Nov. 6 th, 2002ECON 1 – Section 19 – Page 1GSI: R. Estopina ECON 1 – Section 19 Demand and...

Nov. 6th, 2002 ECON 1 – Section 19 – Page 1 GSI: R. Estopina

ECON 1 – Section 19

Demand and Output in the Short Run.

ECON 1 – Section 19 – Page 2 GSI: R. EstopinaNov. 6th, 2002

Contact Details GSI: Ramon Estopina Office Hours: No OH this Thursday !! Office: Evans 508-7 Email: [email protected] Handouts (only sections 104 & 133) after

class in: http://www.ocf.berkeley.edu/~jaychen/econ1/

Please read: Read before downloading!.


Section 19 Agenda Administrative Stuff (10

min) Recap Quiz (10 min) Problem 25.6 (10 min) Problem 25.7 (10 min) Problem 25.9 (10 min) Re-cap (2 min)


Administrative Stuff

PS #3 ready today from Econ-1 website !!!

Due next Wednesday 13th. Remember, no class next

Monday!! -Veterans Day Holiday.

Opportunity to catch-up and get ready for Midterm.


Review of Last Lecture - 11/4th

Chapter 25: AD: planned vs actual spending. Consumption Function and MPC Autonomous vs Induced spending Keynesian Model

Assumptions Keynesian Cross Diagram Shifts in AD Equilibrium Output Potential Output Gaps (recessionary/expansionary)

Paradox of thrift & multiplier


Recap Quiz - 1 Total planned spending on final goods

and service is called

1)total spending.

2)total consumption.

3)aggregate expenditures.

4)aggregate consumption.

5)aggregate demand.


Recap Quiz - 2 A firm's actual investment will exceed its

planned investment when

1)it sells less than it planned.

2)It sells more than it planned.

3)interest rates rise.

4)interest rates fall.

5)the economy experiences an

unexpected expansion.


Recap Quiz - 3

The largest component of aggregate demand is

1)consumption.

2)investment.

3)government purchases.

4)exports.

5)imports.


Recap Quiz - 4

The objective of stabilization policies is to

1)affect aggregate supply.

2)eliminate output gaps.

3)increase potential GDP.

4)keep inflation constant.

5)cause business cycles


Recap Quiz - 5

The value of the MPC is assumed to be

1)less than 1.

2)greater than 1.

3)less than 0.

4)equal to 1.

5)constant.


Important to remember:

Equation 1 of the day: Aggregate Demand (AD): total

planned spending on final goods and services.

NXGICAD p


Important to remember (2)

Remember: Planned may differ from actual for firms: difference is change in inventories. Firm sells less than expected: inventories

grow (Increase in inventories is counted as actual investment) I > Ip

Firm sells more than expected: inventories decline Ip > I


Important to remember (3) Components of AD. A) CONSUMPTION FUNCTION:

T)c(YCC = constant term capturing factors other than disposable income c = MPC (marginal propensity to consume): amount C raises when

disposable income rises; assume 0 < c < 1

C


Important to remember (4)

B) Rest of factors are exogenous.

TT

XNNX

GG

IIp


Important to remember (5) Combining all equations:

XNGITYcCAD

NXGICAD p

)(

Composed of: Autonomous AD & Induced AD

cY)XNGITc-C(AD


Important to remember (6) In equilibrium Y = AD, so:

Multiplier:

cY)XNGITc-C(Y

)XNGITc-C(Y

c1

1

MPCc

1

1

1

1Mult.


Box 25.2 (F&B page 667) From Example 25.2 (F&B page 664) we have:

=620 /c = 0.8 / = 220 / =300 / =20 / =250 We know the definition of Aggregate Demand is:

AD = C + Ip + G + NX And, in the SHORT RUN:

250TT

20XNNX

300GG

220II

T)0.8(Y620T)c(YCCp

C I G XN T


Box 25.2 (Conclusion) Substituting the components:

AD = [620 + 0.8(Y-250)] + 220 + 200 + 20 And finally:

AD = 960 + 0.8Y In addition, from the short term equilibrium:

Y=AD So the previous equation will be:

Y = 960 + 0.8Y Solving for Y:

Y = 960 / 0.2 = 4,800


Problem 25.6 (F&B page 684)

For the following economy, find Autonomous

aggregate demand

The multiplier SR equilibrium

output Output gap.

12,000 *Y

2,000TT

200XNNX

2,500GG

1,500II

T)0.5(Y3,000Cp


Problem 25.6 (cont’d) A) The relationship between aggregate

demand and output is given by:

YAD

YAD

NXGICAD p

5.06200

20025001500)2000(5.03000

Autonomous aggregate demand equals 6200, the part of aggregate demand that does not depend on output.


Problem 25.6 (cont’d) To find short-run equilibrium output, use

the equation Y=AD and solve for Y:

400,12

62005.0

5.06200

Y

Y

YY

ADY

What is the Output Gap? Remember last class: Y*-Y


Problem 25.6 (cont’d)

So we have: SR equilibrium output (Y) = 12,400 Potential output (Y*)= 12,000 Output gap is = –400.

Is this a recessionary or expansionary gap? Expansionary, Y > Y*


Problem 25.6 (cont’d) The multiplier can be found by the

formula of the multiplier (obviously) = 1/(1-c)

20.511

c11

There is another way to solve it (more complicated), but I know you are curious.


Problem 25.6 (cont’d) Imagine that autonomous aggregate

demand rises from 6200 to 6300. Now the equation Y=AD becomes

Y= 6,300 + 0.5Y Solving for output yields Y = 12,600,

an increase of 200 over the solution found before.

