11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 13: Spending and Ch. 13: Spending and Output in the Short RunOutput in the Short Run

22

(Neo) Classical Theory(Neo) Classical Theory

Markets always clear.Markets always clear.When Supply does not equal to When Supply does not equal to

Demand, price changes to equate the Demand, price changes to equate the two.two.

Labor market works the same way, too.Labor market works the same way, too. In the 19th century, general price levels In the 19th century, general price levels

sometimes went up and sometimes sometimes went up and sometimes down but there hasn’t been any trend. down but there hasn’t been any trend.

33

The Great DepressionThe Great DepressionLiving through the Great Depression, Living through the Great Depression,

people rightfully questioned the people rightfully questioned the received wisdom of economists.received wisdom of economists. If markets tended to clear, why did the If markets tended to clear, why did the

labor market show up to 25% labor market show up to 25% unemployment?unemployment?

The 1936 publication of The 1936 publication of TheThe General General Theory of Employment, Interest and Theory of Employment, Interest and Money Money by John Maynard Keynes by John Maynard Keynes provided an explanation for markets not provided an explanation for markets not to clear in the short run.to clear in the short run.

44

The Model by KeynesThe Model by Keynes

Prices (including the price of labor - wages) Prices (including the price of labor - wages) do not change in the short run.do not change in the short run.

Firms respond to demand changes by Firms respond to demand changes by adjusting their production and keeping the adjusting their production and keeping the price constant.price constant.

Demand changes occur all the time and the Demand changes occur all the time and the structure of the economy changes as the structure of the economy changes as the demand for say, horse carriages fell and demand for say, horse carriages fell and trains and cars rose. This would not affect trains and cars rose. This would not affect labor.labor.

55

The Model by KeynesThe Model by Keynes If the total spending (aggregate demand) If the total spending (aggregate demand)

fell, then almost all markets would feel the fell, then almost all markets would feel the drop in demand.drop in demand.

Production in general would fall.Production in general would fall.Recession (and depression) would be felt.Recession (and depression) would be felt.To avoid this aggregate demand shortfall, To avoid this aggregate demand shortfall,

the government should step in and by the the government should step in and by the use of monetary and fiscal policies, should use of monetary and fiscal policies, should stimulate total spending.stimulate total spending.

66

Why Are Prices Constant in Why Are Prices Constant in the Short Run?the Short Run?

Menu costs.Menu costs.Fear of uncertainty.Fear of uncertainty.Contracts.Contracts. Information lag.Information lag.

77

Keynesian Assumption: Firms Meet Keynesian Assumption: Firms Meet Demand at Preset PricesDemand at Preset Prices

Will new technologies eliminate menu costs?Will new technologies eliminate menu costs? Keynesian theory assumes that menu cost prevent Keynesian theory assumes that menu cost prevent

firms from changing prices.firms from changing prices. Many new technologies (bar codes) have reduced Many new technologies (bar codes) have reduced

menu cost and increased price flexibility.menu cost and increased price flexibility. Pricing decisions also require market analysis, Pricing decisions also require market analysis,

strategic considerations, and cost analysis.strategic considerations, and cost analysis. These factors are a component of menu costs.These factors are a component of menu costs.

88

Constant Price Means Wide Constant Price Means Wide Output FluctuationsOutput Fluctuations

P

Q

S

Q1 Q2

99

Circular Flow ExplanationCircular Flow Explanation

Firms Households

Consumption Expenditures

Wages, profits, rent, interest

If the upper flow (C+I+G+NX) is LESS THAN the lower flow (Income = Value of Output), inventories will pile up (I>Ip) and the firms will cut back in production. If the upper flow is MORE THAN the lower flow, inventories will fall below the desired level (I<Ip) andthe firms will increase production.

1010

Circular Flow ExplanationCircular Flow Explanation

Firms Households

Consumption Expenditures

Wages, profits, rent, interest

The upper flow is the aggregate demand: C+I+G+NX. The lower flowis Output: Y. When Aggregate Demand is <Y, Y falls. There is a positive output gap (Y*-Y>0) and the economy has slowed down. When I<Ip, C+I+G+NX is greater than Y, or Y>Y* and there isan expansionary (negative) output gap.

