4. Learning Objectives
1. Identify the key assumptions of the basic Keynesian
model
2. Explain how to develop a model of Planned Aggregate
Expenditure (PAE)
3. Analyze how an economy reaches short-run
equilibrium in the basic Keynesian model
Do the analysis with both numbers and graphs
5. Learning Objectives
4. Show how a change in planned aggregate expenditure
can cause a change in the short-run equilibrium
output
Explain how this is related to the income-expenditure
model
5. Explain why the basic Keynesian model suggests that
fiscal policy is useful
6. John Maynard Keynes (1883 –
1946)
The idea that a decline in aggregate
spending may cause output to fall
below potential output was one of the
key insights of John Maynard Keynes.
The goal of this lecture is to present a
theory/model of how recession and
expansion may arise from
fluctuations in planned aggregate
expenditure or total planned
spending.
7. 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
Menu price is the cost of changing prices
Determining the new price
Incorporating prices into the business
Informing consumers of new prices
Firms change prices when the marginal benefits exceed the
marginal costs
Key
Assumption
8. Keynesian Model
Will new technologies make the Keynesian theory less
relevant to the real world??
Technology has reduced menu costs
Bar codes and scanners reduce costs of changing prices in the store
Online surveys
Highly segmented airline pricing
Internet mechanisms for setting price
eBay ■ Priceline
Other costs remain
Competitive analysis ■ Deciding the new prices
Informing consumers
12. Planned Aggregate Expenditure (PAE)
Planned aggregate expenditure is planned spending on
final goods and services
Four components of planned aggregate expenditure
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) is exports minus imports
13. Planned Aggregate Expenditure (PAE)
Actual spending equals planned spending for
Consumption
Government purchases of final goods and services
Net exports
Adjustments between actual and planned spending
are accomplished with changes in inventories
The general equation for planned aggregate
expenditures is
PAE = C + IP + G + NX
14. Develop a Model of PAE:
Consumption Expenditures
Consumption (C) accounts for two-thirds of total
spending
Powerful determinant of planned aggregate spending
Includes purchases of goods, services, and consumer
durables, but not houses
Rent is considered a service
C depends on disposable income, (Y – T)
16. Develop a Model of PAE:
Consumption Function
The consumption function is an equation relating
planned consumption to its determinants, notably
disposable income (Y – T)
C = C + (mpc) (Y – T)
where C is autonomous consumption spending
mpc is the change in consumption for a given
change in (Y – T)
Autonomous consumption is spending not related to the
level of disposable income
A change in C shifts the consumption function
17. Develop a Model of PAE:
Consumption Function
C = C + (mpc) (Y – T)
The wealth effect is the tendency of changes in asset
prices to affect household's wealth and this
consumption spending
This effect is included in C
C also captures the effects of interest rates on
consumption
Higher rates increase the cost of using credit to purchase
consumer durables and other items
18. Develop a Model of PAE:
Consumption Function
C = C + (mpc) (Y – T)
Marginal propensity to consume (mpc) is the
increase in consumption spending when disposable
income increases by $1
mpc is between 0 and 1 for the economy
If households receive an extra $1 in income, they spend
part (mpc) and save part
(Y – T) is disposable income
Output plus government transfers minus taxes
Main determinant of consumption spending
19. Develop a Model of PAE:
Consumption Function
Disposable income (Y – T)
Consumptionspending(C)
C
C = C + (mpc) (Y – T)
Δ (Y – T)
Δ C
C
Intercept
Slope = Δ C / Δ (Y – T)
slope
20. Planned Aggregate Expenditure
(PAE)
Two dynamic patterns in the economy
1. Declines in production lead to reduced spending
2. Reductions in spending lead to declines in production
and income
Consumption is the largest component of PAE
Consumption depends on output, Y
PAE depends on Y
21. Planned Spending Example
PAE = C + IP + G + NX
C = C + mpc (Y – T)
PAE = C + mpc (Y – T) + IP + G + NX
Suppose that planned spending components have the
following values
PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20
PAE = 960 + 0.8 Y
C = 620 mpc = 0.8 T = 250
IP = 220 G = 330 NX = 20
22. Planned Spending Example
C = 620 + 0.8 (Y – 250)
PAE = 960 + 0.8 Y
If Y increases by $1, C will increase by $0.80
PAE increases by 80 cents
Planned aggregate expenditure has two parts
Autonomous expenditure, the part of spending that
is independent of output
$960 in our example
Induced expenditure, the part of spending that
depends on output (Y)
0.8 Y in our example
25. Short-Run Equilibrium
Short-run equilibrium is the level of output at which
planned spending is equal to output
No change in output as long as prices are constant
Our equilibrium condition can be written
Y = PAE
Using our previous example, PAE = 960 + 0.8 Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
26. Short-Run Equilibrium Search
Output (Y) PAE = 960 + 0.8 Y Y – PAE Y = PAE?