We have shown that an increase in autonomous aggregate demand of 100 raises short-run equilibrium output by 200. Therefore the multiplier must equal 2.


Problem 25.6 (Conclusion) By how much would autonomous AD

have to change to eliminate the output gap? As the multiplier is 2, to eliminate the

output gap of –400, autonomous aggregate demand would have to change by –200, that is, autonomous aggregate demand would have to fall.

If autonomous aggregate demand falls from 6200 to 6000, then short-run equilibrium output equals 12,000 and the output gap is eliminated.



Following with the previous problem but now = 0.

A) What would be the SR equilibrium output? We proceed as before:

YAD

YAD

NXGICAD p

5.06000

025001500)2000(5.03000

XN


Problem 25.7 (cont’d) Then we apply the definition of short-

run equilibrium output, Y = AD.

000,12

60005.0

5.06000

Y

Y

YY

ADY



B) Economic recovery abroad increases the demand for the country’s exports. As a result = 100.

What happens to the SR Equilibrium Output?

XN


Problem 25.7 (cont’d) An increase of by 100 implies that

autonomous aggregate demand rises by 100, so now we have:

So the increase in net exports of 100 has increased output by 200.

200,12

61005.0

5.06100

5.06100

Y

Y

YY

ADY

YAD

XN



C) Now assume foreign economies are slowing and the demand for the country’s exports is reduced. As a result = -100.

What happens to the SR Equilibrium Output?

XN


Problem 25.7 (cont’d) A decrease of by 100 implies that autonomous

aggregate demand falls by 100, so now we have:

So the decline in net exports of 100 lowers output by 200.

800,11

59005.0

5.05900

5.05900

Y

Y

YY

ADY

YAD

XN


Problem 25.7 (Conclusion) How these results help explain the

tendency of recessions and expansions to spread across countries?

The example shows that a weak economy in one country, by reducing that country’s imports from a second country, can create economic weakness in the second country as well.

Similarly, an expansion that increases a country’s purchases of foreign products strengthens the economies of its trade partners.



For the following economy, find how much would Gov. purchases have to change to eliminate any output gap (this is fiscal policy).

580 *Y

150TT

10XNNX

120GG

70II

T)0.8(Y40Cp


Problem 25.9 (cont’d) We solve for short-run equilibrium

output via the usual two steps. First, find the relationship of

aggregate demand to output:

YAD

YAD

NXGICAD p

8.0120

1012070)150(8.040


Problem 25.9 (cont’d) Second, use the condition Y = AD to

solve for short-run equilibrium output:

600

1202.0

8.0120

Y

Y

YY

ADY

The output gap is Y*-Y = 580-600 = -20, so there is an expansionary gap of 20.


Problem 25.9 (cont’d) To answer the question about the

effects of fiscal policy we need to know the multiplier for this economy.

In this case:

58.01

1

1

1

c



Now we can find the appropriate fiscal policies to eliminate the output gap.

Because actual output exceeds potential output by 20, and the multiplier is 5, a decrease of 4 in government purchases (from 120 to 116) will eliminate the output gap. You can verify this directly by setting

=116 and re-solving for short-run equilibrium output.G



By how much would taxes have to change? (Assume MPC = 0.8) For the case of a tax change we have to be

careful. A change in taxes of ΔT does not change autonomous aggregate demand by ΔT, because consumers do not spend 100% of any tax cut (or reduce spending by 100% of any tax increase).

A change in taxes of ΔT instead changes autonomous aggregate demand by cΔT , where c is the marginal propensity to consume (MPC) out of disposable income.


Problem 25.9 (cont’d) In the case of government spending,

eliminating the output gap requires reducing autonomous aggregate demand by 4.

To reduce autonomous aggregate demand by 4 via a tax change, Gov. will increase taxes by 5.

Since the MPC = 0.8, a tax increase of 5 will lead consumers to reduce their spending by 4, as desired.

You can also verify it by setting =115 and solving for short-run equilibrium output.

T


Problem 25.9 (cont’d) What happens if now Y*=630?

If potential output is 630, then the output gap is Y*-Y=30, that is, there is a recessionary gap of 30.

As the multiplier is 5, this gap can be eliminated by raising government purchases by 6.

An increase in shifts the expenditure line upwards.

AD

Output

Y*=630600

Y=AD

AD=120+0.8Y

AD=126+0.8Y

G


Problem 25.9 (Conclusion) Alternatively, cut taxes by 6/0.8 =

7.5. Because the MPC is 0.8, a cut in taxes of 7.5 will also stimulate autonomous aggregate demand by 6 and output by 6*5 = 30.

The Keynesian cross diagram in this case shows the expenditure line rising too, rather than falling, to restore Y=Y*.


Problems for next sections !!!

For next section: Chapter 26: Problems 3, 8, 9.

Remember: This is not mandatory.

It won’t be graded. Only for those of you that need improvement in Exam grades.


Next class Next Class:

Section 20 – Wednesday, Nov 13th

No class next Monday. Veterans Day Holiday. Due PS#4 !!!! If you want more practice, work on Next Sections

Problems (although you probably have enough). Read ch. 26 & 27. You can download handouts this afternoon. Thank you for coming on time !!!

Enjoy the long weekend & C-U Wednesday !!.

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Nov. 6 th, 2002ECON 1 – Section 19 – Page 1GSI: R. Estopina ECON 1 – Section 19 Demand and...

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