copyright © 2001 by the mcgraw-hill companies, inc. all rights reserved. aggregate demand and...

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand and Output

in the Short Run

2


John Maynard Keynes

Most influential economist of the 20th centuryPublished The General Theory of

Employment, Interest, and Money in 1936Keynes’ idea was that

A decline in aggregate spending may cause output to fall below potential output for long periods of time

Government spending would increase aggregate demand and restore full employment

3


Modeling Fluctuations

Goal of this chapterTo develop a model of how recessions and

expansions may arise from fluctuations in aggregate spending following Keynes

Basic Keynesian model or the Keynesian CrossThe diagram used to illustrate the theory

is not complete or entirely realistic model

4


Assumptions

Aggregate demand fluctuatesTotal planned spending changes

In the short run, firms meet the demand for their products at preset pricesDo not respond to every change in demand by

changing their pricesSet a price for some period and meet the demand

at that priceProduce just enough to satisfy their customers

5


Meet the Demand

Menu costs: The costs of changing pricesFirms do not change their prices

frequentlyOr, in the short run

Firms will eventually change prices if there is a large imbalance between sales and potential output

6


Aggregate Demand

Aggregate demand (AD)Total planned spending on final goods

and servicesFour components

Consumer expenditure (C)Investment (I)Government purchases (G)Net exports (NX)

7


Planned vs. Actual

Aggregate demand is planned spendingPlanned may differ from actual for firms

When a firm sells either less or more of its product than expected

For households, governments, and foreign purchasers we can reasonably assume that actual equals planned

8


Unplanned Investment

Suppose a firm’s actual sales are less then expectedWarehouses fill up

Actual investment is greater than planned investmentThe extra inventory becomes part of actual investment

I > Ip

Ip planned investmentI actual investment

If a firm sells more than expectedI < Ip

The firm planned on increasing inventories more than it actually did

9


Definition of Aggregate Demand

Aggregate demand equals the economy’s total planned spending

AD = C + Ip + G + NX

10


Consumption

C is nearly 2/3rds of ADMany determinants of consumption spending

Prices, incomes, tastes, etc.

Disposable incomeAfter-tax income is particularly importantNational income (Y) minus net taxes (T)

As disposable income rises, consumption (C) rises

11


Consumption FunctionThe relationship between consumption

spending and its determinants, such as disposable (after-tax) income

C C c Y T ( )C constant term capturing factors other than

disposable incomec is the MPC (Marginal propensity to consume)

The amount by which consumption rises when disposable income rises by $1

We assume that 0 < c < 1

12


Fig. 13.1A Consumption Function

13


Fig. 13.2The U.S. Consumption Function,

1960-1999

14


AD and Output

How is AD affected by changes in YRecall, Y is aggregate incomeC depends on YC is a large part of ADAD depends on Y

15


AD and Output

pAD C I G NX

For now assume that Ip, G, NX, and T are fixed, so that

I I

G G

NX NX

T T

p

[ ( )] pAD C c Y T I G NX

16


AD and Output

Substituting and rearranging,

[ ( )]AD C c Y T I G NX

Shows if Y increases by one unit, then AD increases by c units

Positive relationship between Y and AD

c is the MPC

( )AD C cT I G NX cY

17


Autonomous AD

Autonomous aggregate demandThe portion of aggregate demand

that is determined outside the model

( )C cT I G NX Induced aggregate demand

The portion of aggregate demand that is determined within the model [cY]

18


SR Equilibrium Output

Short-run equilibrium outputThe level of output at which output Y

equals aggregate demand ADThe level of output that prevails during

the period in which prices are predetermined

Y = AD

Y – AD = 0

19


Numerical SR Equilibrium

Using Example 25.2 and Table 25.1SR equilibrium occurs when Y = 4,800

If output Y was 4,000Firms are not producing enoughInventories are being depleted, I < Ip

Firms respond by increasing productionIf output Y was 5,000

Firms are producing too enoughInventories are piling up, I > Ip

Firms respond by decreasing production

20


Fig. 13.3 Determination of Short-Run

Equilibrium Output (Keynesian Cross)

21


AD and Gaps

Using Example 25.2 and adding the assumption that potential output also equals 4,800,We can see how a fall in AD can lead to a

recession

22


Fig. 13.4A Decline in Spending Leads to a Recession

23


The Multiplier

Income-expenditure multiplierThe effect of a one-unit increase in

autonomous aggregate demand on short-run equilibrium output

An initial change in spending leads to a larger change in short-run

equilibrium outputSimplified form: 1

1 MPC

24


Stabilization

The Keynesian model says that recessions are caused by insufficient aggregate spendingImplying that policymakers must find ways to

increase aggregate demandStabilization policies

Government policies that are used to affect aggregate demand, with the objective of eliminating output gaps

Monetary policyFiscal policy

25


Government Policy

Monetary policyDecisions on the size of the money supply

Fiscal policyDecisions about the government’s budget

Government spendingGovernment revenues

26


Government Purchases and AD

Keynes thought that changes in G would be the most effective tool for reducing output gapsIncreased government purchases can

eliminate a recessionary gap

27


Fig. 13.5An Increase in Government

Purchases Eliminates a Recessionary Gap

28


Fig. 13.6U.S. Military Expenditures as a

Share of GDP, 1940-1999

29


Taxes, Transfers and AD

Fiscal policymakers also determine the level ofTax collections

Payments from the private sector to the government

Transfer paymentsPayments from the government to the private

sector (e.g., welfare, social security payments)

30


Taxes, Transfers, and AD

Using taxes and/or transfers affects AD indirectly by changing disposable income

Increase in disposable incomeDecrease taxesIncrease transfers

Decrease in disposable incomeIncrease taxesDecrease transfers

31


Qualifications of Fiscal Policy

The real world is more complicated than the basic Keynesian model

1. Fiscal policy may affect potential output Y* as well as AD Investments in public capital increase growth and potential

output Y*Roads, airports, schools, etc.

Taxes and transfers affect incentivesPeople save less with higher taxes on savingTax break on new investment encourages firms to make

more investmentPolicymakers should take both the demand side and

supply side effects into account

32


Qualifications of Fiscal Policy

2. Fiscal policy is not always flexible enough to be useful for stabilizationChanges in government spending or taxes are slow

usually a lengthy legislative process ensuesBudget changes proposed by the president must be

submitted to Congress 18 or more months before they go into effect

Policymakers may have goals other than stabilizing ADAdequate national defenseIncome support for the poorReelection

33


Automatic Stabilizers

Automatic stabilizersProvisions in the law that imply automatic

increases in government spending or decreases in taxes when real output declines“Recession aid” flows out when the

unemployment rate reaches a certain amountTransfer payments increase and tax revenues

decline during a recession

copyright © 2001 by the mcgraw-hill companies, inc. all rights reserved. aggregate demand and...

Documents