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Economics 102: Principles of Macroeconomics

Aggregate Spending in the Short Run and the Keynesian Cross

Why do uctuations occur? John Maynard Keynes British economist (1883-1946). The General Theory of Employment, Interest, and Money. Keynes idea: drops in aggregate spending might lead actual output to fall below potential output. Fiscal policy might be a useful tool to stabilize the economy.

Aggregate Expenditure
Recall from National Income and Product Accounts:

GDPexp

= + + +

Private Consumption (C) Investment (I) Government Expenditures (G) Net Exports (X - M)

GDPexp

Aggregate Expenditure

Planned Spending versus Actual Spending


Can Planned Investment dier from Actual Investment? One important source of discrepancy: planned investment versus actual investment. What happens when a rm sells less output than what it expected? Unsold output increases inventories. Recall in NIPA: Investment = + + Residential Fixed Investment Non-Residential Fixed Investment Changes in Inventories

This increase in in inventories investment as as a aconsequence consequence of of unsold unsold output output This increase yields level of of investment investment that is higher higher than than what what the the firm rmhad had yields a a level that is initially planned. initially planned. Planned Investment diers from Actual Investment. Lets look at an example.

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100.

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output.

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500.

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500. Actual Investment (I) = 1000 + 500 = $ 1,500.

Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500. Actual Investment (I) = 1000 + 500 = $ 1,500. I > Ip .

Example 1 Continued

What if the rm sells $ 2,100 worth of output?

Example 1 Continued

What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?).

Example 1 Continued

What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0

Example 1 Continued

What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100.

Example 1 Continued

What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100. Actual Investment (I) = 1000 + (-100) = $ 900.

Example 1 Continued

What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100. Actual Investment (I) = 1000 + (-100) = $ 900. I < Ip .

Consumption Function
Assume that consumption today depends on disposable income today. Marginal Propensity to Consume (mpc) the additional amount of consumption as a result of a one-dollar increase in disposable income. C Consumption = Disposable Income DI

mpc =

Note mpc (0, 1).

We can dene a consumption function: + mpc (Yt Tt ) = C

Ct

sometimes called autonomous consumption is a term that C, captures factors other than current disposable income that aect consumption. mpc (Yt Tt ) measures the responsiveness of consumption to changes in disposable income.

consumption

C = C + c x (Y T)

slope = mpc=c

disposable income

Planned Expenditure and Output


Production (Output) Income Spending

Production, Income and Spending activities are not isolated, but instead feed on each other. In particular, Planned Aggregate Spending (PAE) depends on output through the consumption function.

PAE = C + Ip + G + NX = + mpc (Y-T) + Ip + G + NX C

PAE = C + Ip + G + NX = = + mpc (Y-T) + Ip + G + NX C mpc T + Ip + G + NX C + mpc Y

A one-dollar increase in Y will lead to an increase of mpc dollars in PAE. Why?

Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C

PAE =

Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C

PAE =

= [ 500 + 0.9 (Y-100) ] + 1000 + 500 + 100

Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C

PAE =

= [ 500 + 0.9 (Y-100) ] + 1000 + 500 + 100 = 2010 + 0.9 Y

Short-Run Equilibrium

A short-run equilibrium output is dened as a level of output that equals Planned Aggregate Expenditure.

Y = PAE = YSR

planned aggregate expenditure

planned aggregate expenditure = C + Ip + G + NX

output Y

planned aggregate expenditure Y = PAE planned aggregate expenditure = C + Ip + G + NX

45 output Y

planned aggregate expenditure Y = PAE planned aggregate expenditure = C + Ip + G + NX

45 Y = PAE = YSR output Y

planned aggregate expenditure Y = PAE planned aggregate expenditure = C + Ip + G + NX

PAE

At Y < YSR firms are producing too little output and cannot meet demand PAE > Y Y

45 Y < YSR Y = PAE = YSR output Y

planned aggregate expenditure Y At Y > YSR firms are producing too much output and are exceeding demand Y > PAE PAE Y = PAE planned aggregate expenditure = C + Ip + G + NX

45 Y = PAE = YSR Y > YSR output Y

Example 2 Continued
To nd the Short-Run Equilibrium:

Y = PAE

Example 2 Continued
To nd the Short-Run Equilibrium:

