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Why do uctuations occur? John Maynard Keynes British economist (1883-1946). The General Theory of Employment, Interest, and Money. Keynes idea: drops in aggregate spending might lead actual output to fall below potential output. Fiscal policy might be a useful tool to stabilize the economy.
Aggregate Expenditure
Recall from National Income and Product Accounts:
GDPexp
= + + +
Private Consumption (C) Investment (I) Government Expenditures (G) Net Exports (X - M)
GDPexp
Aggregate Expenditure
This increase in in inventories investment as as a aconsequence consequence of of unsold unsold output output This increase yields level of of investment investment that is higher higher than than what what the the firm rmhad had yields a a level that is initially planned. initially planned. Planned Investment diers from Actual Investment. Lets look at an example.
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100.
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output.
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500.
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500. Actual Investment (I) = 1000 + 500 = $ 1,500.
Example 1
Imagine a rm has planned to invest $1,000 to purchase new equipment. It produces $2,000 worth of output, but by the end of the year it has only been able to sell $1,500 worth of output. Assume for simplicity that, at the beginning of the year inventories are equal 100. Production - Sales = 2,000 - 1,500 = $500 = Unsold Output. Inventories at the end of the year = $600 Inventories = Inventories (end of year) - Inventories (start of year) = $500. Actual Investment (I) = 1000 + 500 = $ 1,500. I > Ip .
Example 1 Continued
Example 1 Continued
What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?).
Example 1 Continued
What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0
Example 1 Continued
What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100.
Example 1 Continued
What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100. Actual Investment (I) = 1000 + (-100) = $ 900.
Example 1 Continued
What if the rm sells $ 2,100 worth of output? Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?). Inventories at the end of the year = $0 Inventories = Inventories (end of year) - Inventories (start of year) = $-100. Actual Investment (I) = 1000 + (-100) = $ 900. I < Ip .
Consumption Function
Assume that consumption today depends on disposable income today. Marginal Propensity to Consume (mpc) the additional amount of consumption as a result of a one-dollar increase in disposable income. C Consumption = Disposable Income DI
mpc =
Ct
sometimes called autonomous consumption is a term that C, captures factors other than current disposable income that aect consumption. mpc (Yt Tt ) measures the responsiveness of consumption to changes in disposable income.
consumption
C = C + c x (Y T)
slope = mpc=c
disposable income
Production, Income and Spending activities are not isolated, but instead feed on each other. In particular, Planned Aggregate Spending (PAE) depends on output through the consumption function.
Example 2
Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C
PAE =
Example 2
Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C
PAE =
Example 2
Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100, = 500. Then, we can re-write PAE as: and C + mpc (Y-T) + Ip + G + NX C
PAE =
Short-Run Equilibrium
A short-run equilibrium output is dened as a level of output that equals Planned Aggregate Expenditure.
Y = PAE = YSR
output Y
45 output Y
PAE
At Y < YSR firms are producing too little output and cannot meet demand PAE > Y Y
planned aggregate expenditure Y At Y > YSR firms are producing too much output and are exceeding demand Y > PAE PAE Y = PAE planned aggregate expenditure = C + Ip + G + NX
Example 2 Continued
To nd the Short-Run Equilibrium:
Y = PAE
Example 2 Continued
To nd the Short-Run Equilibrium:
Example 2 Continued
To nd the Short-Run Equilibrium:
Example 2 Continued
To nd the Short-Run Equilibrium:
Example 2 Continued
To nd the Short-Run Equilibrium:
Y = PAE Y = 2010 + 0.9 Y 0.1 Y = 2010 YSR = 20, 100 solve for Y
drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C
PAE =
drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C
PAE =
drops to 400. What is the new short run equilibrium Imagine C output? new + mpc (Y-T) + Ip + G + NX C
PAE =
E2
E2
In equilibrium, we have:
Y = PAE
In equilibrium, we have:
In equilibrium, we have:
Note, a decrease of 100 in autonomous consumption lead to a decrease of more than 100 (actually, 1000!) in equilibrium output. Why? Multiplier Eect: one dollar that is not spent is one dollar that does not become income of someone else, and then this person spends less, and then someone else has less income so therefore s/he also spends less, and ... Link between aggregate spending and mpc. What happens if mpc is higher/lower?
100
100
100
100
100 10 save
100
90
spend
100
90
100
100
90
spend
81
spend
100
90
81
100
100
90
spend
81
spend
72.9
spend
100
90
81
72.9
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
= 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x (0.9 x 100) + = 90 = 90 = 81 = 81 = 72.9
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
= 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x (0.9 x 100) + = 90 = 90 = 81 = 81 = 72.9
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + )
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) Y = 100 (1 0.9) = 1,000
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) initial spending Y = 100 (1 0.9)
mpc
= 1,000
100
72.9
7.29
save
100
90
spend
81
spend
72.9
spend
65.61 spend
100
90
81
72.9
65.61
Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 100 + Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + ) initial spending Y = 100 (1 0.9)
mpc
= 1,000
multiplier =
1 (1 mpc)
Y
spending
initial
Y* Y = PAE
E2
Y* Y = PAE PAE3 = ?? + 0.9Y ( C = 400, G = ??) E3 PAE2 = 1910 + 0.9Y ( C = 400, G = 500)
E2
Is scal policy an eective stabilizer? Japan. Financing expenditure increases. Decits. Flexibility of scal policy. How fast can it be implemented?