The Keynesian Model of Short-Run Fluctuations

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1 rinciples of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University Spending and Output in the Short Run What causes fluctuations? What caused the 200 recession? Lower consumer spending Lower investment Why was it so mild? Greater government expenditures Lower taxes Improved consumer spending How did the exact number get determined? Short Run 2 The Keynesian Model of Short-Run Fluctuations ronounced like canesian The Keynesian Model s s Crucial Assumption: Firms Meet Demand at reset rices In the short run, firms meet the demand for their products at preset prices. Firms do not respond to every change in the demand for their products by changing their prices. Instead, they typically set a price for some period, then meet the demand at that price. Short Run 4 The Keynesian Model s s Crucial Assumption: Firms Meet Demand at reset rices In the short run, firms meet the demand for their products at preset prices. By meeting the demand, we mean that firms produce just enough to satisfy their customers at the prices that have been set. The Keynesian Model s s Crucial Assumption: Firms Meet Demand at reset rices Meeting Demand at reset rices: Is a logical management decision because of menu costs or contracts with customers. Also, prices may be sticky because wages are sticky. rices should be changed only if the benefit of charging the optimal price exceeds the cost of price adjustment. In the long run firms will change prices. Short Run 5 Short Run 6

2 The Keynesian Model s s Crucial Assumption: Firms Meet Demand at reset rices Will new technologies eliminate menu costs? Keynesian theory assumes that menu cost prevent firms from changing prices. Many new technologies (bar codes) have reduced menu cost and increased price flexibility. The Keynesian Model s s Crucial Assumption: Firms Meet Demand at reset rices Will new technologies eliminate menu costs? ricing decisions also require market analysis, strategic considerations, and cost analysis These factors are a component of menu costs, which technology may reduce but not eliminate. Short Run 7 Short Run 8 Wage Stickiness may lead to rice Stickiness After being laid off from her job as a manager at Ford Motor Co.'s [Mexican] unit, [Karina] Maldonado searched unsuccessfully for a job for months before settling on a position selling cars at a Volkswagen AG dealership. Her commute is two hours and her pay is half of what she earned at Ford. At first I looked for something close to home and well - paid, Maldonado, who ran the auto parts division at Ford's Land Rover unit in Mexico. Then I said I'd take something anywhere, as long as it was in planning. In the end, I didn't care as long as it was a job. Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 2, 2004 (Bloomberg) Aggregate Aggregate Total spending on final goods and services AE = C + I + G + NX AE = lanned AE + Unplanned AE Short Run 9 Short Run 0 Aggregate Aggregate The Components of Aggregate. Consumer expenditure or Consumption (C)( Household spending on durables, nondurables, and services 2. Investment (I)( New capital goods spending New residential spending Increases in inventories (planned or unplanned) The Components of Aggregate 3. Government purchases Federal, state, and local spending on goods and services 4. Net exports Exports - imports Short Run Short Run 2 2

3 Aggregate lanned Spending Versus Actual Spending Actual expenditures may not equal AE. Suppose a firm planned to sell 500,000 (and keep some as inventory) but only sold 450,000 Then inventories are larger than expected: I > planned Investment (I( ) lanned Spending Versus Actual Spending Actual expenditures may not equal AE. Suppose a firm planned to sell 500,000 (and keep some as inventory) but sold 550,000 If inventories are smaller than expected: I < I Short Run 3 Short Run 4 Actual and planned investment Flight Kite Co. produces $5 million of kites per year. Expected sales = $4.8 million and planned inventory accumulation = $200,000 Capital expenditure = $ million If actual sales = $4.8 million I = $,000,000 + $200,000 = $,200,000 I = I + unplanned inventory accumulation = $,200, = $,200,000 I = I If actual sales are: $4,600,000 instead of $,000 I = $,000,000 + $200,000 = $,200,000 I = I + unplanned inventory accumulation = $,200,000 + $200,000 = $,400,000 I > I Short Run 5 Short Run 6 If actual sales are: $5,000,000 $5,000,000 I = $,000,000 + $200,000 = $,200,000 I = I + unplanned inventory accumulation = $,200,000 $200,000 = $,000,000 I < I AE = C + I + G + NX Short Run 7 Short Run 8 3