Y = PAE Y = 2010 + 0.9 Y

Example 2 Continued
To nd the Short-Run Equilibrium:

Y = PAE Y = 2010 + 0.9 Y solve for Y

Example 2 Continued
To nd the Short-Run Equilibrium:

Y = PAE Y = 2010 + 0.9 Y 0.1 Y = 2010 solve for Y

Example 2 Continued
To nd the Short-Run Equilibrium:

Y = PAE Y = 2010 + 0.9 Y 0.1 Y = 2010 YSR = 20, 100 solve for Y

drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C

PAE =

drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C

PAE =

= [ 400 + 0.9 (Y-100) ] + 1000 + 500 + 100

drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C

PAE =

= [ 400 + 0.9 (Y-100) ] + 1000 + 500 + 100 = 1910 + 0.9 Y

planned aggregate expenditure

Y* Y = PAE PAE1 = 2010 + 0.9Y E1

45 Y1SR = 20,100 output Y

planned aggregate expenditure

Y* Y = PAE PAE1 = 2010 + 0.9Y E1

PAE2 = 1910 + 0.9Y

45 Y1SR = 20,100 output Y

planned aggregate expenditure

Y* Y = PAE PAE1 = 2010 + 0.9Y E1

PAE2 = 1910 + 0.9Y

E2

45 Y2SR = 19,100 Y1SR = 20,100 output Y

planned aggregate expenditure

Y* Y = PAE PAE1 = 2010 + 0.9Y E1

PAE2 = 1910 + 0.9Y

E2

45 Y2SR = 19,100 Y1SR = 20,100 output Y

output gap (recessionary)

In equilibrium, we have:

Y = PAE

In equilibrium, we have:

Y = PAE Y = 1910 + 0.9 Y 0.1 Y = 1910

In equilibrium, we have:

Y = PAE Y = 1910 + 0.9 Y 0.1 Y = 1910 YSR = 19, 100

Note, a decrease of 100 in autonomous consumption lead to a decrease of more than 100 (actually, 1000!) in equilibrium output. Why? Multiplier Eect: one dollar that is not spent is one dollar that does not become income of someone else, and then this person spends less, and then someone else has less income so therefore s/he also spends less, and ... Link between aggregate spending and mpc. What happens if mpc is higher/lower?

100

100

100

100

100 10 save

100

90

spend

100

90

100

100 10 save 90 9 save

100

90

spend

81

spend

100

90

81

100

100 10 save 90 9 save 81 8.1 save

100

90

spend

81

spend

72.9

spend

100

90

81

72.9

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

= 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x (0.9 x 100) + = 90 = 90 = 81 = 81 = 72.9

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

= 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x (0.9 x 100) + = 90 = 90 = 81 = 81 = 72.9

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 +

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 +

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + )

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) Y = 100 (1 0.9) = 1,000

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) initial spending Y = 100 (1 0.9)
mpc

= 1,000

100

100 10 save 90 9 save 81 8.1 save

72.9
7.29

save

100

90

spend

81

spend

72.9

spend

65.61 spend

100

90

81

72.9

65.61

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) initial spending Y = 100 (1 0.9)
mpc

= 1,000

multiplier =

1 (1 mpc)

Y
spending

initial

Fiscal Policy as a Stabilizer


Keyness idea: when aggregate demand falls, scal policy (in particular government spending) can be a useful tool to close output gaps. Why? G itself is part of Planned Aggregate Spending. Therefore, it can inuence output. What would be the increase in G necessary to close the recessionary gap in Example 2? Is it more, less or exactly 1000? What about changes in T?

planned aggregate expenditure

Y* Y = PAE

PAE2 = 1910 + 0.9Y ( C = 400, G = 500)

E2

45 Y2SR = 19,100 Y1SR = 20,100 output Y

output gap (recessionary)

planned aggregate expenditure

Y* Y = PAE PAE3 = ?? + 0.9Y ( C = 400, G = ??) E3 PAE2 = 1910 + 0.9Y ( C = 400, G = 500)

E2

45 Y2SR = 19,100 Y1SR = 20,100 output Y

output gap (recessionary)

Fiscal Policy as a Stabilizer

Is scal policy an eective stabilizer? Japan. Financing expenditure increases. Decits. Flexibility of scal policy. How fast can it be implemented?