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
Only when Y = 4,800 does planned spending equal
output
28. Output Greater than Equilibrium
Suppose output reaches
5,000
Planned spending is
less than total output
Unplanned inventory
increases
Businesses slow down
production
Output goes down
PAE
Output (Y)
96
0
PAE = 960 +
0.8Y
45o
Y = PAE
4,800 5,000
29. Output Less than Equilibrium
Suppose output is only
4,500
Planned spending is
more than total
output
Unplanned inventory
decreases
Businesses speed up
production
Output goes up
PAE
Output (Y)
96
0
PAE = 960 +
0.8Y
Y = PAE
4,8004,700
30.
31. Planned Spending and
the Output Gap
Output Y
Plannedaggregateexpenditure
(PAE)
960
E
PAE = 960 + 0.8Y
45o
Y = PAE
4,800
Y*
Recessionary gap
PAE = 950 + 0.8Y
950
F
4,750
32. Planned Spending and
the Output Gap
Autonomous consumption, C, decreases by 10
Causes a downward shift in the planned aggregate
expenditures curve
The economy eventually adjusts to a new lower level of
equilibrium spending an output, $4,750
Suppose that the original equilibrium
level, $4,800, represented potential output, Y*
A recessionary gap develops
Size of the recessionary gap is 4,800 – 4,750 = $50
Entire decrease is in Consumption spending
Same process applies to a decrease in IP, G, or NX
–
33. Planned Spending and
the Output Gap
Japanese recession in 1990s reduced Japanese imports
East Asian economies developed by promoting
exports
The decrease in exports to Japan decreased planned
aggregate expenditures in these countries
The decrease in planned spending caused the economies
to contract to a new, lower level of planned spending and
output
Japan exported its recession to its neighbors
US recessions have similar effects on its major trading
partners
34. Planned Spending and
the Output Gap: US Recession 2001
Robust investment spending, 1995 – 2000
High growth economy
New technologies: internet, fiber optics, genetic
engineering
Not as promising as anticipated
Recession caused by a decline in autonomous
spending
Less investment in 2001
Terrorist attack 9/11
Travel spending decreased
Recovery began 2002
35. Income-Expenditure Multiplier
The income – expenditure multiplier shows the effect
of a one-unit increase in autonomous expenditure on
short-run equilibrium output
Previous example
Initial planned expenditure = 960 + 0.8 Y
New planned expenditure = 950 + 0.8 Y
Equilibrium changed from $4,800 to $4,750
A $10 change in autonomous expenditures caused a $50
change in output
Multiplier = 5
The larger mpc, the greater the multiplier
36.
37. Stabilization Policy
Stabilization policies are government actions to
affect planned spending with the intention of
eliminating output gaps
Expansionary policies increase planned spending
Contractionary policies decrease planned spending
Two major stabilization tools are fiscal policy and
monetary policy
Fiscal policy uses changes in government
spending, transfers, or taxes
Monetary policy uses changes in the money supply
38. Fiscal Policy and Recessions
Government spending is part of planned spending
Changes in government spending will directly affect planned
aggregate expenditures
Suppose planned spending decreases $ 10 from
Y = 960 + 0.8 Y to
Y = 950 + 0.8 Y
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
39. How can the Government eliminate
an Output Gap?
Output Y
Plannedaggregateexpenditure
(PAE)
960
PAE = 960 + 0.8Y
45o
Y = PAE
F
PAE = 950 + 0.8Y
95
0
4,750
E
4,800
Y*
40. Example: Japanese Spending
In the 1990s Japan spent over $1 trillion on public
works
Highways, subways, and transportation projects
Concert halls
Re-laying cobblestone sidewalks
41. Taxes and Transfers
Planned aggregate expenditures are affected by taxes
and transfers
The effect is indirect, channeled through the effects on
disposable income
Lower taxes or higher transfers increase disposable
income
Increases in disposable income lead to higher C
42. Fiscal Policy as a Stabilization Tool:
Three Qualifications
The use of fiscal policy to stabilize the economy is
more complicated than suggested by the basic
Keynesian model.
Three qualifications must be made to the use of fiscal
policy as a stabilization tool.
1. Fiscal policy may affect potential output as well as
potential spending
2. Large and persistent government budget deficits
reduce national saving and growth
3. The relative inflexibility of fiscal policy
43. Spending and Output in the Short
Run
Short-Run Spending and Output
Planned
Aggregate
Expenditures
(PAE)
Consumption
Function
Short-Run
Equilibrium
Changes in
Equilibrium
Output Gaps
Multiplier
Fiscal Policy
Limitations
Keynesian Model
