Chapter 25

Spending and Output in the Short Run

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Identify the key assumption of the basic Keynesian model and explain
how this affects the production decisions made by firms and the
consumption decisions made by households.
2. Discuss the determinants of planned investment and aggregate
consumption spending and how these concepts are used to develop a
model of planned aggregate expenditure.
3. Analyze, using graphs and numbers, how an economy reaches short-
run equilibrium in the basic Keynesian model.
4. Show how a change in planned aggregate expenditure can cause a
change in short-run equilibrium output and how this is related to the
income-expenditure multiplier.
5. Explain why the basic Keynesian model suggests that fiscal policy is
useful as a stabilization policy.
6. Discuss the qualifications that arise in applying fiscal policy in real-
world situations.

2
© 2019 McGraw-Hill Education.
 Recessionary Gap
• Great Depression
– Available resources are unemployed
– Public’s willingness or ability to spend declines
• A decrease in spending leads to lower production
– Laid-off workers reduce their spending
– Insufficient spending to support the normal level of
production
• Conventional economic policy of the 1920s and
1930s would not solve this problem
– John Maynard Keynes revolutionized economic thought
and public policy

3
© 2019 McGraw-Hill Education.
 John Maynard Keynes
(1883 – 1946)
• After World War I, Keynes recognized that the
terms of the peace would lead to another war
– German war reparations would prevent growth
and recovery
• The General Theory of Employment, Interest,
and Money (1936) is his best-known work
– Problem was explaining why economies kept a
recessionary gap for long periods
• Aggregate spending is too low for full employment
• Stabilization policies use government spending or
taxes to substitute for spending in other sectors
4
© 2019 McGraw-Hill Education.
 Keynesian Model
• Building block for current theories of short-run
economic fluctuations and stabilization policies
• In the short run, firms meet demand at preset
prices
– Firms typically set a price and meet the demand at that
price in the short run
• Menu costs are the costs of changing prices
– Determining the new price
– Incorporating prices into the business
– Informing consumers of new prices

• Firms change prices when the marginal benefits

exceed the marginal costs
5
© 2019 McGraw-Hill Education.
 Technology of Changing Prices
• Technology has reduced menu costs
– Bar codes and scanners reduce costs of changing
prices in the store
– Online surveys
• Highly segmented airline pricing
• Internet mechanisms for setting price
■ eBay ■ Priceline
• Other costs remain
■ Competitive analysis ■ Deciding the new prices
■ Informing consumers

6
© 2019 McGraw-Hill Education.
 Planned Aggregate Expenditure
• Planned aggregate expenditure (PAE) is total
planned spending on final goods and services
• Four components of planned aggregate expenditure
– Consumption (C) by households
– Investment (I) is planned spending by domestic
firms on new capital goods
– Government purchases (G) are made by federal,
state, and local governments
– Net exports (NX) equals exports minus imports

7
© 2019 McGraw-Hill Education.
 Planned Investment Example
• Fly-by-Night Kite produces $5 million of kites
per year
– Expected sales are $4.8 million and planned inventory
increase is $0.2 million
– Capital expenditure of $1 million is planned
• Total planned investment is $1.2 million
• If actual sales are only $4.6 million
– Unplanned inventory investment of $0.2 million
– Actual investment is $1.4 million
• If actual sales are $5.0 million
– Unplanned inventory decrease of $0.2 million
– Actual investment is $1.0 million
8
© 2019 McGraw-Hill Education.
 Planned Aggregate Expenditure
(PAE)
• Actual spending equals planned spending for
– Consumption
– Government purchases of final goods and
services
– Net exports
• Adjustments between actual and planned spending
are accomplished with changes in inventories
• The general equation for planned aggregate
expenditures is

PAE = C + IP + G + NX
9
© 2019 McGraw-Hill Education.
 Consumption Expenditures
• Consumption (C) accounts for two-thirds of
total spending
– Powerful determinant of planned aggregate
expenditure
– Includes purchases of goods, services, and
consumer durables, but not new houses
• Rent is considered a service
• C depends on disposable income, (Y – T)

10
© 2019 McGraw-Hill Education.
Consumption, 1960-2016

11
© 2019 McGraw-Hill Education.
 Consumption Function
• 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 is the change in consumption for a given change
in disposable income
0 < mpc < 1
– Autonomous consumption is spending not related
to the level of disposable income
• A change in C shifts the consumption function

12
© 2019 McGraw-Hill Education.
 Consumption Function
C = C + (mpc) (Y – T)
• The wealth effect is the tendency of
changes in asset prices to affect household's
wealth and thus their consumption spending
– This effect is included in C
• Autonomous consumption also captures the
effects of interest rates on consumption
– Higher rates increase the cost of using credit to
purchase consumer durables and other items

