The Simple Keynesian Model (closed economy) PDF

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The Simple Keynesian Model (closed economy)...

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After this lecture you should be able to: 1. Explain the usefulness of the short-run macro model. 2. List the four components of aggregate expenditure included in the simple macro model of this chapter. 3. List the determinants of consumption spending and describe their effects on consumption spending. 4.

Describe a consumption function in terms of autonomous consumption and the marginal propensity to consume.

5.

Show how changes in taxes and in autonomous consumption changes affect the consumption-income line.

6.

Define government spending.

7.

Define net exports.

8. Explain why short-run equilibrium output is not necessarily full-employment output. 9. Use the multiplier to show how a change in spending affects equilibrium output in an economy. 10. Use the short-run macro model of the chapter to explain the causes of the 2008–09 recession.

The main purpose in building the short-run macro model is to explain fluctuations in real GDP that the long-run, classical model cannot explain. The short-run macro model focuses on the role of spending in explaining economic fluctuations. It explains how shocks that initially affect one sector of the economy quickly influence other sectors, causing changes in total output and employment. In this model, spending is the only force that determines how much output the economy will produce. For years, the economics taught us to refrain from intervening in the economy other than to protect and define property rights. The economy itself was self-correcting so that if you intervened, you may just mess things up. This was a long held belief that some still believe today (e.g., classicalist economists). So, what changed? The Great Depression changed much in economics. As an aside, a depression is defined as a prolonged and severe recession. Which means we get to decide if a recession is bad enough to call a depression. Another definition is that it is a recession when your neighbor gets laid off. It’s a bad recession when many of your neighbors get laid off and it is a depression when you get laid off. For more information, check out my YouTube clip on the Great Depression. The music and pictures are in the public domain, so if you really like the song, feel free to rip and burn at will. Throughout this lecture, you will find hyperlinks to videos that hopefully reinforce the materials. The short-run macro model focuses on spending in markets for currently produced U.S. goods and services—that is, spending on things that are included in U.S. GDP. Spending has four components: (real) consumption spending, (real) investment spending, (real) government purchases, and (real) net exports. This week you are also learning about inflation, so “real” means you have taken the impact of inflation out of the picture (or adjusted everything to a common base year.) The Consumption Function Consumption is positively related to real disposable income, real wealth, and expectations of future income, and is negatively related to the interest rate. What does this mean? It simply means that you buy more stuff if you have higher incomes, higher net wealth or expect a big raise or monetary gift in the future. For more information, check out my YouTube clip on the Consumption Function. The consumption function illustrates the relationship between consumption and disposable income. Changes in disposable income lead to movements along the consumption function. The slope of the consumption function is equal to the marginal propensity to consume, that is, the amount by which consumption spending changes when disposable income rises by one dollar. The vertical intercept represents autonomous consumption spending, the combined impact on consumption spending of everything other than disposable income. Changes in wealth, the interest rate, or expectations of future income lead to a change in autonomous consumption spending. These changes are shown graphically as a shift of the consumption schedule.

The consumption-income line shows the relationship between real consumption spending and real income, rather than real disposable income. When the government collects a fixed amount of taxes from households, the consumption-income line shifts downward by the amount of the tax times the MPC. The slope of the consumption-income line, however, is unaffected by taxes, and is equal to the MPC. For more information on finding the MPC or examples of how to use it, check out my YouTube clip on the Consumption Function Equilibrium. A change in income causes consumption spending to change and leads to a movement along the consumption-income line, while consumption spending changes that occur for any other reason will cause the consumption-income line to shift. These other changes work by changing autonomous consumption or taxes. Exogenous Variables and Aggregate Expenditures In the short-run macro model, (planned) investment spending includes plant and equipment purchases by business firms, and new home construction. Inventory investment is treated as unintentional and undesired, and is therefore excluded from the definition. Government purchases include all of the goods and services that government agencies buy during the year. Net exports equal exports minus imports. Export spending measures production sold to foreigners, while import spending measures our spending on foreign output. Thus, to accurately measure domestic output, we must add U.S. exports and subtract U.S. imports. These two adjustments can be made together by simply including net exports as the foreign sector’s contribution to total spending. Investment spending, government purchases, and net exports are all treated as given values, determined by forces outside of this model. Aggregate expenditure (AE) is the sum of spending by households, businesses, the government, and the foreign sector on final goods and services. Since the relationship between income and spending is circular, when income increases, aggregate expenditure will rise by the MPC times the change in income. See my YouTube video on going from Consumption Function to Aggregate Expenditures for a closed economy. When aggregate expenditure is less than GDP, output will decline in the future. Similarly, when aggregate expenditure is greater than GDP, output will tend to rise in the future. Therefore, in the short run, equilibrium GDP is the level of output where output and aggregate expenditure are equal. Output minus aggregate expenditures equals the change in inventories during any period. When output equals aggregate expenditures, then inventory changes will equal zero, so another way to find the equilibrium GDP in the economy is to find the output level where inventory changes are equal to zero. Graphically, equilibrium GDP is found at the intersection of the aggregate expenditure line and the 45° line. At any output level where the aggregate expenditure line lies below the 45° line, aggregate expenditure is less than GDP and inventory accumulation will cause firms to reduce output in the future. At any output level where the aggregate expenditure line lies above the 45° line, aggregate expenditure is greater than GDP and inventory depletion will cause firms to increase output in the future.