4 Consumer Spending and the Economy Consumption (C)( ) accounts for two thirds of total spending. What determines Consumption? Check out Explaining Consumption.xls Consump tion (C ) U.S. Consumption Levels and Output, Income (GD) Short Run 9 Short Run 20 % Chang e in C % Changes C = Consumer Spending and the Economy The primary determinant of C is disposable income or T Consumption Function The relationship between consumption spending and its determinants, in particular, disposable (after-tax) tax) income % Change in GD Short Run 2 Short Run 22 Relating Consumption to Income and Other Determinants The consumption function: C = C + c( - T) Consumption is a function of other factors (C) and disposable income (-T) Short Run 23 C = C + c( - T) C = a constant; represents the non-income determinants of C.. It is called autonomous consumption Consumer optimism Wealth Real interest rates rices Short Run 24 4

5 What effect did the decline in the U.S. stock market values have on consumption spending? From March 2000 to March 2002 the S& 500 fell 49%. Households lost $6.5 trillion of wealth in two years $ decrease in wealth reduces C (autonomous consumption) by 3 to 7 cents/year The $6.5 trillion loss could reduce C between $95 and $455 billion Short Run 25 Short Run 26 C has risen since 2002 Higher housing prices (greater wealth) Lower interest rates The income-related (induced) part of C has also risen Increase in disposable income (( T) C = C + c( - T) c = marginal propensity to consume MC is the amount by which consumption rises when disposable income rises by $; 0 < c < Short Run 27 Short Run 28 A Consumption Function What do we know so far? Consumption spending C C Slope = c = MC C = C + Consumption function c( - T) = C + I + G + NX Actual expenditures may not equal AE If so, unplanned inventory (de)accumulation( will occur. Consumption depends positively on disposable income (Income after taxes) Disposable income -T Short Run 29 Short Run 30 5

6 and Output The relationship between changes in production and income and AE A large part of AE is C C depends on AE depends on We still haven t shown this connection AE Short Run 3 C Example AE = C + I + G + NX C = C + c( T) AE = C + c( T) + I + G + NX C = 620; c = 0.8; T = I = 220; G = 300; NX = From C to AE, algebraically For the moment we assume that only C T = 250; depends on. Assume all other NX = 20 components of AE are exogenous. Short Run 32 C AE Then: From C to AE, numerically [ ( - ] [ ] AE = 250) AE = 0.8(250) AE = AE = ( ) lanned s C+I +G+NX C From C to AE, graphically Slope = c = MC Slope = c = MC Output, AE AE = C + I + G + NX C = C + Consumption function c( - T) Short Run 33 Short Run 34 = C + I + G + NX If increases by $, C will increase by 80 cents (c( = 0.80) And because C is part of AE, AE increases by 80 cents ($ X 0.80) There are two parts to AE: Autonomous expenditure (960) Is independent of output: Does not vary when output changes It varies with prices, consumer confidence, interest rates, wealth, etc. Induced expenditure (0.8) Depends on output ()( Short Run 35 Short Run 36 6

7 expenditure Graphing the s Function Induced expenditure AE Slope = 0.6 expenditure AE Slope = 0.6 expenditure AE Slope = 0.5 Autonomous expenditure Is the part of expenditure that does not depend on output Induced expenditure Is the part of expenditure that depends on output ()( (a) Real output Autonomous expenditure Copyright McGraw-Hill/Irwin c 2004 by The McGraw-Hill Real output Real output (b) (c) Short Run 37 Short Run 38 Short-run run Equilibrium Output The Key Keynesian Assumption: roducers meet demand at preset prices in the short-run. run. Suppose planned demand for goods is higher than production: Instead of raising prices, firms will increase production, until = AE. Short-run run Equilibrium Output Therefore, = AE is a condition for economic equilibrium (in the short run) Short Run 39 Short Run 40 Short-run run Equilibrium Output Short-run run equilibrium: = AE AE = C + c( T) + I + G + NX AE = C ct + I + G + NX + c Short-run run Equilibrium Output Short-run run Equilibrium Output The level of output at which output equals planned aggregate expenditure AE Short-run run equilibrium output: the level of output that prevails as long as prices are predetermined. Autonomous Induced = AE Short Run 4 Short Run 42 7

