# Week 5

Lectures 9 & 10

Spending and Output in the Short-Run (continued) Reference: Bernanke, Olekalns and Frank - Chapter 5 Key Issues • 45-degree diagram • Equilibrium and disequilibrium • Injections and withdrawals • Multiplier

Review In Week 4 we developed a simple algebraic model of output. It consists of: An equilibrium condition: • output that equals planned aggregate expenditure A definition of PAE:
PAE = C + I P + G + NX

Y = PAE

An economic model for consumption:
C = C + c(Y − T )
2

Two Sector Model Assumptions (simplifying): • no government sector • no foreign sector (i.e. a closed economy) Planned aggregate expenditure
PAE = C + I P

Consumption function (no taxes, so consumption depends on total, not disposable income)
C = C + cY

Planned investment is exogenous

3

A Diagram Showing Consumption and Investment C, I
C = C + cY

IP

Y

4

Planned Aggregate Expenditure PAE = C + I P = C + I P + cY PAE = C + I P C. I. PAE C = C + cY IP Y 5 .

45-Degree Diagram How can we represent equilibrium diagrammatically? Equilibrium is where PAE 20 10 10 20 Y 6 Y = PAE .

Y = PAE for all points on the 45-degree line Y = PAE PAE PAE1 450 Y1 Y 7 .

Equilibrium GDP in the 2-Sector Model 45-degree line PAE PAE C IP Ye Y 8 .

Equilibrium GDP in the 2-Sector Model: The Algebra Equilibrium Condition Definition of PAE Consumption Function (Substitution) (Collect terms in Y) Equilibrium GDP Y = PAE PAE = C + I P C = C + cY Y = C + cY + I P Y (1 − c) = C + I P Ye = 1 [C + I P ] 1− c 9 .

Y = PAE Y =C+IP Now subtract C from both sides Y −C = I P or S = IP S = Withdrawals (WD): Part of income not consumed IP= Injections ( INJ P ): All exogenous spending 10 .Injections and Withdrawals There is an alternative way to look at the equilibrium condition for GDP.

Short-Run Equilibrium Condition INJ P = WD Planned Injections equals Withdrawals Saving Function Y −C = I P C = C + cY Y − C − cY = I P − C + (1 − c)Y = I P so S = IP S = −C + (1 − c)Y 11 .

Injections and Withdrawals Diagram INJ P = WD IP = S I P = −C + (1 − c)Y I P.S S = −C + (1 − c)Y IP Ye Y 12 .

i.e. What happens if these conditions are not met? 13 .Equilibrium We have two equivalent equilibrium conditions for the level of GDP: • Y = PAE • INJ P = WD If these conditions hold there will be no tendency for GDP to change. Y = Y e .

14 .Disequilibrium Suppose that the level of GDP is such that either: • PAE > Y and or • PAE < Y and INJ P < WD INJ P > WD In either case there will be a tendency for the level of GDP to change.

PAE > Y 45-degree line PAE PAE PAE0 Y0 Y Planned Expenditure exceeds Aggregate Production 15 .

Adjustment to Equilibrium Firms will experience an unplanned decline in their inventories To re-build their inventories firms will increase their level of production This will cause GDP to increase and it will move towards its equilibrium value. where PAE cuts the 45-degree line GDP will increase until PAE=Y. 16 .

45-degree line PAE PAE PAE0 Y0 Ye Y 17 .

S S = −C + (1 − c)Y IP Ye Y1 Y Withdrawals (saving) exceed Planned Injections (investment) 18 .INJ P < WD I P.

where INJ P = WD 19 .Adjustment to Equilibrium Firms will experience an unplanned increase in their inventories To reduce their inventories firms will revise downward their production plans This will cause GDP to fall and it will move towards its equilibrium value.

Paradox of Thrift Suppose there is an exogenous increase in agents’ desire to save This can be represented by an upward shift in the saving function S′ S S Y 20 .

I S IP Ye Y 21 .Initial Equilibrium S.

I S new S IP e Ynew Ye Y Prediction: The level of GDP will fall 22 .Prediction: The aggregate amount of saving is unchanged S.

8) = 250 1 1 250 = Ye = 250 = 5 × 250 = 1250 (1 − 0.Numerical Example for 2-Sector Model Equilibrium Condition Definition of PAE Consumption Function Some Numbers Find Ye? PAE = 50 + 200 + 0.2 23 .8Y Y = PAE PAE = C + I P C = C + cY I P = 200 C = 50 + 0.8Y Y = 250 + 0.8) 0.8Y = 250 + 0.8Y Y (1 − 0.

250 Y 24 .45-degree line PAE Y = 250 + 0.8Y 1.

Four Sector Model Re-introduce • government sector G • foreign sector NX PAE = C + I P + G + NX 1. Consumption Function: C = C + c(Y − T ) • Consumption depends on disposable income 25 .

Import Function: • Imports are proportional to disposable income • We can define to import ∆M =m ∆(Y − T ) as the marginal propensity 26 .New Functions T = T + tY 2. M = m(Y − T ) 3. Tax Function: • There is an exogenous component to taxes part that is proportional to income tY ∆T =t ∆Y T and a • We can define as the marginal tax rate (how much tax is paid on an additional dollar of income).

Some Simplifications C = C + c(Y − T ) T = T + tY M = m(Y − T ) Consumption C = C + c(Y − T − tY ) = C − cT + c(1 − t )Y Imports M = m(Y − T ) = m(Y − T − tY ) = −mT + m(1 − t )Y NB. BOF (page 149) write the import function as: M = m(1 − t )Y 27 .

