mba lecture 5

8/6/2019 MBA Lecture 5

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MB MC

Spending and

Output in theShort Run: Part 2

Lecture 4


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MBA Lecture 4 Slide 2

MB MC

Contents

1. Short-Run Equilibrium Output

(Keynesian Cross)

2. Income-Expenditure Multiplier

3. Stabilizing Planned Spending

4. Role of Fiscal Policy


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Short-run equilibrium

Keynesian Assumption

Producers meet demand at preset

prices in the short-run

Short-run equilibrium: Y = PAE


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Short-run equilibrium

Short-run Equilibrium OutputThe level of output at which output

(Y ) equals planned aggregate

expenditure (PAE)

Short-run equilibrium output is the

level of output that prevails during

the period in which prices arepredetermined


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Determination of Short-Run

Equilibrium Output (Keynesian Cross)

Output Y

Plann

ed

aggreg

ate

ex

penditure

PAE

960

Expenditure line

PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium PAEintersects the 45o line @ 4,800

Disequilibrium < 4,800, PAE > Y > 4,800, PAE < Y


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A Decline In Planned

Spending Leads To A Recession

Output Y

Plann

ed

aggreg

ate

ex

penditure

PAE

960

E

Expenditure line

PAE = 960 + 0.8Y

45o

Y = PAE

4,800

Y*

Recessionary gap

F

Expenditure line

PAE = 950 + 0.8Y

A decline in autonomous

aggregate expenditure (C)

shifts the expenditure line

down

950

4,750


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Planned Aggregate Expenditure

ObservationsOther factors remaining constant, a

decline in autonomous spending

causes short-run equilibrium output tofall and creates a recessionary gap.

A decrease in autonomous spending

can be caused by a reduction in C, IP

, G,and/orNX.


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ObservationsOther factors remaining constant, an

increase in autonomous spending causes

short-run equilibrium output to rise andcreates an expansionary gap.

An increase in autonomous spending can

be caused by an increase in C, IP

, G,and/orNX.


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Income-Expenditure Multiplier

The effect of a 1-unit increase in autonomous

expenditure on short-run equilibrium output,

or

Change in the equilibrium level of output for

one unit change in autonomous expenditure

For example, a multiplier of 5 means that a 10-

unit decrease in autonomous expenditure

reduces short-run equilibrium output by 50

units


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The Multiplier

Recall

PAE = 960 + 0.8Y, equilibrium Y = 4,800

C fell by 10PAE = 950 + 0.8Y, equilibrium Y = 4,750#

The Multiplier: 1/ (1 - MPC)


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The Multiplier Effect

The decrease in the equilibrium Ywas

5 times the fall in C.

The income-expenditure multiplierequaled 5.

The size of the multiplier is influenced

by the MPC.The Multiplier: 1/ (1 - MPC)


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Stabilizing Planned Spending

In the Keynesian Model:Recessionary and expansionary

gaps are caused by inadequate or

excessive spending, respectively.Stabilization policies are used to

affect planned aggregate

expenditures to eliminate outputgaps.


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Stabilization Policies

Government policies that are used

to affect planned aggregate

expenditure, with the objective of

eliminating output gaps


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Expansionary PoliciesGovernment policy actions intended to

increase planned spending and output

Contractionary PoliciesGovernment policy actions designed to

reduce planned spending and output


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Tools of Stabilization Policy

Fiscal policy

Monetary policy

S bili i Pl d S di


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MB MC Stabilizing Planned Spending:

The Role of Fiscal Policy

Tools of fiscal policyGovernment spending

Direct effect on PAE

Taxation

Indirect effect on PAE

Transfer payments

Indirect effect on PAE

St bili i Pl d S di


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Tools of fiscal policy

Government spending

We saw that 10 units decrease inautonomous spending resulted a 50

units decline in short-run equilibrium

output (multiplier effect).

St bili i Pl d S di


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Tools of fiscal policy

Government spending

Thus, to cover that 50 units fall in outputgovt. can increase its expenditure by tenunits (e.g., military expenditure).

Govt. expenditure is a part of autonomousexpenditure.Autonomous expenditure as well as output

then will return to its original level.


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An Increase In Government

Purchases Eliminates A Recessionary Gap

Planned

aggreg

ate

ex

penditure

PAE

960

Expenditure line

PAE = 960 + 0.8Y

E

An increase in Gshifts the

expenditure line upward

Output Y

Y = PAE

F

45o

4,800

Recessionary gap

Expenditure line

PAE = 950 + 0.8Y

950

4,750

Y*

St bili i Pl d S di


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Taxes, Transfers, and Aggregate

SpendingTaxes and transfers affect PAEindirectly

ExampleUsing a tax cut to close a recessionary

gap

Stabilizing Planned Spending:


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ExampleAssumeRecessionary gap = 50

MPC = 0.8, multiplier = 5Use a tax cut to eliminate the gapThe tax cut must increase PAEby 10For every dollar reduction in taxes,

consumption will increase by 80cents (MPC = 0.8)

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Example: Assume

Recessionary gap = 50

MPC = 0.8, multiplier = 5

Use a tax cut to eliminate the gap

Change in spending (10) = tax cut x MPC(0.8)

Tax cut = change in spending / MPC = 10/0.8= 12.5

A tax cut of 12.5 will raise PAEby 10 (12.5 x0.8) = 10

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The same results could be obtained byincreasing transfer payments by 12.5

units.80% of 12.5 ( = 10) will be consumed.Consumption expenditure will increase

and, therefore, PAE will be increased by

10.

mba lecture 5

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