Operating at equilibrium does not guarantee full employment. If aggregate spending is too high or too low, the aggregate expenditure line will cross the 45° line at some output level other than full employment output, and the economy will remain at a short-run equilibrium where full employment is not achieved. Graphically, it looks like this:

At a point of GDPA you can see that aggregate expenditures will exceed Real GDP. This will cause business inventories to drop and signal businesses to hire more workers and produce more output. If in the following year, the produce at GDPB, then they have overshot expenditures and inventories will rise. This signals business to reduce output and lay off workers. The solution finally converges where the Aggregate Expenditures Function crosses the 45-degree line. This is equilibrium. For those of you who like numbers, see if you can find equilibrium given the following table. Real%GDP% $0% $100% $200% $300% $400% $500% $600%

Consumption% Spending% $30% $115% $200% $285% $370% $455% $540%

Planned% Investment% $40% $40% $40% $40% $40% $40% $40%

Government% Spending% $20% $20% $20% $20% $20% $20% $20%

Net%Exports%% A$15% A$15% A$15% A$15% A$15% A$15% A$15%

Aggregate% Expenditures% $75% $160% $245% $330% $415% $500% $585%

Hint: It is where Real GDP = Aggregate Expenditures. Keep in mind that this is the same concept as we discussed with the circular flow. Every dollar spent is a dollar earned. Unless there is a shock to the system (change in exogenous variables, you wouldn’t expect a change.

Next, assume there is a drop in aggregate expenditures. Let’s say that Investment falls due to “animal spirits” or pessimistic news. The resulting decrease in Real GDP shown in the following graph is actually larger than the decrease in Investment (shown by the gap between the two Aggregate Expenditure lines.) This is due to the multiplier effect. It works in both directions so that increases in investment lead to an even larger increase in GDP or decreases in Investment lead to a larger decrease in Real GDP. Real Aggregate Expenditure

(C + I + NX) 1 (C + I + NX) 2

45°

Y2

Y1

Real GDP

Changes in spending—in investment, government purchases, or autonomous consumption— lead to a multiplier effect on GDP, where the initial shock sets off a chain reaction, leading to successive rounds of changes in spending and income. The expenditure multiplier is the number by which the initial spending change is multiplied to get the change in equilibrium GDP. The formula for the expenditure multiplier is 1/(1 – MPC). Automatic stabilizers reduce the size of the multiplier, and therefore reduce the impact of spending changes. They work by shrinking the additional spending that occurs in each round of the multiplier. Some real-world automatic stabilizers are changes in taxes, transfer payments, interest rates, imports, and forward-looking behavior. Perhaps the most important automatic stabilizer of all is the passage of time—in the long run our multipliers have a value of zero. After any change in spending, output will eventually return to full employment, so the change in equilibrium GDP will be zero. Automatic destabilizers increase the size of multiplier, and therefore increase the impact of spending changes. They work by increasing the additional spending that occurs in each round of the multiplier. Some real-world automatic destabilizers are asset prices and wealth, and investment spending. In the real world, the multiplier is impacted by both automatic stabilizers and automatic destabilizers so coming a real value can be difficult. Economists generally agree that the current number is smaller than it was during the Great Depression and most put the actual value in the neighborhood of 1.5. In the long run, however, the value of the multiplier is zero. The recession of 2008-09 was likely caused by a spike in oil prices and the collapse of the

housing bubble. After the declines in spending fueled by the first two events, the U.S. economy was hit by a third event: a serious financial crisis. All of these events caused a significant decline in investment and consumption spending. Over time, as the multiplier process took place, the decrease in spending brought down both GDP and employment. Remember from Principle No. 10, from Thinking Like an Economist – Society faces a shortrun tradeoff between inflation and unemployment. – The concept of a business cycle was introduced as fluctuations in economic activity, such as employment and production. How can we use the simple Keynesian model to correct for a slump in the economy? See my following YouTube video to see how: Business Cycles and the Keynesian Solution....