Lecture Principles of economics (Asia Global Edition) - Chapter 22

Spending, Output, and Fiscal
Policy
Chapter 22

McGraw­Hill/Irwin

Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved.
22­1


Learning Objectives
Identify the key assumptions of the basic Keynesian model
and explain how this affects the production decisions made
by firms
2.
Discuss the determinations of planned investment and
aggregate consumption spending and how these concepts
are used to develop a model of planned aggregate
expenditure
3.
Analyze, using graphs, how an economy reaches short-run
equilibrium in the basic Keynesian model
7.
Show how a change in planned aggregate expenditure can
cause a change in short-run equilibrium output and how this
is related to the income-expenditure multiplier
5. Explain why the basic Keynesian model suggests that fiscal
policy is useful as a stabilization policy, and discuss the
qualifications that arise in applying fiscal policy in real-world
situations
22­2

1.


Recessionary Gap
•

Great Depression
–
–

•

A decrease in spending leads to lower
production
–
–

•

Available resources are unemployed
Public’s willingness or ability to spend declines

Laid-off workers reduce their spending
Insufficient spending to support the normal level of
production

Conventional economic policy of the 1920s and
1930s would not solve this problem
–

John Maynard Keynes revolutionized economic
thought and public policy
22­3


John Maynard Keynes (1883 –
1946)
•

After World War I, Keynes recognized that the
terms of the peace would lead to another war
–

•

German war reparations would prevent growth and
recovery

The General Theory of Employment, Interest,
and Money (1936) is his best-known work
–

Problem was explaining why economies kept a
recessionary gap for long periods
•
•

Aggregate spending is too low for full employment
Stabilization policies use government spending or
taxes to substitute for spending in other sectors

22­4


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 costs are the costs 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
22­5


Technology of Changing Prices
•

Technology has reduced menu costs
–
–

•
•

Highly segmented airline pricing
Internet mechanisms for setting price
–

•

Bar codes and scanners reduce costs of changing
prices in the store
Online surveys

eBay

■ Priceline

Other costs remain
–

–

Competitive analysis
prices
Informing consumers

■ Deciding the new

22­6


Planned Aggregate Expenditure
•

•

Planned aggregate expenditure (PAE) is total
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) equals exports minus imports
22­7


Planned Investment Example
•

Fly-by-Night Kite produces $5 million of kites
per year
–
–

•

If actual sales are only $4.6 million
–
–

•

Expected sales are $4.8 million and planned
inventory increase is $0.2 million
Capital expenditure of $1 million is planned
•
Total planned investment is $1.2 million
Unplanned inventory investment of $0.2 million
Actual investment is $1.4 million

If actual sales are $5.0 million
–

–

Unplanned inventory decrease of $0.2 million
Actual investment is $1.0 million
22­8


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

22­9


Consumption Expenditures
•

Consumption (C) accounts for two-thirds of total
spending
–
–

Powerful determinant of planned aggregate
expenditure
Includes purchases of goods, services, and
consumer durables, but not new houses
•

•

Rent is considered a service

C depends on disposable income, (Y – T)

22­10


Consumption in the U.S.
1964 - 2012
11000

9000
8000
7000
6000
5000
4000
3000
2000

11000

10000

9000

8000

7000

6000

5000

4000

3000

2000

0

1000

1000
0

Consumpt ion (2005 dollars, billions)

10000

Disposable Income (2005 dollars, billions)

22­11


Consumption Function
•

The consumption function is an equation
relating planned consumption (C) 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 disposable income
0 < mpc < 1
–

•

Autonomous consumption is spending not
related to the level of disposable income

A change in C shifts the consumption function
22­12


Consumption Function
•

C = C + (mpc) (Y – T)
The wealth effect is the tendency of changes in
asset prices to affect household's wealth and
thus their consumption spending
–

•

This effect is included in C

Autonomous consumption also captures the
effects of interest rates on consumption
–

Higher rates increase the cost of using credit to
purchase consumer durables and other items

22­13

2000 – 2002 Stock Market
Decline

•

Stock prices fell 49% between March 2000 and
October 2002
–

Households owned $13.3 trillion in stocks in 2000
•

•

A $1 decrease in wealth decreases consumption
by
3–7¢
–

•

Stock market decline potentially destroyed $6.5
trillion of household wealth

Suggests a decrease in consumer spending of
$195 – 455 billion would occur

Consumption spending continued to increase
22­14

2000 – 2002 Consumer
Spending

•

Consumer spending increased despite sharp fall
in stock prices
–
–

After-tax income increased
Interest rates decreased
•

–

Spurred spending on durables

Housing wealth increased
•
•

Housing prices increased 20% in the period
Partially offset lost wealth from stock market

22­15


More on the 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
22­16


Consumption spending (C)

Consumption Function
C = C + (mpc) (Y – T)
Intercept

C

slope

ΔC

C

Δ (Y – T)

Slope = Δ C / Δ (Y – T)

Disposable income (Y – T)
22­17


Planned Aggregate Expenditure
(PAE)
•

Two dynamic patterns in the economy

1.
2.

•

Declines in production lead to reduced spending
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

22­18


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
C = 620
IP = 220

mpc = 0.8
G = 330

T = 250
NX = 20

PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20
PAE = 960 + 0.8 Y
22­19


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
22­20


Planned aggregate expenditure
(PAE)

Planned Expenditure Graph

96
0

PAE = 960 +
0.8Y

Slope =
0.8
4,80
0

Output (Y)
22­21


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
22­22


Short-Run Equilibrium Search

•

Output (Y)
4,000

PAE = 960 + 0.8 Y
4,160

Y – PAE
–160

Y = PAE?
No

4,200

4,320

–120

No

4,400
4,600
4,800

4,480
4,640
4,800

–80
–40
0

No
No
Yes

5,000
5,200

4,960
5,120

40
80

No
No

Only when Y = 4,800 does planned spending equal
output
22­23


Planned aggregate expenditure (PAE)

Short-Run Equilibrium Graph
Y = PAE
PAE = 960 + 0.8Y
Slope = 0.8

960

45o
4,800

Output (Y)

22­24

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

Y = PAE

PAE = 960 +
0.8Y

PAE

•

96
0

45o
4,800

5,000

Output (Y)

22­25