13
© 2019 McGraw-Hill Education.
 2000 – 2002 Stock Market Decline
• Stock prices fell 49% between March 2000 and
October 2002
– Households owned $13.3 trillion in stocks in 2000
• Stock market decline potentially destroyed $6.5 trillion of
household wealth
• A $1 decrease in wealth decreases consumption
by
3–7¢
– Suggests a decrease in consumer spending of
$195 – 455 billion would occur
• Consumption spending continued to increase

14
© 2019 McGraw-Hill Education.
2000 – 2002 Consumer Spending
• Consumer spending increased despite
sharp fall in stock prices
– After-tax income increased
– Interest rates decreased
• Spurred spending on durables
– Housing wealth increased
• Housing prices increased 20% in the period
• Partially offset lost wealth from stock market

15
© 2019 McGraw-Hill Education.
 More on the Consumption Function

C = C + (mpc) (Y – T)
• Marginal propensity to consume (mpc) is
the increase in consumption spending when
disposable income increases by $1
– mpc is between 0 and 1 for the economy
– If households receive an extra $1 in income, they
spend part (mpc) and save part
• (Y – T) is disposable income
– Output plus government transfers minus taxes
– Main determinant of consumption spending

16
© 2019 McGraw-Hill Education.
 Consumption Function
Consumption spending (C)
C = C + (mpc) (Y – T)
C
Intercept slope

ΔC
C
Δ (Y – T) Slope = Δ C / Δ (Y – T)

Disposable income (Y – T)

17
© 2019 McGraw-Hill Education.
 Planned Aggregate Expenditure
(PAE)
• 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
• Consumption is the largest component
of PAE
– Consumption depends on output, Y
– PAE depends on Y
18
© 2019 McGraw-Hill Education.
 Planned Expenditure Example
PAE = C + IP + G + NX
C = C + mpc (Y – T)
PAE = C + mpc (Y – T) + IP + G + NX
• Suppose that planned spending components
have the following values
C = 620 mpc = 0.8 T = 250
IP = 220 G = 330 NX = 20

PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20

PAE = 960 + 0.8 Y
19
© 2019 McGraw-Hill Education.
 Planned Expenditure Example
C = 620 + 0.8 (Y – 250)
PAE = 960 + 0.8 Y
• If Y increases by $1, C will increase by $0.80
– PAE increases by 80 cents
• Planned aggregate expenditure has two parts
– Autonomous expenditure, the part of spending that
is independent of output
• $960 in our example
– Induced expenditure, the part of spending that
depends on output (Y)
• 0.8 Y in our example

20
© 2019 McGraw-Hill Education.
Planned Expenditure Graph
Planned aggregate expenditure (PAE)

PAE = 960 + 0.8Y

960
Slope = 0.8

4,800

Output (Y)

21
© 2019 McGraw-Hill Education.
 Short-Run Equilibrium
• Short-run equilibrium is the level of output at which
planned spending is equal to output
– No change in output as long as prices are
constant
– Our equilibrium condition can be written
Y = PAE
• Using our previous example, PAE = 960 + 0.8 Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
22
© 2019 McGraw-Hill Education.
 Short-Run Equilibrium Search
Output (Y) PAE = 960 + 0.8 Y Y – PAE Y = PAE?
4,000 4,160 –160 No
4,200 4,320 –120 No
4,400 4,480 –80 No
4,600 4,640 –40 No
4,800 4,800 0 Yes
5,000 4,960 40 No
5,200 5,120 80 No

• Only when Y = 4,800 does planned spending equal

output
23
© 2019 McGraw-Hill Education.
Short-Run Equilibrium Graph
Planned aggregate expenditure (PAE)
Y = PAE

PAE = 960 + 0.8Y

Slope = 0.8

960

45o
4,800

Output (Y)

24
© 2019 McGraw-Hill Education.
 Output Greater than Equilibrium
• Suppose output
Y = PAE
reaches 5,000
• Planned spending is
PAE = 960 +
less than total output 0.8Y
• Unplanned inventory

PAE
increases 96
0
• Businesses slow
45o
down production 4,800 5,000
• Output goes down Output (Y)

25
© 2019 McGraw-Hill Education.
Output Less than Equilibrium
• Suppose output
is only 4,500 Y = PAE

• Planned spending is
more than total PAE = 960 +
0.8Y
output

PAE
• Unplanned inventory 960
decreases
• Businesses speed up
4,500 4,800
production Output (Y)
• Output goes up

26
© 2019 McGraw-Hill Education.
A Fall in Planned Spending Leads to
a Recession
Planned aggregate expenditure Y = PAE
PAE = 960 + 0.8Y

PAE = 950 + 0.8Y

E
(PAE)

