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ECON1002 Introductory Macroeconomics, S2 2016

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TUTORIAL 4 (Week 5)

Reading Guide: Review Chapter 5 of BOF as preparation for this tutorial. You should also look over your lectures notes for Week 4. Key Concepts: Aggregate expenditure; the consumption function; short-run macroeconomic equilibrium; the 45-degree diagram; the multiplier, fiscal policy REVIEW OF CONCEPTUAL UNDERSTANDING These are to be attempted before the tutorial. They will not normally be covered in the tutorial, maybe, except for a quick review, time permitting. The answers are typically found in the textbook and lecture notes. 1. Obtain or construct the data representing the (real) aggregate expenditures in Australia since 2000: one place to look is http://www.rba.gov.au/statistics/tables/index.html#output_labour. Plot the data with the date on the horizontal axis. What has been the recent trend in Australia’s aggregate expenditure? 2. What is the Keynesian view of consumption? Any limitations in his view? 3. What do you understand by the equilibrium in the Keynesian model? What is the role of the 45-degree line or diagram? 4. What do you understand by the output gap and the multiplier? 5. Define the planned aggregate expenditures and list its components. PROBLEMS 1.

What are the key assumptions of the Keynesian model? Explain why this assumption is needed if one is to accept the view that aggregate spending is a driving force behind short-term fluctuations.

In the short run, firms meet demand at pre-set prices. The fact that firms produce to meet demand implies that changes in demand affect output in the short run. 2. The government is considering two alternative policies, one involving increased government purchases of 50 units, the other involving tax cuts of 50 units. Which policy will stimulate planned aggregate expenditure more? Why? The increase in government purchases raises autonomous aggregate demand by 50 units. The tax cut raises disposable income by 50 units, which also stimulates aggregate demand by raising consumption spending. However, the tax cut raises autonomous aggregate demand by only 50 units times the marginal propensity to consume (MPC); since the MPC is less than one, the tax cut will increase autonomous aggregate demand by less than 50 units. Tutorial Tasks

ECON1002 Introductory Macroeconomics, S2 2016

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Thus the increase in government purchases is predicted to have the greater impact on aggregate demand, via its effect through the multiplier process. 3.

An economy is described by the following equations: C= 1800 +0.6(Y-T)

; consumption function

Ip = 900

; planned investment

G=1500

; government spending

NX = 100

; net exports

T = 1500

; taxes

Y* = 9000

; potential output

a. Find a numerical equation linking planned aggregate expenditure to output. p AD = C + I + G + NX

AD = C + c (Y − T ) + I + G + N X

AD = 1800 + 0.6( Y − 1500 ) + 900 + 1500 + 100 AD = 3400 + 0.6Y b. Find the exogenous expenditure and induced expenditure in this economy. Autonomous aggregate demand is 3400, induced aggregate demand is 0.6Y . c. What is the output gap for this economy? If the natural rate of unemployment is 4 percent, what is the actual unemployment rate for this economy (use Okun’s law)? Solve for the equilibrium output and use the Okun’s law formula to get the answer. 4. An economy is described by the following equations: C= 40 + 0.8(Y – T) I p= 70 G = 120 NX = 0 T = 150 Y* = 580 The multiplier in this economy is 5.

a. Find short-run equilibrium output. Planned aggregate expenditure (PAE) is given by

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ECON1002 Introductory Macroeconomics, S2 2016

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PAE = C + I p + G + NX PAE = 40 + 0.8(Y − 150) + 70 + 120 + 0 PAE = 110 + 0.8Y

Algebraically, short-run equilibrium occurs where output (Y) = PAE, or where Y = 110 + 0.8Y Y − 0.8Y = 110 0.2Y = 110 Y = 550 The equilibrium short-run output level is 550.

b. Economic recovery abroad increases the demand for the country’s exports; as a result, NX rises to 100. What happens to short-run equilibrium output? PAE = C + I p + G + NX PAE = 40 + 0.8(Y − 150) + 70 + 120 + 100 PAE = 210 + 0.8Y Short-run equilibrium occurs where output (Y) = PAE, or where Y = 210 + 0.8Y

Y − 0.8Y = 210 0.2Y = 210 Y = 1050 The equilibrium short-run output level is 1050, 500 higher than the original equilibrium. An autonomous increase of 100 in NX has led to an increase of 500 in equilibrium output, which is what we would expect, given that the multiplier for this economy is 5 (5 × change in autonomous expenditure = 5 × 100 = 500 = change in equilibrium output level).

