Chapter 11 Spending Output and Fiscal Policy Chapter 11 Outline Spending Output and Fiscal Policy I Identify the key assumption of the basic Keynesian model A Building block for current theories of short run economic fluctuations and stabilization policies B In the short run firms meet demand at preset prices i Firms typically set a price and meet the demand at that price in the short run 1 Menu costs are the costs of changing prices a Determining the new price b c Incorporating prices into the business Informing consumers of new prices II Define planned aggregate expenditure PAE and identify the four components of PAE A Planned aggregate expenditure PAE is total planned spending on final goods and services B Four components of planned aggregate expenditure i Consumption C by households ii Investment I is planned spending by domestic firms on new capital goods iii Government purchases G are made by federal state and local government iv Net exports NX equals exports minus imports C Planned Investment Example i Fly by Night Kite produces 5 million of kites per year 1 Expected sales are 4 8 million and planned inventory increase is 0 2 million 2 Capital expenditure of 1 million is planned 3 Total planned investment is 1 2 million ii If actual sales are only 4 6 million 1 Unplanned inventory investment of 0 2 million 2 Actual investment is 1 4 million iii If actual sales are 5 0 million 1 Unplanned inventory decrease of 0 2 million 2 Actual investment is 1 0 million iv Y C I 4 6 1 4 6 MILLION v PAE C IP 4 6 1 2 5 8 MIL vi Y Actual spending vii PAE Planned expenditure 11 1 Chapter 11 Spending Output and Fiscal Policy III Explain why planned spending may differ from actual spending A Actual spending equals planned spending for i Consumption ii Government purchases of final goods and services iii Net exports B Adjustments between actual and planned spending are accomplished with changes in inventories C The general equation for planned aggregate expenditures is D PAE C IP G NX E Consumption Expenditures i Consumption C accounts for two thirds of total spending 1 Powerful determinant of planned aggregate expenditure 2 Includes purchases of goods services and consumer durables but not new houses a Rent is considered a service ii C depends on disposable income Y T IV Explain how the consumption function relates consumption spending to disposable income and other factors A 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 marginal propensity to consumption slope of consumption is the change in consumption given change in disposable income for a i Autonomous consumption C is spending not related to the level of 0 mpc 1 disposable income ii Induced consumption MPC X Y T B A change in C shifts the consumption function C C C mpc Y T D The wealth effect is the tendency of changes in asset prices to affect household s wealth and thus their consumption spending i This effect is included in C E Autonomous consumption also captures the effects of interest rates on consumption i Higher rates increase the cost of using credit to purchase consumer durables and other items F Marginal propensity to consume mpc is the increase in consumption spending when disposable income increases by 1 i mpc is between 0 and 1 for the economy ii If households receive an extra 1 in income they spend part mpc and save part G Y T is disposable income i Output plus government transfers minus taxes 11 2 Chapter 11 Spending Output and Fiscal Policy ii Main determinant of consumption spending V 2000 2002 Stock Market Decline A Stock prices fell 49 between March 2000 and October 2002 i Households owned 13 3 trillion in stocks in 2000 1 Stock market decline potentially destroyed 6 5 trillion of household wealth B A 1 decrease in wealth decreases consumption by 3 7 i Suggests a decrease in consumer spending of 195 455 billion would occur C Consumption spending continued to increase VI 2002 2002 Consumer Spending A Consumer spending increased despite sharp fall in stock prices i After tax income increased Interest rates decreased ii 1 Spurred spending on durables B Housing wealth increased i Housing prices increased 20 in the period ii Partially offset lost wealth from stock market VII Explain the relationship between the consumption function and planned aggregate expenditure A Planned Aggregate Expenditure PAE i 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 11 3 Chapter 11 Spending Output and Fiscal Policy ii Consumption is the largest component of PAE 1 Consumption depends on output Y 2 PAE depends on Y iii If Y increases by 1 C will increase by 0 80 1 PAE increases by 80 cents iv Planned aggregate expenditure has two parts 1 Autonomous expenditure the part of spending that is independent of output a 990 in our example 1 0 8 Y in our example v Induced expenditure the part of spending that depends on output Y VIII Define short run equilibrium output and be able to find the level of short run equilibrium using tables graphs and if assigned by your instructor algebraically A Short run equilibrium is the level of output at which planned spending is equal to output i No change in output as long as prices are constant ii Our equilibrium condition can be written Y PAE B Using our previous example PAE 960 0 8 Y Y 960 0 8 Y 0 2 Y 960 Y 4 800 11 4 Chapter 11 Spending Output and Fiscal Policy 11 5 Chapter 11 Spending Output and Fiscal Policy C New Equilibrium i Autonomous consumption C decreases by 10 1 Causes a downward shift in the planned aggregate expenditure 2 The economy eventually adjusts to a new lower level of equilibrium spending and output 4 750 ii Suppose that the original equilibrium level 4 800 represented potential curve output Y 1 A recessionary gap develops 2 Size of the recessionary gap is 4 800 4 750 50 3 Entire decrease is in consumption spending iii Same process applies to a decrease in IP G or NX IX Explain how changes in planned spending lead to short run fluctuations and related this to the income expenditure multiplier A Japanese recession in 1990s reduced Japanese imports B East Asian economies developed by promoting exports i The decrease in exports to Japan decreased planned aggregate expenditure in these countries ii The decrease in planned spending caused the economies to