1111

Aggregate Demand Aggregate Demand FluctuationsFluctuations

Consumption expenditures fluctuate.Consumption expenditures fluctuate.Confidence, fear levels, demography, wealth, Confidence, fear levels, demography, wealth,

taxes, etc. change.taxes, etc. change. Investment expenditures fluctuate.Investment expenditures fluctuate.

Optimism/pessimism about the future; interest Optimism/pessimism about the future; interest rate changes.rate changes.

Government expenditures change.Government expenditures change.Budget items, wars…Budget items, wars…

Net Exports change.Net Exports change.Demand for our exports or exchange rates Demand for our exports or exchange rates

change.change.

1212

ConsumptionConsumption

Relating Consumption to Income and Other Relating Consumption to Income and Other DeterminantsDeterminantsThe consumption function:The consumption function:

C = a constant; represents the non income C = a constant; represents the non income determinants of determinants of CCConsumer optimismConsumer optimismWealthWealthReal interest ratesReal interest rates

)( TY mpc C C__

1313

The U.S. Consumption Function, The U.S. Consumption Function, 1960-20041960-2004

1414

Algebraic Short Run EquilibriumAlgebraic Short Run Equilibrium

Y = C + I + G + NX (Output=Aggregate Demand)C = a +c (Y-T)(Consumption=Autonomous+c*Disposable Income)

c = MPC = Change in Consumption/Change in Disposable Income

Y = a +cY -cT + I + G + NX

Y = (a + I +G + NX - cT) + cY Aggregate Demand Function is comprised of autonomous and induced parts.Y = [1/(1-c)][a+I+G+NX-cT]Equilibrium income is multiplier times autonomous expenditures.

1515

Numerical Determination of Numerical Determination of Short-Run Equilibrium OutputShort-Run Equilibrium Output

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

1616

Determination of Short-Run Equilibrium Determination of Short-Run Equilibrium Output (Keynesian Cross)Output (Keynesian Cross)

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

Expenditure line PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium• PAE intersects the 45o line @ 4,800Disequilibrium• < 4,800, PAE > Y• > 4,800, PAE < Y

1717

Determination of Short-Run Equilibrium Determination of Short-Run Equilibrium Output (Keynesian Cross)Output (Keynesian Cross)

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

Expenditure line PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium Algebraically • At equilibrium: PAE = C + Ip + G + NX• Y = 960 + 0.8Y• 0.2Y = 960• Y = 960/0.2 = 4,800 = equilibrium

1818

A Decline In Planned A Decline In Planned Spending Leads to a RecessionSpending Leads to a Recession

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

E

Expenditure line PAE = 960 + 0.8Y

45o

Y = PAE

4,800Y*

Recessionary gap

F

Expenditure line PAE = 950 + 0.8Y

A decline in autonomous aggregate expenditure (C) shifts the expenditure line down

950

4,750

1919

Determination of Short-Run Determination of Short-Run Equilibrium Output After a Fall In SpendingEquilibrium Output After a Fall In Spending

(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?

•If Y = 4,800 > PAE = 4,790•Y = PAE @ 4,750•Output Gap: Y* (4,800) > Y (4,750)

2020

Japanese RecessionJapanese Recession

Why was the deep Japanese recession of the Why was the deep Japanese recession of the 1990s bad news for the rest of East Asia?1990s bad news for the rest of East Asia?Recession in Japan reduced Japanese importsRecession in Japan reduced Japanese importsThe decline in East Asian exports to Japan The decline in East Asian exports to Japan

reduced domestic spending in non-export sectorsreduced domestic spending in non-export sectors

2121

2000-2002 Decline in the 2000-2002 Decline in the U.S. Stock MarketU.S. Stock Market

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

Households lost $6.5 trillion of wealth in Households lost $6.5 trillion of wealth in two yearstwo years

$1 decrease in wealth reduces $1 decrease in wealth reduces CC by 3 to 7 by 3 to 7 cents/yearcents/year

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

2222

2000-2002 Stock Market2000-2002 Stock Market

CC rose from 2000-2002 rose from 2000-2002Higher housing prices (greater wealth)Higher housing prices (greater wealth)Lower interest ratesLower interest ratesLowering taxesLowering taxes