8 The Equilibrium Level of Aggregate Income Suppose AE > Sales > roduction Inventories fall Businesses produce more: Suppose AE < Sales < roduction Inventories rise Businesses produce less: Short-run run Equilibrium Output. = AE 2. AE = C + c( T) + I + G + NX This is a system with two equations and two unknowns. Solve it by putting equation 2 into equation : = C + c( T) + I + G + NX Short Run 43 Short Run 44 () Output Numerical Determination of Short-Run Equilibrium Output (2) lanned aggregate expenditure (3) - AE (4) = AE? 4,000 4, ,200 4,400 4,600 5,000 5,200 4,320 4,480 4,640 4,960 5, es Equilibrium: = AE; () = AE () If = 4,000 < AE = (4000) = 4,60 If = 5,000 > AE = (5,000) = 4,960 Short Run 45 Determination of Short-Run Equilibrium Output (Keynesian Cross) lanned aggregate expenditure AE 45 o = AE Output Short Run 46 Determination of Short-Run Equilibrium Output (Keynesian Cross) Determination of Short-Run Equilibrium Output (Keynesian Cross) = AE lanned aggregate expenditure AE 960 Slope = 0.8 line Output Short Run 47 lanned aggregate expenditure AE 960 Slope = o Output line Equilibrium AE intersects the 45 o Short Run 48 8

9 The Equilibrium Level of Aggregate Income Suppose AE > Sales > roduction Inventories fall Businesses produce more: Suppose AE < Sales < roduction Inventories rise Businesses produce less: The Equilibrium Level of Aggregate Income Remember Inventories are a kind of investment: lanned changes in inventory are part of I. Unplanned changes in inventory are part of I (but not of I ). Unplanned inventory changes make sure actual aggregate expenditures = income all the time. When AE=, unplanned inventory changes = 0. Short Run 49 Short Run 50 Determination of Short-Run Equilibrium Output (Keynesian Cross) lanned aggregate expenditure AE 960 AE> 45 o AE< Output = AE line Disequilibrium If AE >, AE > Inventories fall If AE <, AE < Inventories rise Short Run 5 A Decline In lanned Spending Leads To A Recession lanned aggregate expenditure AE o E * Output = AE line Suppose the economy starts from short-run equilibrium, And suppose that = *, actual equilibrium output = potential output. (This isn t always so). Short Run 52 A Decline In lanned Spending Leads To A Recession lanned aggregate expenditure AE o F E = AE Recessionary gap line line AE = A decline in autonomous aggregate expenditure (AE) shifts the expenditure line down 4,750 * Output Short Run 53 Autonomous Spending can fall because The exchange rate appreciates. Makes exports more expensive, NX < 0. The government cuts the budget deficit. G G < 0 T T > 0, government expenditure falls or taxes rise. The Central Bank raises interest rates. I < 0, investment falls. rices rise. The purchasing power of consumers wealth falls, C < 0, autonomous consumption falls. Short Run 54 9

10 Original Aggregate () Output 4,000 4, ,200 4,400 4,600 5,000 5,200 4,320 4,480 4,640 4,960 5, es Equilibrium: = AE; () = AE () If = 4,000 < AE = (4000) = 4,60 If = 5,000 > AE = (5,000) = 4,960 (2) lanned aggregate expenditure (3) - AE (4) = AE? Short Run 55 Short-Run Equilibrium Output After A Fall In Spending () Output 4,600 (2) lanned aggregate expenditure AE = ,630 (3) - AE -30 (4) = AE? 4,650 4,700 4,750 4,850 4,900 4,950 5,000 4, ,70-0 4,750 0 es 4, , , , , If = then AE = 4,790 < = 4,750 Output Gap: * () > (4,750) Short Run 56 Other factors remaining constant, a decline in autonomous spending causes short-run run equilibrium output to fall. If the economy started at full employment, this creates a recessionary gap. A decrease in autonomous spending can be caused by a reduction in C, I, G, and/or NX. Short Run 57 An Increase In lanned Spending Leads To An Expansion lanned aggregate expenditure AE o E * F 4,900 Output = AE Expansionary gap line line AE = An increase in autonomous aggregate expenditure shifts the expenditure line up Short Run 58 What caused the recession? Decline in consumer confidence (C fell) Between January and October 990, the U of M s M s index of consumer confidence fell by 3%. Credit crunch (caused I to fall) February 2005 January 990 September 2005 August Jan-90 Feb-90 Mar-90 Apr-90 May-90 Jun-90 Jul-90 Aug-90 Sep-90 Oct-90 v-90 Dec-90 Jan-9 Feb-9 Mar-9 Apr-9 May-9 Jun-9 Jul-9 Aug-9 Sep-9 Oct-9 v-9 Dec-9 Short Run 59 Cons Confidence 90-9 Cons Confidence 2005 Short Run 60 0