c. Repeat part b, but this time assume that foreign economies are slowing, reducing the demand for the country’s exports, so that NX = -100. (A negative value of net exports means that exports are less than imports.) Planned aggregate expenditures will then be given by PAE = C + I p + G + NX PAE = 40 + 0.8(Y − 150) + 70 + 120 − 100 PAE = 10 + 0.8Y Short-run equilibrium occurs where output (Y) = PAE, or where

Tutorial Tasks

ECON1002 Introductory Macroeconomics, S2 2016

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Y = 10 + 0.8Y Y − 0.8Y = 10 0.2Y = 10 Y = 50 The equilibrium short-run output level is 50, 500 lower than the original equilibrium. An autonomous decrease of 100 in NX has led to a decrease of 500 in equilibrium output, which is what we would expect, given that the multiplier for this economy is 5 (5 × change in autonomous expenditure = 5 × –100 = −500 = change in equilibrium output level).

d. How do your results help to explain the tendency of recessions and expansions to spread across countries? Changes in autonomous spending in one country lead to changes in autonomous spending in other countries through NX. A recession in one country caused by a reduction in autonomous spending will lead to a reduction in NX in another country that trades with that country. This reduction in NX will lead to a reduction in overall autonomous expenditure in the second country, reducing output in that country (leading to a possible recession). Similarly, an economic expansion in one country that causes an increase in the NX of another country that trades with that country, will lead to an increase in overall autonomous expenditure in the second country, increasing output in that country (leading to a possible expansion).

Further problems: Attempt Problems 3, 4 and 5 in the Textbook page 162-3. 4a. Numerical determination of short-run equilibrium output (1) Output Y 8200 8300 8400 8500 8600 8700 8800 8900 9000

(2) Aggregate demand [ AD = 3400 + 0.6Y ] 8320 8380 8440 8500 8560 8620 8680 8740 8800

(3)

(4)

Y − AD –120 –80 –40 0 40 80 120 160 200

Y = AD ? No No No YES No No No No No

So short-run equilibrium output is 8500.

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ECON1002 Introductory Macroeconomics, S2 2016

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b. We have that AD = 3400 + 0.6Y (see Problem 3). To find short-run equilibrium output we use the condition that defines short-run equilibrium output, Y = AD .

Y = AD Y = 3400 + 0.6 Y 0.4Y = 3400 Y = 8500 The result is the same as we found in part a. c. Full employment output Y * is 9000 (see Problem 2), so the output gap, Y * −Y , equals 9000 – 8500 = 500. As a percentage of full employment, the gap is 500/9000 = 5.6%. By Okun’s Law, cyclical unemployment is: 5.6/1.5 = 3.73% Since the natural rate is 4%, the actual unemployment rate is 4% + 3.7% = 7.7%.

5. For the economy in Problem 3, we have AD = 3400 + 0.6Y (see part a of Problem 3). To find short-run equilibrium, we use the condition Y = AD . Substituting for AD and solving, we find output Y = 8500 (see part b of Problem 4). The three parts of the problem ask us to re-solve for short-run equilibrium output under different assumptions. a. First find the relationship of aggregate demand to output: AD = C + I p + G + NX AD = 1800 + 0.6(Y − 1500) + 900 + 1600 + 100 AD = 3500 + 0.6 Y Now use the condition Y = AD to find short-run equilibrium output:

Y = AD Y = 3500 + 0.6Y 0.4Y = 3500 Y = 8750 b. We can use the same approach to find the effect of a decrease in tax collections:

AD = 1800 + 0.6(Y − 1400) + 900 + 1500 + 100 AD = 3460 +0.6 Y Now use the condition Y = AD :

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ECON1002 Introductory Macroeconomics, S2 2016

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Y = 3460 + 0.6Y 0.4Y = 3460 Y = 8650 c. Finally, for a decrease in planned investment spending:

AD = 1800 + 0.6(Y − 1500) + 800 + 1500 + 100 AD = 3300 + 0.6 Y Now use the condition Y = AD :

Y = 3300 + 0.6Y 0.4Y = 3300 Y = 8250 In part a, an increase in autonomous aggregate demand of 100 led to an increase in short-run equilibrium output of 250. In part b, an increase in autonomous aggregate demand of 60 (equal to the MPC, 0.6, times the decrease in taxes, 100), led to an increase in output of 150. Finally in part c, a decrease in autonomous aggregate demand of 100 led to a decrease in output of 250. All three examples demonstrate that the multiplier, equal to the change in output per 1-unit change in autonomous aggregate demand, is 2.5 for this economy. We can verify this 1 . In this economy, c = 0.6 , so the also by the formula for the multiplier, 1− c 1 1 multiplier is = = 2.5 1 − 0.6 0.4

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