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Economics 102: Principles of Macroeconomics

Aggregate Spending in the Short Runand the Keynesian Cross

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Why do fluctuations occur?

John Maynard Keynes British economist (1883-1946). TheGeneral Theory of Employment, Interest, and Money.

Keynes idea: drops in aggregate spending might lead actualoutput to fall below potential output.

Fiscal policy might be a useful tool to stabilize the economy.

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Planned Spending versus Actual Spending

Can Planned Investment differ from Actual Investment?

One important source of discrepancy: planned investment versusactual investment.

What happens when a firm sells less output than what it expected?Unsold output increases inventories.

Recall in NIPA:

Investment = Residential Fixed Investment+ Non-Residential Fixed Investment+ Changes in Inventories

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This increase in investment as a consequence of unsold outputyields a level of investment that is higher than what the firm hadinitially planned.

Planned Investment differs from Actual Investment.

Lets look at an example.

This increase in inventories as a consequence of unsold output

yields a level of investment that is higher than what the firm had

initially planned.

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare equal 100.

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare equal 100.

Production - Sales = 2,000 - 1,500 = $500 = Unsold Output.

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare equal 100.

Production - Sales = 2,000 - 1,500 = $500 = Unsold Output.

Inventories at the end of the year = $600

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare 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.

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare 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.

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Example 1

Imagine a firm has planned to invest $1,000 to purchase newequipment. It produces $2,000 worth of output, but by the end ofthe year it has only been able to sell $1,500 worth of output.Assume for simplicity that, at the beginning of the year inventoriesare 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.

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Example 1 Continued

What if the firm sells $ 2,100 worth of output?

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Example 1 Continued

What if the firm sells $ 2,100 worth of output?

Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?).

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Example 1 Continued

What if the firm sells $ 2,100 worth of output?

Production - Sales = 2,000 - 2,100 = $ -100 = Unsold Output (?).

Inventories at the end of the year = $0

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Example 1 Continued

What if the firm 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 (startof year) = $-100.

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Example 1 Continued

What if the firm 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 (startof year) = $-100.

Actual Investment (I) = 1000 + (-100) = $ 900.

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Example 1 Continued

What if the firm 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 (startof year) = $-100.

Actual Investment (I) = 1000 + (-100) = $ 900.

I < Ip.

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Consumption Function

Assume that consumption today depends on disposable incometoday.

Marginal Propensity to Consume (mpc) the additional amount ofconsumption as a result of a one-dollar increase in disposable

income.

mpc = Consumption

Disposable Income=

C

DI

Note mpc (0, 1).

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We can define a consumption function:

Ct = C + mpc (Yt Tt) C, sometimes called autonomous consumption is a term that

captures factors other than current disposable income that affectconsumption.

mpc (Yt Tt) measures the responsiveness of consumption tochanges in disposable income.

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consumption

C

slope = mpc=c

C

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Planned Expenditure and Output

Production

(Output)Income Spending

Production, Income and Spending activities are not isolated, but

instead feed on each other.

In particular, Planned Aggregate Spending (PAE) depends onoutput through the consumption function.

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PAE = C + Ip + G + N X

=

C + mpc (Y-T) + Ip + G + N X

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PAE = C + Ip + G + N X

=

C + mpc (Y-T) + Ip + G + N X=

Cmpc T + Ip + G + N X + mpc Y

A one-dollar increase in Y will lead to an increase ofmpc dollars inPAE. Why?

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Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100,and C = 500. Then, we can re-write PAE as:

PAE =

C + mpc (Y-T) + Ip + G + N X

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Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100,and C = 500. Then, we can re-write PAE as:

PAE =

C + mpc (Y-T) + Ip + G + N X= [ 500 + 0.9 (Y-100) ] + 1000 + 500 + 100

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Example 2

Suppose mpc = 0.9, Ip = 1000, G = 500, T = 100, NX = 100,and C = 500. Then, we can re-write PAE as:

PAE =

C + mpc (Y-T) + Ip + G + N X= [ 500 + 0.9 (Y-100) ] + 1000 + 500 + 100

= 2010 + 0.9 Y

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Short-Run Equilibrium

A short-run equilibrium output is defined as a level of output thatequals Planned Aggregate Expenditure.

Y = PAE = YSR

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planned

aggregate

expenditure

p

e

C

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planned

aggregate

expenditure

Y = PAE

p

e

C

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planned

aggregate

expenditure

Y = PAE

p

e

C

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planned

aggregate

expenditure

Y = P

At Y < YSRfirms are producing

too little output and

cannot meet demand

PAE > YY

PAE

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planned

aggregate

expenditure

Y = P

At Y > YSRfirms are producing

too much output and

are exceeding

demand

Y > PAE

Y

PAE

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Example 2 Continued

To find the Short-Run Equilibrium:

Y = PAE

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Example 2 Continued

To find the Short-Run Equilibrium:

Y = PAE

Y = 2010 + 0.9 Y

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Example 2 Continued

To find the Short-Run Equilibrium:

Y = PAE

Y = 2010 + 0.9 Y solve for Y

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Example 2 Continued

To find the Short-Run Equilibrium:

Y = PAE

Y = 2010 + 0.9 Y solve for Y

0.1 Y = 2010

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Example 2 Continued

To find the Short-Run Equilibrium:

Y = PAE

Y = 2010 + 0.9 Y solve for Y

0.1 Y = 2010

YSR = 20, 100

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Imagine C drops to 400. What is the new short run equilibriumoutput?