11 Why was the deep Japanese recession of the 990s bad news for the rest of East Asia? Recession in Japan reduced Japanese imports The decline in East Asian exports to Japan reduced domestic spending on all other goods. What caused the 200 recession in the United States? Reduction in investment spending Short Run 6 Short Run 62 8% 7% 6% 5% 4% 3% Investment / GD Short Run 63 What do we know so far? is of two kinds: autonomous and induced. roducers meet demand at preset prices in the short-run, run, so =AE indicates equilibrium. 45 o If AE >, production increases. Changes in autonomous AE change equilibrium. AE = AE Short Run 64 A E w, wait a minute! In the example, autonomous consumption (C) fell by 0 billion, but equilibrium output fell by 50 billion! When Bob s s C fell, he stopped buying from Lucas, who stopped buying from edro, who stopped buying from Alexandra, who stopped buying from you In the example, the income-expenditure expenditure multiplier equaled 5. The size of the multiplier is influenced by the MC. Short Run 66

12 The First Five Steps of a Multiplier G increases by 00: they buy $00 worth of staples from Bob. Bob s income increases by 00. He spends 40% of it on Kate s bikes, according to his MC = 0.4. Kate s income rises by 40, so she spends 40% of it on Jason s burgers. Jason s income rises by 6, so he spends 40% of it on Susan s vinyl siding. Susan s income increases by 6.4, so she spends 40% of it on eter s travel agency services. eter s income rises by 2.56, so MC = Multiplier = /(-0.4) =.7 Short Run 67 Income- Multiplier The effect of a -unit increase in autonomous expenditure on short-run run equilibrium output. For example, a multiplier of 5 means: a a 0- unit decrease in autonomous expenditure reduces short-run run equilibrium output by 50 units. Short Run 68 Recall. = AE 2. AE = C + c( T) + I + G + NX Short Run 69 Recall. = AE 2. AE = C + c( T) + I + G + NX Solution = C + c( T) + I + G + NX = C + c ct + I + G + NX - c = C C ct + I + G + NX ( c) = C C ct + I + G + NX = ( C ct + I + G + NX ) c Short Run 70 = c ( C ct + I + G + NX ) = c ( C ct + I + G + NX ) Autonomous Because 0<c< (c is positive and less than one), the multiplier is always positive and bigger than one. Autonomous A change in autonomous spending increases by /(-c). = Multiplier * (autonomous AE) Short Run 7 Short Run 72 2

13 = c Multiplier = ( C ct + I + G + NX ) Autonomous (autonomous AE) = ( C ct + I + G + NX ) c reviously we assumed C = 620; c = 0.8; T = 250; I = 220; G = 300; NX = 20 lugging this in we get = 0.8 ( (250) ) = 4800 Which takes a lot less work than Table 26. Short Run 73 Short Run 74 = ( C ct + I + G + NX ) c Suppose now C = 820; c = 0.7; T = 600; I = 600; G = 600; NX = 200 lugging this in we get = 0.7 ( (600) ) = 6000 Which takes a lot less work than Exercise 26. Equation As the MC increases, the multiplier increases: MC Multiplier = /(-MC) MC Multiplier = /(-MC) Short Run 75 Short Run 76 rocess When aggregate production > aggregate expenditures: Businesses reduce production levels, Which reduces income, which reduces expenditures, Which reduces production, which reduces income, Which reduces... etc. rocess The process ends when aggregate production equals aggregate expenditures. Firms are selling all they produce, so they have no reason to change their production levels. Short Run 77 Short Run 78 3

