Spending and Output in the Short Run

The Keynesian Model

Building block for current theories of short-run economic fluctuations and stabilization policies

In the short run, firms meet demand at preset prices

• Firms typically set a price and meet the demand at that price in the short run

Firms change prices when the marginal benefits exceed the marginal costs

What has Technology reduced?

menu costs

bar codes and scanners reduce costs of changing prices in the store

online surveys

Planned Aggregate Expenditure (PAE)

total planned spending on final goods and services

Actual spending equals planned spending for

• Consumption

• Government purchases of final goods and services

• Net exports

4 Components of PAE

• Consumption (C) by households

• Investment (I) is planned spending by domestic firms on new capital goods

• Government purchases (G) are made by federal, state, and local governments

• Net exports (NX) equals exports minus imports

PAE Formula

PAE = C + I^P + G + NX

2 Dynamic Patterns in the Economy

• Declines in production lead to reduced spending

• Reductions in spending lead to declines in production and income

Consumption Expenditure

Accounts for two-thirds of total spending

• Powerful determinant of planned aggregate expenditure

• Includes purchases of goods, services, and consumer durables, but not new houses

  • Rent is considered a service

C depends on disposable income: the after-tax amount of income that people are able to spend, (Y – T)

Consumption Function

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

C = C + (mpc) (Y – T),

• where C is autonomous consumption

• marginal propensity to consume (mpc) is the increase in consumption spending when disposable income increases by $1

• 0 < mpc < 1

• (Y – T) is disposable income

  • Output plus government transfers minus taxes

  • Main determinant of consumption spending

Short-Run Equilibrium

the level of output at which planned spending is equal to output

• no change in output as long as prices are constant

• can be written Y = PAE

Output Greater then Equilibrium Example

Suppose output reaches 5,000 – Planned spending is less than output – Unplanned inventory increases – Businesses slow down production – Output goes down

Suppose output is only 4,500 – Planned spending is more than total output – Unplanned inventory decreases – Businesses speed up production – Output goes up

Income-Expenditure Multiplier

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

Income-Expenditure Multiplier Example

• Initial planned expenditure = 960 + 0.8Y

• New planned expenditure = 950 + 0.8Y

  • The 10-unit drop in C implied a 10 unit drop in autonomous expenditure

  • Equilibrium changed from $4,800 to $4,750

  • A $10 change in autonomous expenditures caused a $50 change in output

  • Multiplier = 5

• The larger the MPC, the greater the multiplier

Stabilisation Policy

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

• Expansionary policies increase planned expenditure

• Contractionary policies decrease planned expenditure

• Fiscal policy uses changes in government spending, transfers, or taxes

• Monetary policy uses changes in the money supply

The Tools of Fiscal Policy

• Government spending - Direct effect on PAE

• Taxation - Indirect effect on PAE

• Transfer payments - Indirect effect on PAE

Discretionary Fiscal Policy

Government decisions to change:

• Government spending (G) - Direct effect on PAE

• Net taxes (T) - Indirect effect on PAE

Both change the government deficit (G – T)

Government Spending

part of planned spending

changes will directly affect planned aggregate expenditures

Government Spending Example

• Suppose planned spending decreases $10 from Y = 960 + 0.8Y to Y = 950 + 0.8Y

  • Equilibrium Y decreases from $4,800 to $4,750

    • Recessionary gap is $50

• Stabilization policy indicates a $10 increase in government spending will restore the economy to Y* at $4,800

US Military Spending

• Decreased sharply after World War II

  • Peaks for wars and Reagan military build-up

• Added demand helped end the Great Depression

  • Recessions associated with declines

  • Increases can help stimulate the economy

Crowding-Out Effect

• The tendency of an increase in government expenditure to increase the rate of interest, and reduce consumption and investment by the private sector

• Occurs when PAE is affected by changes in interest rates

What does the Strength of the Crowding-Out Effect depend on?

1. The responsiveness of consumption and investment to interest rate changes

   • For any given interest rate the crowding-out will be stronger the greater the resulting decline in consumption and investment

2. The responsiveness of the demand for money to interest rate changes

What is PAE influenced by?

changing total taxes and/or transfer payments

the effect is indirect, channelled through the effects on disposable income

• lower taxes or higher transfers increase disposable income

• increases in disposable income lead to higher C

Net Taxes (T) Formula

total taxes - transfer payments - government interest payments

Supply-Side Effects of Fiscal Policy

Fiscal policy may affect potential output as well as potential spending

• Investment in infrastructure increases Y*

• Taxes and transfers affect incentives and can change potential output, Y*

Government Deficit

the difference between government spending and net taxes (G - T)

What do Large and Persistent Budget Deficits cause?

reduced national saving which means less investment and therefore less growth

What are the 2 Limits of Fiscal Policy Flexibility?

The legislative process requires time

• Change in fiscal policy may be slow

Competing political objectives

• National defence

• Entitlements such as Medicare and income support

Automatic Stabilisers

Automatic changes in the government budget deficit which help to dampen fluctuations in economic activity

What do Automatic Stabilisers do?

increase government spending or increase taxes when real output declines

• built into laws so no decision is required

• unemployment compensation, progressive income tax