7–17–1 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of...

Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

7–1

Chapter 7Spending and Outputin the Short Run


7–2

• An introduction to the Keynesian model• Aggregate expenditure (AE)• Planned aggregate expenditure and output• Short-run equilibrium output• Illustrating equilibrium using withdrawals and injections• The 45-degree diagram• Equilibrium and disequilibrium• The four-sector model• Planned spending and the output gap• The multiplier• Stabilising planned spending: the role of fiscal policy• Fiscal policy as a stabilisation tool: three qualifications

Chapter 7: Spending and Outputin the Short Run


7–3

Pre-Keynesian Dogma

• There will never be excess production because firms will cut prices to sell it

• There will never be persistent unemployment because workers will cut their wages to keep and get jobs

• Fluctuations in demand will be accommodated by flexible prices and wages without changes in output and employment


7–4

Keynesian Ideas

• Pre-Keynesian dogma ignores the reality of depressions and long-term unemployment

• In the short run, unemployed workers do not cut their wages

• In the short run, firms accommodate a cut (rise) in demand by reducing (increasing) output and employment, not by reducing (increasing) prices


7–5

Implication

• If private demand is insufficient for full employment, governments should fill the recessionary gap with public spending


7–6

Why Prices are Not Fully Flexible

• Price rises involve ‘menu’ costs including loss of customer ‘goodwill’

• Prices can’t be cut if wages aren’t• Workers resist wage cuts because, in the absence

of simultaneous price cuts, they reduce living standards, social status, and self respect


7–7

Aggregate Expenditure (AE)

• AE = C + I + G + NX• C = consumption spending by households• I = investment spending by firms• G = public spending by governments• NX = foreign spending on our exports, net of our

spending on imports


7–8

Inventory Investment

• When firms produce goods which they do not sell, this is an inventory investment expenditure by them

• This may be planned (desired) or unplanned (undesired)


7–9

Planned vs Actual Spending

• Firms’ actual inventory investment • Firms’ planned inventory investment • Firms’ unplanned inventory investment • Unplanned inventory investments signify excessive

production and subsequent reductions in output


7–10

Planned Aggregate Spending

• PAE = C + IP + G + NX• IP stands for planned investment


7–11

Determinants of Consumption

• Disposable income: [Y – T ]• Other determinant: optimism/pessimism, wealth

etc. which do not depend on income; denoted by C• C = C + c [Y – T ]• Exogenous and induced components of C• c = the MPC = 1 – MPS

7–12

A Consumption Function

7–13

Australian Consumption Function


7–14

Planned Aggregate Spending

• PAE = C + c [Y – T ] + IP + G + NX• PAE = [C + IP + G + NX] + c [Y – T ]• An exogenous component and an induced

component• Increase in Y of $1 induces an increase in PAE of

$c through increased C


7–15

Short-Run Equilibrium Y, Ye

• In equilibrium, supply = demand• Supply: GDP = Y• Demand: [C + IP + G + NX] + c [Y – T ]• Set supply = demand and solve for Y = Ye

• Ye = [C + IP + G + NX – cT ] / [1 – c]


7–16

Determinants of Ye

• Exogenous expenditures: C, IP, G, NX• Exogenous Taxes: T• The MPC: c• Know these, know Ye


7–17

Illustration on 45o Diagram

• Need to find the level of Y or GDP which generates demand equal to the level of GDP (supply) itself

• This occurs where the PAE line cuts the 45o line

• This line marks equal distances along the axis for GDP and the axis for PAE, so we know where they are equal

7–18

Short-Run Equilibrium


7–19

Disequilibrium

• To the left of the intersection:– PAE > Y– excess demand– unplanned inventory loss (disinvestment)– Y rises

• To the right of the intersection:– PAE > Y– excess supply– unplanned gain in inventories– Y falls

7–20

Numerical Illustration


7–21

Fall in PAE Reduces Ye

• Shift down in PAE gives lower Ye

• Fall in C, IP, G, NX• Conversely for a shift up in PAE

7–22

Reduction in PAE Lowers Ye


7–23

Withdrawals and Injections

• Y = C + IP + G + NX• Y = C + S + T• Therefore S + T = IP + G + NX• LHS are withdrawals from spending – income from

GDP not spent• RHS are injections of spending


7–24

Paradox of Thrift

• Increased desire to save (consume less) shifts down PAE and reduces Ye

• S + T = IP + G + NX• So S = IP + G + NX – T• S remains constant because [IP + G + NX – T ] is

constant• So aggregate saving has not increased


7–25

Paradox of Thrift

• Despite people wanting to save a bigger proportion of their income, aggregate saving has not risen because income has fallen

• 20% of 100 is the same as 10% of 200!


7–26

The Expenditure Multiplier

• Shifts in PAE change Ye by a multiple of shift in PAE

• Shift in PAE changes exogenous spending and Y, which induces further changes in C and Y

• The size of the multiplier increases with MPC


7–27

Fiscal Policy to Raise Ye

• Increase G, shifting PAE directly• Lower T, raise disposable income and increase C

by the MPC, shifting PAE indirectly• Increase social security benefits (negative tax),

raise disposable income and increase C by the MPC, shifting PAE indirectly

7–28

Increased G Eliminates Recessionary Gap


7–29

Changed Role of Fiscal Policy

• When Keynes was writing, monetary policy was ineffective because of extreme pessimism associated with the Great Depression

• In these circumstances, expansionary fiscal policy was the only option to raise PAE

• In normal times, monetary policy is effective in stabilisation, so discretionary fiscal policy is less called for


7–30

Modern Fiscal Stabilisation

• In recession, when income-tax collections automatically fall, let the budget move into deficit

• In booms, when income-tax collections automatically rise, let the budget move into surplus

• This provides automatic stabilisation and a budget which is in long-run balance


7–31

Persistent Budget Deficits

• Assume that the G which it finances is not wasteful• Then deficits are caused by low T• Low T means disposable income is higher than it

would be without deficit• This means C is higher than it would be• This means I is lower than it would be


7–32

Annual Budget Balancing

• Is destabilising and undesirable because:– In recession, T falls automatically– Budget balance requires reduce G also– This deepens recession – Conversely in boom

• We should aim for balance OVER CYCLE

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