Keynesian model of Business Cycles, Spending and Output in the

Short Run and Policy

BSE2701

Daolu Cai

NUS Business School

September 14, 2023

Outline

Frank-et-Bernanke 8e, Chapter 13

Keynesian Model

Fiscal Stimulus

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Learning Objectives

At the end of this lecture, you will be able to:

• Discuss the determinants of planned investment and aggregate consumption spending and
how these concepts are used to develop a model of planned aggregate expenditure.
• 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.
• Discuss the qualifications that arise in applying fiscal policy in real-world situations.

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 Keynesian Model

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Great Depression

1 Great Depression 1929–1941 The longest and deepest downturn in the history of the
United States
• Available resources are unemployed
• Public’s willingness or ability to spend declines
2 Monetarist View (Friedman)
• poor monetary policy by the U.S. central bank, the Federal Reserve, was the primary cause
• A Monetary History of the United States, 1867–1960, with Anna J. Schwartz,
3 Keynesian View (Keynes)
• Aggregate spending is too low for full employment
• Stabilization policies use government spending or taxes to substitute for spending in other
sectors.
• The General Theory of Employment, Interest, and Money (1936) is his best-known work

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Keynesian Model

1 Stick prices: Firms typically set a price and meet the demand at that price in the short
run → inability to use the price mechanism to clear insufficient demand. (Infrequent
changes in prices)
• Menu costs: are the costs of changing prices, determining the new price, and informing
consumers of new prices.
2 Companies change prices when the marginal benefits exceed the marginal costs.
3 Technology has reduced menu costs.
• Technology has reduced menu costs.

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Planned Aggregate Expenditure
1 Planned aggregate expenditure (PAE) : is total planned spending on final goods and
services.
• 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.
2 Example of Planned Investment
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.
3 If actual sales are only $4.6 million.
• Unplanned inventory investment of $0.2 million.
• Actual investment is $1.4 million.
4 If actual sales are $5.0 million.
• Unplanned inventory decrease of $0.2 million.
• Actual investment is $1.0 million.

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Planned Aggregate Expenditure (PAE)
1 Actual spending equals planned spending for
• Consumption.
• Government purchases of final goods and services.
• Net exports.
2 Adjustments between actual and planned spending are accomplished with changes in
inventories.
3 The general equation for planned aggregate expenditures is.

PAE = Y P = C + I P + G + NX (1)

4 Recall changes in inventories are considered as investment in national accounting.

5 Consumption (C) accounts for two-thirds of total spending. → Powerful determinant of
planned aggregate expenditure.
• Includes purchases of goods, services, and consumer durables
• C depends on disposable income the after-tax amount of income that people are able to
spend, (Y − T )

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The Keynesian Consumption Function

The consumption function is an equation

C
45◦ line
relating planned consumption (C) to its de-
terminants, notably disposable income (Y −
T ).
1 C̄ is autonomous consumption
C = C̄ + (mpc)(Y − T )
spending (spending not related to the
C2 level of disposable income.)
2 Marginal propensity to consume
C1
(mpc) is the change in consumption
for a given change in disposable
income - is the increase in
consumption spending when
disposable income increases by $1
Y
0 Y1 Y2 3 mpc is between 0 and 1 for the
economy.

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Planned Expenditure
1 Two dynamic patterns in the economy.
• Declines in production lead to reduced spending.
• Reductions in spending lead to declines in production and income.
2 We have PAE:

PAE = Y P = C + I P + G + NX (2)
C = C̄ + mpc(Y − T ) (3)
P P
y = C̄ + mpc(Y − T ) + I + G + NX (4)
3 Suppose that planned spending components have the following values :
C̄ = 620, , mpc = 0.8, T = 250, I P = 220, G = 300, NX = 20 then:

y P = C̄ + mpc(Y − T ) + I P + G + NX (5)
= 620 + 0.8(Y − 250) + 220 + 300 + 20 (6)
= 960 + 0.8Y (7)
4 If Y increases by $1, C will increase by $0.80, PAE (Y P ) increases by 80 cents.
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Short-Run Equilibrium

PAE Y P Short-run equilibrium is the level of output

45◦ line(Y = Y P )
at which planned spending is equal to out-
put.
1 No change in output as long as prices
Y P = 960 + 0.8Y
are constant.
2 Our equilibrium condition can be
written: Y P = Y
YP
3

PAE = Y P = 960 + 0.8Y (8)

Y = 960 + 0.8Y (9)
Y Y = 4800 (10)
0 Y = 4800

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A Fall in Planned Spending Leads to a Recession

PAE Y P
Suppose, C̄ , decreases by 10.
45◦ line(Y = Y P )
1 Causes a downward shift in the
planned aggregate expenditure curve.
2 The economy eventually adjusts to a
Y P = 960 + 0.8Y ↓ new lower level of equilibrium
Y P = 950 + 0.8Y spending and output, $4,750.
3 A recessionary gap develops. Size of
Y P the recessionary gap

4, 800 − 4, 750 = 50 (11)

4 Same process applies to a decrease in

Y other components of aggregate
0 Y = 4750 Y = 4800
expenditure

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Income-Expenditure Multiplier

PAE Y P Suppose, C̄ , decreases by 10.

45◦ line(Y = Y P )
1

4, 800 − 4, 750 = 50 (12)

P
Y = 960 + 0.8Y ↓ 2 The income-expenditure multiplier (or multiplier)
P shows the effect of a one-unit increase (decrease)
Y = 950 + 0.8Y
in autonomous expenditure on short-run
equilibrium output.
3 The 10-unit drop in C implied a 10 unit drop in
YP autonomous expenditure. →Equilibrium changed
from $4,800 to $4,750. → A $10 change in
autonomous expenditures caused a $50 change in
output.
4 Multiplier = 5, the larger the mpc, the greater the
multiplier
Y 5 In general, Multiplier = 1/(1-MPC).
0 Y = 4750 Y = 4800

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Stabilization Policy

1 Stabilization policies are government policies that are used to affect planned aggregate
expenditure, with the objective of eliminating output gaps.
2 Expansionary policies increase planned expenditure.
3 Contractionary policies decrease planned expenditure.
4 Fiscal policy uses changes in government spending, transfers, or taxes.
5 Monetary policy uses changes in the money supply.

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 Fiscal Stimulus

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Government Spending

PAE Y P
45◦ line(Y = Y P )

Government spending is part of planned

P
spending.
Y = 960 + 0.8Y
Y P
= 950 + 0.8Y ↑
1 Changes in government spending will
directly affect planned aggregate
expenditures.
YP
2 Stabilization policy indicates a $10
increase in government spending will
restore the economy to Y* at $4,800.

Y
0 Y = 4750 Y = 4800

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A few examples of Fiscal Stimulus

1 Fiscal Policy During the 2007 –2009 Recession: $600 billion government spending increase
and $288 billion in tax cuts.
2 Covid19

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Write Down a Few Takeaways from Today’s Lecture

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