PAE =

Cnew

+ mpc (Y-T) + Ip + G + N X

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Imagine C drops to 400. What is the new short run equilibriumoutput?

PAE =

Cnew

+ mpc (Y-T)

+ Ip + G + N X

= [ 400 + 0.9 (Y-100) ] + 1000 + 500 + 100

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Imagine C drops to 400. What is the new short run equilibriumoutput?

PAE =

Cnew

+ mpc (Y-T)

+ Ip + G + N X

= [ 400 + 0.9 (Y-100) ] + 1000 + 500 + 100

= 1910 + 0.9 Y

planned

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E1

aggregate

expenditure Y*

Y = PAE

P

planned

t

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aggregate

expenditure Y*

Y = PAE

P

E1P

planned

t

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aggregate

expenditure Y*

Y = PAE

P

P

E1

E2

planned

aggregate

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aggregate

expenditure Y*

Y = PAE

P

P

E1

E2

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In equilibrium, we have:

Y = PAE

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In equilibrium, we have:

Y = PAE

Y = 1910 + 0.9 Y

0.1 Y = 1910

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In equilibrium, we have:

Y = PAE

Y = 1910 + 0.9 Y

0.1 Y = 1910

YSR = 19, 100

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Note, a decrease of 100 in autonomous consumption lead to a

decrease of more than 100 (actually, 1000!) in equilibrium output.Why?

Multiplier Effect: one dollar that is not spent is one dollar thatdoes not become income of someone else, and then this personspends less, and then someone else has less income so therefores/he also spends less, and ...

Link between aggregate spending and mpc. What happens if mpcis higher/lower?

100

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100

Y = 100

100 100

10 save

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100 90

10 save

spend

Y = 100 + 90

100 100

10 90save

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save

spend100 90

10

81

9

save

spend

Y = 100 + 90 + 81

100 100

10 90save

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save

spend100 90

10

81

9

72.9

8.1

save81

sa

spend sp

Y = 100 + 90 + 81 + 72.9

100 100

10 90save

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save

spend100 90

10

81

9

72.9

8.1 sa

81

spend sp

Y = 100 + 90 + 81 + 72.9

100 100

10 90save

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save

spend100 90 81

9

72.9

8.1

81

spend sp

sa

Y = 100 + 90 + 81 + 72.9

Y = 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x

= 90 = 90

100 100

10 90save

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save

spend100 90 81

9

72.9

8.1

81

spend sp

sa

Y = 100 + 90 + 81 + 72.9

Y = 100 + (0.9 x 100) + 0.9 x (0.9 x 100) + 0.9 x 0.9 x

= 90 = 90

100 100

10 90save

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save

spend100 90 81

9

72.9

8.1 sa

81

spend sp

Y = 100 + 90 + 81 + 72.9

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 10

100 100

10 90save

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save

spend100 90 81

9

72.9

8.1 sa

81

spend sp

Y = 100 + 90 + 81 + 72.9

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 10

Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + )

100 100

10 90save81

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save

spend100 90 81

9

72.9

8.1 sa

81

spend sp

Y = 100 + 90 + 81 + 72.9

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 10

Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + )

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100 100

10 90save81

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save

spend100 90 81

9

72.9

8.1 sa

81

spend sp

Y = 100 + 90 + 81 + 72.9

Y = 100 + 0.9 x 100 + 0.92 x 100 + 0.93 x 100 + 0.94 x 10

Y = 100 x ( 1 + 0.9 + 0.92 + 0.93 + 0.94 + )

initial spending

Fiscal Policy as a Stabilizer

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y

Keyness idea: when aggregate demand falls, fiscal policy (inparticular government spending) can be a useful tool to closeoutput gaps.

Why? G itself is part of Planned Aggregate Spending. Therefore, it

can influence output.

What would be the increase in G necessary to close therecessionary gap in Example 2? Is it more, less or exactly 1000?

What about changes in T?

planned

aggregate

expenditure Y*

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expenditure Y*

Y = PAE

P

E2

planned

aggregate

expenditure Y*

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expenditure Y

Y = PAE

P

P

E3

E2

Fiscal Policy as a Stabilizer

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Is fiscal policy an effective stabilizer? Japan.

Financing expenditure increases. Deficits.

Flexibility of fiscal policy. How fast can it be implemented?