F
960
950

45o Recessionary gap

4,750 4,800
Y* Output Y
27
© 2019 McGraw-Hill Education.
 New Equilibrium
–
• Autonomous consumption, C, decreases by 10
– Causes a downward shift in the planned aggregate
expenditure curve
– The economy eventually adjusts to a new lower
level of equilibrium spending and output, $4,750
• Suppose that the original equilibrium level, $4,800,
represented potential output, Y*
– A recessionary gap develops
– Size of the recessionary gap is 4,800 – 4,750 = $50
– Entire decrease is in consumption spending
• Same process applies to a decrease in IP, G, or NX

28
© 2019 McGraw-Hill Education.
New Short-Run Equilibrium Search
Output (Y) PAE = 950 + 0.8 Y Y – PAE Y = PAE?
4,600 4,630 –30 No
4,650 4,670 –20 No
4,700 4,710 –10 No
4,750 4,750 0 Yes
4,800 4,790 10 No
4,850 4,830 20 No
4,900 4,870 30 No
4,950 4,910 40 No
5,000 4,950 50 No

29
© 2019 McGraw-Hill Education.
 What Caused U.S. Recession 2007 -
2009
• Housing price bubble burst summer 2006
– House prices increased an average of 8.2% per
year from 2001 - 2006
– Last period of high increase was 1976 – 1979
• 4.9% per year increase on average
– Using the rule of 72, house prices would double
in 10 years as compared to 15-19 years
• Housing prices declined 6% 2006 – 2007
and over 20% 2007 – 2009
• Financial market crisis
30
© 2019 McGraw-Hill Education.
 What Caused the U.S. Recession
2007 - 2009
• Decline in spending by businesses and
households
– Difficult to borrow
– Uncertainty about the state of the economy
• Decline in planned aggregate
expenditure
– Downward shift of the PAE line
• Recessionary gap

31
© 2019 McGraw-Hill Education.
 Income-Expenditure Multiplier
• The income – expenditure multiplier shows
the effect of a one-unit increase in autonomous
expenditure on short-run equilibrium output
– Initial planned expenditure = 960 + 0.8 Y
– New planned expenditure = 950 + 0.8 Y
• The 10-unit drop in C implied a 10 unit drop in autonomous
expenditure
• Equilibrium changed from $4,800 to $4,750
• A $10 change in autonomous expenditures caused a $50
change in output
• Multiplier = 5
– The larger the mpc, the greater the multiplier

32
© 2019 McGraw-Hill Education.
 Stabilization Policy
• Stabilization policies are government policies that
are used to affect planned aggregate expenditure,
with the objective of eliminating output gaps
– Expansionary policies increase planned
expenditure
– Contractionary policies decrease planned
expenditure
– Fiscal policy uses changes in government
spending, transfers, or taxes
– Monetary policy uses changes in the money
supply

33
© 2019 McGraw-Hill Education.
 Government Spending
• Government spending is part of planned spending
– Changes in government spending will directly affect
planned aggregate expenditures
• Suppose planned spending decreases $10 from
Y = 960 + 0.8 Y to
Y = 950 + 0.8 Y
– Equilibrium Y decreases from $4,800 to $4,750
• Recessionary gap is $50
• Stabilization policy indicates a $10 increase in government
spending will restore the economy to Y* at $4,800

34
© 2019 McGraw-Hill Education.
 $10 Fiscal Stimulus
Planned aggregate expenditure Y = PAE
PAE = 960 + 0.8Y

PAE = 950 + 0.8Y

E
(PAE)

F
960
950

45o
4,750 4,800
Y* Output Y
35
© 2019 McGraw-Hill Education.
 U.S. Military Spending
• Military spending as a share of GDP decreased sharply
after World War II
– Peaks for wars and Reagan military buildup
• Added demand from military spending helped end the
Great Depression
– Recessions
associated with
declines in military
spending
– Increases in G help
stimulate the
economy
36
© 2019 McGraw-Hill Education.
 Taxes and Transfers
• Net tax (T) = total taxes – transfer
payments – government interest payments
• Planned aggregate expenditures are
influenced by changing total taxes and/or
transfer payments
– The effect is indirect, channeled through the
effects on disposable income
• Lower taxes or higher transfers increase
disposable income
• Increases in disposable income lead to higher C

37
© 2019 McGraw-Hill Education.
 Using Tax Cuts to Close a
Recessionary Gap – An Example
• Original planned spending Y = 960 + 0.8 Y
• Autonomous spending decreases Y = 950 + 0.8 Y
• Recessionary gap is $50
• Tax cut to close the gap must be bigger than $10
– Increase disposable income to cause initial
increase in spending to be $10
• Taxes will have to go down by $12.5

