ECO 103 Chp. 13

Menu costs

the costs of changing prices

Planned aggregate expenditure (PAE)

total planned spending on final goods and services

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* Output at each point in time is determines by the amount that people throughout the economy want to spend
* Output is determined by planned aggregate expenditure (aka planned spending)
* PAE = consumption (by households, firms, governments, and foreigners) + planned investment + government spending + net exports

Disposable income

the after-tax amount of income that people are able to spend

* Households and individuals with higher dispopsable incomes will consume more
* Consumption increases as income increases

Consumption function

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the relationship between consumption spending and its determinants, in particilar, disposable (after-tax) income

Autonomous consumption

consumption spending that is not related to the level of disposable income

* Ex. consumers become more optimistic about the future so that they want to consume more and save less at any given level of their current disposable income
* Even though their disposable income hasn’t changes
* Takes into account the effects that real interest rates have on consumption
* Higher real interest rates will make it more expensive to buy consumer durables of credit and so households may consume less and save more
* A decline in real interest rates may increase autonomous consumption

Wealth effect

the tendency of changes in asset prices to affect households’ wealth and thus their consumption spending

Marginal propensity to consumer (mpc)

the amount by which consumption rise when disposable income rises by $1; we assume that 0 < mpc < 1

* If people receive an extra dollar of income, they will consume part of the dollar and save the rest

Autonomous expenditure

the portion of planned aggregate expenditure that is independent of output

Induced expenditure

the portion of planned aggregate expenditure that depends on output

Expenditure line

a line showing the relationship between planned aggregate expenditure and output

* The slope is equal to the marginal propensity to consume
* The vertical intercept is equal to autonomous expenditure
* Changes in autonomous expenditure will shift the expenditure line up while decreases will shift the line down

Short-run equilibrium output

the level of output at which output Y equals planned aggregate expenditure PAE

* The level of output that prevails during the period in which prices are predetermined
* An economy is in short-run equilibrium when Y = PAE
* If short-run equilibrium output differs from potential output, an output gap exists

Income expenditure multiplier (multiplier)

the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output

* Ex. if the multiplier is 5, each 1-unit change in autonomous expenditure leads to a 5-unit change in short-run equilibrium output in the same direction
* The marginal propensity to consume (mpc) helps determine how large the multiplier will be
* If the mpc is large, tgen falls in income will cause people to reduce their spending sharlply, and the multiplier effect will then also be large
* If the mpc is small, then people will not reduce spending so much when income falls, and the multiplier also will be small

Stabilization policies

government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps

Expansionary policies

government policy actions intended to increase planned spending and  output

* Are normally taken when the econolmu is in recession

Contractionary policies

 government policy actions designed to reduce planned spending and output

* If output gaps are caused by too much or too little spending, then then government can help guide the economy by changing its own level of spending
* Changes in taxes or transfers do not affect planned spending directly, but they can work indirectly by changing disposable income in the private sector

Automatic stabilizers

provisions in the law that imply automatic increases in goevrnemtn spending or decreases in taxes when real output declines

Recessionary gap

 a negative output gap; Y < Y\*

* Actual output is less than potential output

Price rigidity

in the short run, firms meet demand at present prices

* Firms typically set a price and meet the demand at that price in the short run
* Firms do not normally change their prices frequently because doing so would be costly
* Economists refer to the costs of changing prices as menu costs

Planned aggregate expenditure (PAE)

output (Y) at each point in time is determined by the amount that people throughout the economy want to spend

* Four components of PAE


1. Consumption by households
2. Investment- planned spending by domestic firms on new capital goods
3. Government purchases- made by fed, state, and local governments
4. Net exports- exports - imports

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* **PAE = consumption expenditure + planned investment + government spending + net exports**

Consumption function

an equation relating planned consumption (C) to its determinants, notably disposable income (Y - T)

* **Consumption = Ĉ (autonomous consumption spending) + marginal propensity to consumer**
* __**Autonomous consumption spending**__**- spending not related to the level of disposable income**
* **All other factors which influence consumption is captured by the autonomous consumption. I.e, interest rate, wealth effect**

Marginal propensity to consume (mpc)- the change in consumption for a given change in disposable income; 0 < mpc < 1

Planned aggregate expenditure function

an equation relating planned aggregate expenditure (PAE) to output Y

* **PAE = consumption expenditure + planned investment + government spending  + net exports**
* **PAE =  Ĉ + mpc (Y - Ť) + autonomous planned investment + autonomous government spending  + autonomous net exports**
* **PAE = autonomous PAE + mpc (Y)**

Autonomous expenditure

the part of spending that is independent of output (Y)

Induced expenditure

the part of spending that depends on output (Y)

Expenditure line

shows the relationship of planned aggregate expenditure to output

* The slope of the expenditure line is equal to the marginal propensity to consume
* The vertical intercept equals the level of autonomous expenditure
* Changes in autonomous expenditure will shift the expenditure line

Basic Keynesian model

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* In the short run, prices are rigid 
* PAE = Y(output)
* PAE = C + Ip + G + NX

Income expenditure multiplier (multiplier)

shows the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output

* The impact on output is often greater than theinitial change in spending because of the “vicioous circle”
* A fall in consumer spending not only reduces the sales of consumer goods directly
* Also reduces the incomes of workers in the industries that produce consumer goods
* As their incomes fall, these workers and capital owners reduce their spending, which reduces the output and incomes of other producers in the economy
* And these reductions in income lead to still further cuts in spending
* Ultimately, these successive rounds of declines in spending and income may lead to a decrease in planned aggregate expenditure and output tha is significantly greater than the change in spending that started the process

Stabilization policies

government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps

* Two major tools of stabilization policy:


1. Monetary policy- refers to decisions about the size of the money supply
2. Fiscal policy- refers to decisions about the government’s budget - how much the government spends and how much tax revenue it collects

Expansionary policies

 increase planned aggregate expenditure to mitigate the effect of recession

* Include an increase in government expenditure and a decrease in net taxes

Contractionary policies

decrease planned expenditure to deal with inflationary risk in an overheating economy

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* Include a decrease in government expenditure and an increase in net taxes

Automatic stabilizers

increase government spending or decrease taxes when real output declines