14 rocess Model in Action Real expenditures $7,000 5,500 4,750 4,000 2,500 2,000 B B 2 A A 2 =AE AE Autonomous spending is determined outside the model and is not affected by changes in income. When autonomous expenditures shift, the multiplier process is called into play. The multiplier model illustrates how a change in autonomous spending changes the equilibrium level of income. $,000 B $4,000 C $7,000 A Real income (in dollars) Short Run 79 Short Run 80 The Steps of the Multiplier rocess The income adjustment process is directly related to the multiplier. Any initial shock (a change in autonomous AE) ) is multiplied in the multiplier process. The multiplier process repeats itself again and again until a new equilibrium level is finally reached. Shifts in the Curve = (C + I + G + NX) - c = ( 200) = =AE 200 AE= AE= Short Run 8 Short Run 82 Shifts in the Curve = (C + I + G + NX) - c = (00) = =AE AE= AE= Shifts in the AE curve Why does the AE curve shift? Because C, I, G, T, or NX change exogenously. What happens if autonomous spending falls by X? Carlos has X less income, so he spends less (by the amount of cx) Rosa has cx less income, so she spends ccx less. edro has c 2 X less income, so he spends c 3 X less. Victoria has c 3 X less income, so she spends c 4 X less. Marcos has c 4 X less income, so he spends c 5 X less Eventually income falls by (/-c)x Short Run 83 Short Run 84 4

15 What do we know so far? Changes in autonomous AE cause a multiplied change in equilibrium. The size of the multiplier is influenced by the MC. = c ( C ct + I + G + NX ) AE= =AE AE= Stabilizing the Economy: Fiscal olicy Short Run 85 Stabilizing lanned Spending: The Role of Fiscal olicy In the Keynesian Model: Recessionary and expansionary gaps are caused by insufficient or excessive spending, respectively. Recessionary gaps are marked by excessive unemployment. Expansionary gaps, by inflation Stabilizing lanned Spending: The Role of Fiscal olicy Stabilization olicies Stabilization policies are used to affect planned aggregate expenditures to eliminate output gaps. These are government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps. They are Monetary and Fiscal policies. Short Run 87 Short Run 88 Stabilizing lanned Spending: The Role of Fiscal olicy Stabilization olicies Expansionary olicies: : Government policy actions intended to increase planned spending and output Contractionary olicies: : Government policy actions designed to reduce planned spending and output Stabilizing lanned Spending: The Role of Fiscal olicy Tools of fiscal policy Government spending Direct effect on AE Taxation Indirect effect on AE Through C,, which is part of AE. Transfer payments Indirect effect on AE Short Run 89 Short Run 90 5

16 An Increase In Government urchases Eliminates A Recessionary Gap lanned aggregate expenditure AE o F E = AE line An increase in G shifts the expenditure line upward Recessionary gap line AE = ,750 Output * Short Run 9 Stabilizing lanned Spending: The Role of Fiscal olicy Why is Japan building roads nobody wants to use? Japan has a recessionary gap $ trillion spending on public works The policy has not been successful to date Was not large enough Wasteful spending may have demoralized consumers Short Run 92 Stabilizing lanned Spending: The Role of Fiscal olicy Does military spending stimulate the economy? U.S. Military s as a Share of GD, Short Run 93 Short Run 94 Stabilizing lanned Spending: The Role of Fiscal olicy Taxes and Aggregate Spending Taxes affect AE indirectly Lower taxes increase disposable income (-T) T). The Consumption Function is C=C+c( C+c(-T) A tax cut of X increases C by cx. Therefore autonomous spending increases by cx when T falls by X. C cx < X. = mpc T Short Run 95 Stabilizing lanned Spending: The Role of Fiscal olicy Example: Using a tax cut to close a recessionary gap Example: Assume Recessionary gap = 50 MC = 0.8 Multiplier = /(-0.8) = /0.2 = 5 Use a tax cut ( T<0)( to eliminate the gap The tax cut must increase AE by 0 0 x 5 = 50 = the output gap. For every dollar T, C by 80 cents (MC = 0.8) C = mpc T Short Run 96 6