Output Net Taxes Disposable Consumption

(Y) (T) Income (Y – T) 610 + 0.8 (Y – T)
4,750 250 4,500 4,210
4,750 237.5 4,512.5 4,220
38
© 2019 McGraw-Hill Education.
 Federal Tax Rebates -- 2001
• Economy showed signs of slowing in
early 2001
– Federal government rebated $300 to
individual and $600 to couples
• Total rebates were about $38 billion
– Also made cuts in tax rates
• Two-thirds of the rebates were spent by
households within six months
• Successful policy

39
© 2019 McGraw-Hill Education.
 Fiscal Policy During the 2007 – 2009
Recession
• Economic Stimulus Act of 2008
– $100 billion in tax cuts
– $60 billion government spending increase
• American Recovery and Reinvestment Act of
2009
– $200 billion in tax cuts
– $60 0billion government spending increase

• Both were effective at raising consumption spending

• Real GDP higher than it would have been otherwise

40
© 2019 McGraw-Hill Education.
 Supply-Side Effects of Fiscal Policy

• Fiscal policy may affect potential output as

well as potential spending
– Investment in infrastructure increases Y*
– Taxes and transfers affect incentives and can
change potential output, Y*
• Supply-side economists emphasize the
supply-side effects of fiscal policy
• Current thinking is more moderate
– Demand-side effects of spending matter
– Supply-side effects also matter
41
© 2019 McGraw-Hill Education.
 Fiscal Policy and Deficit Spending
• Government deficit is the difference between
government spending and net taxes, (G – T)
– Large and persistent budget deficits reduce
national saving
• Less saving means less investment which means less
growth
• Managing the impact of the deficit limits the
government's ability to use fiscal policy as a
stimulus
– Political considerations make it difficult to use
contractionary fiscal policy
42
© 2019 McGraw-Hill Education.
 Fiscal Policy Flexibility
• Two limits to fiscal policy flexibility
– The legislative process requires time
• Change in fiscal policy may be slow
– Competing political objectives
• National defense
• Entitlements such as Medicare and income
support

43
© 2019 McGraw-Hill Education.
 Fiscal Policy Can Be Effective
• Automatic stabilizers increase
government spending or decrease taxes
when real output declines
– Built into laws so no decision is required
– Unemployment compensation, progressive
income tax
• Fiscal policy may be useful to address
prolonged periods of recession
– Monetary policy is more often used to stabilize
the economy
44
© 2019 McGraw-Hill Education.
 Spending and Output in the Short
Run
Short-Run Spending and Output

Keynesian Model Multiplier

Planned Output Gaps

Aggregate Short-Run
Expenditures Equilibrium
(PAE) Fiscal Policy

Consumption Changes in Limitations

Function Equilibrium
45
© 2019 McGraw-Hill Education.
Appendix A

An Algebraic Solution of the Basic

Keynesian Model

© 2019 McGraw-Hill Education.

 The Basic Keynesian Model
• We know that
PAE = C + Ip + G + NX
• And if we assume that these are given
numbers, we can rewrite as
PAE = C + I + G + NX
• Then, combine with consumption
spending (and refer to mpc as c) to get
PAE = (C + c(Y – T)) + I + G + NX
47
© 2019 McGraw-Hill Education.
 The Basic Keynesian Model
• Rearrange to put all the given terms
together:
PAE = (C + cT + I + G + NX) + cY
• Use the short-run equilibrium Y = PAE
Y = (C + cT + I + G + NX) + cY
• Finally, gather Y and cY together and divide:
Y = 1 (C + cT + I + G + NX)
1-c

48
© 2019 McGraw-Hill Education.
 Appendix B

The Multiplier in the Basic Keynesian

Model

© 2019 McGraw-Hill Education.

 The Income and Expenditure
Multiplier
• Suppose autonomous spending
decreases $10 and mpc is 0.8
– First decrease in spending is $10
• Leads to a decrease in output of $10
– Second decrease in spending is $8
– Third decrease is $6.40, etc.
• Sum of the decreases in spending
10 + 8 + 6.4 + 5.12 + …
= 10 [1 + 0.8 + (0.8)2 + (0.8)3…]
50
© 2019 McGraw-Hill Education.
 Income and Expenditure Multiplier
• To find the sum of the series, we need a relationship
when x is between 0 and 1
1
1+x+x +x +x +…=
2 3 4
= multiplier
(1 – x)
• In our case, x = 0.8
10 [1 + 0.8 + (0.8)2 + (0.8)3…]
1 1
= 10 = 10 (1 – x) (1 – 0.8)

= 10 (1 / 0.2) = 10 (5) = 50
–In this case, the multiplier is 5
51
© 2019 McGraw-Hill Education.