The Keynesian model’s crucial assumption: firms meet demand at preset prices

• 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 and then meet the demand at that price. By “meeting the demand”, we mean that firms produce just enough to satisfy their customers at the prices that have been set.

• Menu costs: costs of changing prices.

Planned aggregate expenditure (PAE)

• Planned aggregate expenditure (PAE): total planned spending on final goods and services.

• Consumption function: relationship between consumption spending and its determinants, in particular, disposable income.

• Autonomous consumption: consumption spending that is not related to the level of disposable income.

• Wealth effect: tendency of changes in asset prices to affect households' wealth and thus their consumption spending.

• Marginal propensity to consume (mpc): amount by which consumption rises when disposable income rises by $1; we assume that 0 < mpc < 1.

• Autonomous expenditure: portion of planned aggregate expenditure that is independent of output.

• Induced expenditure: portion of planned aggregate expenditure that depends on output Y.

• Expenditure line: line showing the relationship between planned aggregate expenditure and output.

Short-run equilibrium output

• Short-run equilibrium output: 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.

• The graphical solution is based on a diagram called the Keynesian cross. The Keynesian-cross diagram includes two lines: a 45° line that represents the condition Y = PAE and the expenditure line, which shows the relationship of planned aggregate expenditure to output. Short-run equilibrium output is determined at the intersection of the two lines. If short-run equilibrium output differs from potential output, an output gap exists.

Planned spending and the output gap

• Increases in autonomous expenditure shift the expenditure line upward, increasing short-run equilibrium output; decreases in autonomous expenditure shift the expenditure line downward, leading to declines in short-run equilibrium output. Decreases in autonomous expenditure that drive actual output below potential output are a source of recessions.

• Generally, a one-unit change in autonomous expenditure leads to a larger change in short-run equilibrium output, reflecting the working of the income-expenditure multiplier. The multiplier arises because a given initial increase in spending raises the incomes of producers, which leads them to spend more, raising the incomes and spending of other producers, and so on.

Fiscal policy and recessions

• 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.

• Contractionary policies: government policy actions designed to reduce planned spending and output.

• Fiscal policy: decisions about how much the government spends and how much tax revenue it collects.

• Automatic stabilizers: provisions in the law that imply automatic increases in government spending or decreases in taxes when real output declines.

• Fiscal policy consists of two tools for affecting total spending and eliminating out put gaps:

  • Changes in government purchases

  • Changes in taxes or transfer payments.

• An increase in government purchases increases autonomous expenditure by an equal amount. A reduction in taxes or an increase in transfer payments in creases autonomous expenditure by an amount equal to the marginal propensity to consume times the reduction in taxes or increase in transfers. The ultimate effect of a fiscal policy change on short-run equilibrium output equals the change in autonomous expenditure times the multiplier. Accordingly, if the economy is in recession, an increase in government purchases, a cut in taxes, or an increase in transfers can be used to stimulate spending and eliminate the recessionary gap.

• 3 important qualifications regarding fiscal policy:

  • Changes in taxes and transfer programs may affect the incentives and economic behavior of households and firms

  • Governments must weigh the short-run effects of fiscal policy against the possibility of large and persistent budget deficits

  • Changes in spending and taxation take time and thus fiscal policy can be relatively slow and inflexible.