17 Stabilizing lanned Spending: The Role of Fiscal olicy Example * = 50, multiplier = 5. The tax cut must cause C C = 0. C C = 0 = tax cut x MC = tax cut x 0.8 Tax cut = C C /MC = 0/0.8 = 2.5 A tax cut of 2.5 increases C by 0 which increases by 50. Stabilizing lanned Spending: The Role of Fiscal olicy Example A tax cut of 2.5 increases C by 0 which increases by 50. What increase in G is necessary to achieve the same increase in output? If the desired = 50 and the multiplier = 5, G G = 0. (autonomous AE) = Multiplier Multiplier = (autonomous AE) Short Run 97 Short Run 98 Stabilizing lanned Spending: The Role of Fiscal olicy Why did the federal government send out millions of $300 and $600 checks to households in 200? In the spring 200, the U.S. economy was slowing. Summer 200, families received $38 billion in tax rebates. Survey indicated that only 22% of the households anticipated spending most of their rebates. Tax cuts were accompanied by increases in government spending to stimulate AE. Fiscal olicy as a Stabilization Tool: Three Qualifications Fiscal olicy and the Supply Side Fiscal policy may affect potential output as well as AE. Government spending and potential output ublic capital R & D Human Capital Short Run 99 Short Run 00 Fiscal olicy as a Stabilization Tool: Three Qualifications Fiscal olicy and the Supply Side Fiscal policy may affect potential output as well as AE. Taxation and potential output Tax break for new investment Tax break on interest income may stimulate saving Tax break on income may stimulate more work. Fiscal policy may affect both AE and *. Fiscal olicy as a Stabilization Tool: Three Qualifications The roblem of Deficits Sustaining government deficits reduce saving and investment in new capital goods. If a society has a goal of keeping deficits low, it may have less of an incentive to use fiscal policy to control a recessionary gap. Short Run 0 Short Run 02 7

18 Fiscal olicy as a Stabilization Tool: Three Qualifications The Relative Inflexibility of Fiscal olicy A lack of flexibility may reduce the effectiveness of fiscal policy Two limits to fiscal policy flexibility: The problem of time lags and the legislative process Competing political objectives Fiscal policy may be useful to address prolonged periods of recession, but not to fine-tune the economy. Fiscal olicy as a Stabilization Tool: Three Qualifications Automatic stabilizers help offset the inflexibility of fiscal policy Income tax collections Government takes in more money (automatically) when there is an expansionary gap. Suppose T = t.. Then T T = t Higher taxes reduce discretionary income ( ( T)= T)= T), T), reducing autonomous expenditure ( C= C= c T), and thus closing the expansionary gap. Short Run 03 Short Run 04 What we ve learned = C + I + G + NX Actual expenditures may not equal AE If so, unplanned inventory changes will occur. This will lead to changes in output and AE. AE depends positively on income. Higher income causes AE to rise, but only by a proportion = mpc <. What we ve learned In the short run, planned aggregate expenditures determine income and output. Differences between AE and cause unplanned changes in inventory, which cause output to change. The process stops AE when AE=. Short Run 05 Short Run 06 What we ve learned Changes in autonomous AE cause changes in. = = multiplier The economic AE0 mpc process by which this happens is that as one person s s expenditures rise, someone else s income rise, raising his expenditure, etc. Shifts in the Curve =AE AE= = AE AE= AE = mpc = AE mpc 0 Short Run 07 Short Run 08 8

19 What we ve learned There s s no reason for short-run run equilibrium output to equal potential output. otential output is determined by the productivity and availability of labor, capital, etc. Short-run run equilibrium output is determined by planned aggregate expenditures. There s s no reason for these two to be equal. What we ve learned Fiscal policy (changes in G or T) can be used to close output gaps. But it may respond slowly or inadequately. Because there s s no reason for short-run run to be equal to *, Governments can choose to intervene to make them equal. Short Run * 09 Short Run 0 In the long run, is he dead? Short Run 9

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