Equation for PAE PAE = C + I P + G + NX C = C − cT + c(1 − t )Y M = −mT + m(1 − t )Y NX = X − M Substitute PAE = C − cT + c(1 − t )Y + I P + G + X + mT − m(1 − t )Y Collect the exogenous variables PAE = [C − cT + I P + G + X + mT ] − m(1 − t )Y + c(1 − t )Y PAE = [C − cT + I P + G + X + mT ] + (c − m)(1 − t )Y 28 .

Short-run Equilibrium Equilibrium condition Y = PAE Y = [C − cT + I P + G + X + mT ] + (c − m)(1 − t )Y Solve for equilibrium GDP Y (1 − [(c − m)(1 − t )]) = [C − cT + I P + G + X + mT ] Ye = 1 [C − cT + I P + G + X + mT ] (1 − [(c − m)(1 − t )]) 29 .

Equilibrium in Four Sector Model PAE 45-degree line PAE = C + I P + G + NX Ye Y 30 .

we can re-write the condition for equilibrium in terms of injections and withdrawals. Now or Y − T − C = I P + G + NX − T S = Y − T − C and NX = X − M S = I P + G + X − M −T S +T + M = I P +G + X Withdrawals = (planned) Injections 31 . Y = PAE PAE = C + I P + G + NX Y = C + I P + G + NX Subtract T and C from both sides.Injections and Withdrawals Not surprisingly.

Withdrawals and Injections Diagram INJ P .WD S +T + M IP +G+ X Ye Y 32 .

T . X • A change in one of the parameters: c. m. t 33 . G.How Does the Keynesian Model Explain Fluctuations in GDP? 1 Y = [C − cT + I P + G + X + mT ] (1 − [(c − m)(1 − t )]) e 2 possibilities • A change in one of the exogenous variables: C . I P .

Example: Increase in PAE IP 45 degree line PAE1 PAE0 Y0e Y1e Y 34 .

35 .PAE and the Output Gap Output gap = Actual output less Potential output Output gap = Y − Y * We can use our model to understand contractionary (negative) and expansionary (positive) output gaps We will focus on a contractionary output gap since it is relevant to current economic circumstances. We need to indicate potential output in our model.

Level of PAE is Consistent with GDP equal to Potential Output PAE PAE0 Y* Y 36 .

Decline in Planned Spending leads to Contractionary Gap PAE PAE0 PAE1 Y1e Y* Y e * Contractionary gap = Y1 − Y < 0 37 .

Investment and the 1990s Recession (Feb 90-Oct 91) 33000 31000 160000 158000 156000 154000 152000 150000 148000 146000 144000 142000 140000 Mar-1988 Jun-1988 Sep-1988 Dec-1988 Mar-1989 Jun-1989 Sep-1989 Dec-1989 Mar-1990 Jun-1990 Sep-1990 Dec-1990 Mar-1991 Jun-1991 Sep-1991 Dec-1991 Mar-1992 Jun-1992 Sep-1992 Dec-1992 Mar-1993 Investment (\$ mill) 29000 27000 25000 23000 21000 19000 17000 15000 Investment GDP GDP (\$ mill) 38 .

The Multiplier In the following diagram compare the relative sizes of the change in Y caused by the change in PAE. PAE PAE1 PAE0 ∆PAE ∆Y Y0e Y1e Y 39 .

The Multiplier An additional dollar of exogenous PAE generates more that a dollar’s worth of GDP How much more? 2-Sector Model Equilibrium GDP ∆Y e 1 = >1 ∆C 1 − c Ye = 1 [C + I P ] 1− c or ∆Y e 1 = >1 P ∆I 1− c since 0 < c <1 40 .

G.Size of the Multiplier Suppose MPC = 0.75 0. I . X P Multiplier = 41 .75 Multiplier = 4-Sector Model Ye = 1 [C − cT + I P + G + X + mT ] (1 − [(c − m)(1 − t )]) 1 (1 − [(c − m)(1 − t )]) 1 1 1 = = =4 1 − c 1 − 0.25 C .

.Economics of the Multiplier 2-Sector Model PAE = [C + I P ] + cY Y = PAE Increase exogenous PAE by 100 Rounds 3 c × (c ×100) ∆PAE ∆Y 1 100 100 2 c ×100 c ×100 4 c(c × c ×100) ………. c × (c ×100) c(c × c ×100) Initial increase in GDP of 100 is paid out as income 42 .

] or 1 100[ ] 1− c 43 ............. c(c × c ×100) 100 + c ×100 + c 2 ×100 + c 3 ×100 + .... or 100[1 + c + c 2 + c 3 + .What is the Total Effect on GDP? Rounds 1 2 3 c ×100 c × (c ×100) ∆PAE 100 c ×100 c × (c ×100) ∆Y 100 Total Increase in GDP 4 c(c × c ×100) ………...

......) S − cS = 1 1 S= 1− c Done 44 ..... Subtract cS from S S − cS = 1 + c + c 2 + c 3 + .....Does Let [1 + c + c + c + ... − (c + c 2 + c 3 + ...... Multiply both sides by c cS = c1 + cc + cc 2 + cc 3 + ........] Really 2 3 Equal 1 1− c ? S = 1 + c + c 2 + c 3 + .. or cS = c + c 2 + c 3 + c 4 + ................

We have a model that can explain short-run fluctuations in GDP. 45 .Recap We have a model that can determine the level of GDP (in the short-run). Finally we now have a framework for thinking about macroeconomic policy. Well Done.