Increase in disposable income (Increase in disposable income (Y – TY – T))

What caused the 2001 recession in the What caused the 2001 recession in the United States?United States?Reduction in investment spendingReduction in investment spending

2323

Fiscal PolicyFiscal Policy

Why did the federal government send out Why did the federal government send out millions of $300 and $600 checks to millions of $300 and $600 checks to households in 2001?households in 2001?In the spring 2001, the U.S. economy was slowing.In the spring 2001, the U.S. economy was slowing.Summer 2001, families received $38 billion in tax Summer 2001, families received $38 billion in tax

rebates.rebates.A recent study indicated that two-thirds of the A recent study indicated that two-thirds of the

rebates were spent by households within six rebates were spent by households within six months.months.

2424

MultiplierMultiplier

If a and I drops, what will happen to Y?If a and I drops, what will happen to Y?Y = [1/(1-c)][a+I+G+NX-cT]Y = [1/(1-c)][a+I+G+NX-cT]One can plug in the new values and find One can plug in the new values and find

Y.Y.One can take the “Change in Y” to be One can take the “Change in Y” to be

equal to [1/(1-c)]*Change in a+I.equal to [1/(1-c)]*Change in a+I.One can show the effect graphically by One can show the effect graphically by

shifting AD downward.shifting AD downward.

2525

MultiplierMultiplier

Suppose a dropped from 400 to 350, Suppose a dropped from 400 to 350, and I dropped from 300 to 250. Find and I dropped from 300 to 250. Find the new equilibrium Y.the new equilibrium Y.

Y = [1/(1-c)][a+I+G+NX-cT]Y = [1/(1-c)][a+I+G+NX-cT]Y = 5 (700) = 3500Y = 5 (700) = 3500Y = 5 (-100) = -500Y = 5 (-100) = -500

2626

Graphical Short Run EquilibriumGraphical Short Run Equilibrium

800

4000 Y

ADAD

700

3500

What is the value of the multiplier? What is mpc equal to?

2727

Role of Fiscal PolicyRole of Fiscal Policy

In the Keynesian system, it is obvious In the Keynesian system, it is obvious that in response to changes in C, I, and that in response to changes in C, I, and NX, government can counter them by NX, government can counter them by changing G or T.changing G or T.

If a+I fell by 100, how much G should If a+I fell by 100, how much G should change to keep Y=4000?change to keep Y=4000?

If a+I fell by 100, how much T should If a+I fell by 100, how much T should change to keep Y=4000?change to keep Y=4000?

2828

The Problem of DeficitsThe Problem of Deficits

Sustaining government deficits reduce saving Sustaining government deficits reduce saving and investment in new capital goods.and investment in new capital goods.

The goal of keeping deficits low may reduce The goal of keeping deficits low may reduce the incentive to use fiscal policy to control a the incentive to use fiscal policy to control a recessionary gap.recessionary gap.

2929

Fiscal Policy and the Supply SideFiscal Policy and the Supply Side

Fiscal policy may affect potential output as Fiscal policy may affect potential output as well as well as Aggregate Expenditures.Aggregate Expenditures.Public capitalPublic capitalR & DR & DHuman CapitalHuman CapitalTransfer paymentsTransfer payments

3030

Limits on Fiscal PolicyLimits on Fiscal PolicyThe problem of time lags and the legislative The problem of time lags and the legislative

processprocessCompeting political objectivesCompeting political objectivesAutomatic stabilizersAutomatic stabilizers help offset the help offset the

inflexibility of fiscal policyinflexibility of fiscal policyTransfer paymentsTransfer paymentsIncome tax collectionsIncome tax collections

Fiscal policy may be useful to address Fiscal policy may be useful to address prolonged periods of recessionprolonged periods of recession

3131

Automatic StabilizersAutomatic Stabilizers

Without any act by the Congress, fiscal Without any act by the Congress, fiscal measures kick in to keep Y close to Y*.measures kick in to keep Y close to Y*. Income taxes.Income taxes.Unemployment insurance.Unemployment insurance.Welfare payments.Welfare payments.Recession aid transfers.Recession aid transfers.

3232

Does military spending Does military spending stimulate the economy?stimulate the economy?