Asian

exports)

Wages and profits declined in East

Asian export industries which spilled

over to the non-export sectors

Fiscal Policy as a Stabilization

Tool: Three Qualifications 1. Fiscal Policy and the Supply Side

Keyenesian Model assumes fiscal policy affects PAE only

Supply side argument - tax breaks give individuals incentive to invest, take risks and create capital, thereby raising potential output; no effect on PAE is expected

In reality, fiscal policy may affect potential output as well as PAE. Government expenditures on public capital (roads, airports), R&D, and human capital (education) will affect potential output

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Fiscal Policy as a Stabilization

Tool: Three Qualifications

2. The Problem of Rising Budget Deficits

Sustained government deficits reduce saving and

investment in new capital goods – crowding out.

The goal of keeping deficits low may reduce the

incentive to use fiscal policy to control a

recessionary gap.

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Fiscal Policy as a Stabilization

Tool: Three Qualifications 3. A lack of flexibility may reduce the effectiveness of

fiscal policy

Two limits to fiscal policy flexibility

The problem of time lags and the

legislative process

Competing political objectives

Fiscal policy is therefore less useful for

stabilizing aggregate spending than the

basic Keyenesian model suggests.

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Fiscal Policy and Automatic

Stabilizers Automatic stabilizers help offset the inflexibility

of fiscal policy. These are provisions in the law

that imply automatic increases in government

spending or decreases in taxes when real

output declines (unemployment benefits,

taxes are hooked to incomes). These change

automatically without the delays of the

legislative process.

Fiscal policy may be useful to address prolonged periods of recession

- Great Depression

In the US, monetary policy has been used more frequently.

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Some Interesting Videos

Round 1:

https://www.youtube.com/watch?v=d0nERTFo-Sk

Round 2:

https://www.youtube.com/watch?v=GTQnarzmTOc

Keynes vs. Hayek Rap Video, Round 2: Q&A with Russ Roberts on top-down and bottom-up economics

https://www.youtube.com/watch?v=5NIyCJC9ehQ

Lyrics

http://genius.com/John-papola-and-russ-roberts-fear-the-boom-

and-bust-hayek-vs-keynes-lyrics

http://genius.com/John-papola-fight-of-the-century-keynes-vs-hayek-round-two-lyrics

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End of

Chapter

Summary