Principles of economics, Chapter 22 Planned investment differs from actual investment when firms’

sales are different from what they expected, so that additions

The Keynesian model’s crucial assumption:
to inventory (a component of investment) are different from
Firms meet demand at preset prices what firms anticipated (planed investment).
Firms typically set a price for some period and then meet the -Numerical example in the pdf, page 631.

demand at that price (produce just enough to satisfy their

So we have the aggregate investment function:
customers at the prices that have been set).
p
I =I −I r r
Economists refer to the costs of changing prices as menu
costs. The decision to change prices reflects a cost-benefit Ir = sensitivity of investment to the interest rate

comparison. I
p
= planned investment

The Keynesian model developed in this chapter ignores the

With these assumptions we
fact that prices will eventually adjust, and therefore should be
can define PAE by the following equation:
interpreted as applying to the short run.
PAE=C+ I p +G+ NX
Planned aggregate expenditure

Planned aggregate expenditure (PAE) is total planned

spending on final goods and services. It has four components:

 Consumption expenditure (C)

 Investment (I)
 Government expenditures (G)
 Net exports (NX)

Planned spending versus actual spending

 Consumer spending and the economy consumption via changes in autonomous consumption as the
wealth effect.
The largest component of planned aggregate expenditure is
consumption spending. The real interest rates will affect the C , higher real interest

Factors that determine how much people plan to spend rates will cause a decrease in the C . The opposite is also true

(consumption): a decline in real interest rates will cause an increase in the C .

 After-tax income Marginal propensity to consume (mpc) the amount by which

consumption rises when disposable income rises by $1; we
 Private sector`s disposable income
assume that 0 < mpc < 1.
We can write this relationship between consumption and
disposable income as the consumption function:
So the PAE function is:

C=C+ ( mpc ) ( Y −T )−c r r

PAE=( C−mpcT + I +G+ NX )+ mpcY −c r r−I r r
(Y-T): disposable income
PAE=autonomous expenditure+induced expenditure
C ̅: Autonomous consumption
mpc: marginal propensity to consume

c r = sensitivity of consumption to the interest rate

The autonomous consumption is the consumption spending

that is not related to the level of disposable income.
Economists refer to the effects of changes in asset prices on
Planned aggregate expenditure and output
Declines in production (which imply declines in the income
received by producers) lead to reduced spending.
Why do changes in production and income affect planned
aggregate spending?
The consumption function, which relates consumption to
disposable income, is the basic source of this relationship.
Because consumption spending C is a large part of planned
aggregate spending, and because consumption depends on
output Y, aggregate spending as a whole depends on output.
Planned aggregate expenditure can be divided into two parts,
a part that depends on output (Y) and a part that is
independent of output:
 Autonomous expenditure, the portion of planned
aggregate expenditure that is independent of output.
 Induced expenditure, the portion of planned
aggregate expenditure that depends on output Y.
In a graph an expenditure line is a line showing the
relationship between planned aggregate expenditure and
output. (The function of PAE)
Short-run equilibrium output
Short-run equilibrium output: the level of output at which
output Y equals planned aggregate expenditure PAE; the level
of output that prevails during the period in which prices are
predetermined.
Y =PAE
Finding short-run equilibrium output: graphical approach
Output (Y) is plotted on the horizontal axis and planned
aggregate expenditure (PAE) on the vertical axis.
The graphical solution is based on a diagram called the
Keynesian cross. The Keynesian-cross diagram includes two
lines: a 45° line that represents the condition Y 5 PAE and the
expenditure line, which shows the relationship of planned
aggregate expenditure to output. Short-run equilibrium output
is determined at the intersection of the two lines. If short-run
equilibrium output differs from potential output, an output gap
exists.
Only at the intersection, will firms be producing enough to just
satisfy planned spending on goods and services.
Planned spending and the output gap
Increases in autonomous expenditure shift the expenditure line
upward, increasing short-run equilibrium output.
Decreases in autonomous expenditure shift the expenditure
line downward, leading to declines in short-run equilibrium
output.  Source of recessions.
Generally, a one-unit change in autonomous expenditure leads
to a larger change in short-run equilibrium output, reflecting the
working of the income-expenditure multiplier. The multiplier
arises because a given initial increase in spending raises the
incomes of producers, which leads them to spend more,
raising the incomes and spending of other producers, and so
on.
Fiscal policy and recessions
Stabilization policies government policies that are used to
affect planned aggregate expenditure, with the objective of
eliminating output gaps.
Expansionary policies government policy actions intended to
increase planned spending and output.
Contractionary policies government policy actions designed
to reduce planned spending and output.
Fiscal policy decisions about how much the government
spends and how much tax revenue it collects.
The two major tools of stabilization policy are monetary policy
and fiscal policy.
Government purchases and planned spending
Changes in government purchases were probably the most
effective tool for reducing or eliminating output gaps. If output
gaps are caused by too much or too little total spending, then
the government can help to guide the economy toward full
employment by changing its own level of spending.
An increase in government purchases increases autonomous
expenditure by an equal amount.
Taxes, transfers, and aggregate spending
T =Total taxes−Tranfer payments−G .∫ . payments
Tax policy, as part of fiscal policy, involves the first two parts of
net taxes: total taxes and transfer payments. Transfer
payments, recall, are payments made by the government to
the public, for which no current goods or services are received.
A reduction in taxes or an increase in transfer payments
increases autonomous expenditure by an amount equal to the
marginal propensity to consume times the reduction in taxes or
increase in transfers.

Fiscal policy as a stabilization tool: three qualifications

 Changes in taxes and transfer programs may affect the

incentives and economic behavior of households and
firms.
 Governments must weigh the short-run effects of fiscal
policy against the possibility of large and persistent
budget deficits.
 Changes in spending and taxation take time and thus
fiscal policy can be relatively slow and inflexible.

However, automatic stabilizers (provisions in the law that

imply automatic increases in government spending or
reductions in taxes when output declines) can overcome the
problem of legislative delays to some extent and contribute to
economic stability.