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 )
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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

A Diagram Showing Consumption and Investment C, I

C = C + cY

IP

Planned Aggregate Expenditure

PAE = C + I P = C + I P + cY PAE = C + I P

C, I, PAE
C = C + cY

IP

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

Y = PAE

for all points on the 45-degree line

Y = PAE

PAE
PAE1

450

Y1

Equilibrium GDP in the 2-Sector Model 45-degree line PAE PAE

C

IP
Ye

Y
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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

Injections and Withdrawals There is an alternative way to look at the equilibrium condition for GDP.
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

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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

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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

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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, i.e. Y = Y e . What happens if these conditions are not met?

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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.

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PAE > Y 45-degree line PAE PAE

PAE0

Y0

Planned Expenditure exceeds Aggregate Production

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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.

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45-degree line PAE PAE

PAE0

Y0

Ye

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INJ P < WD

I P,S
S = C + (1 c)Y

IP Ye

Y1

Withdrawals (saving) exceed Planned Injections (investment)

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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, where INJ P = WD

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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

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Initial Equilibrium S,I

S

IP Ye

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Prediction: The aggregate amount of saving is unchanged S,I

S new
S

IP
e Ynew

Ye

Prediction: The level of GDP will fall

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Numerical Example for 2-Sector Model Equilibrium Condition Definition of PAE Consumption Function Some Numbers Find
Ye?
PAE = 50 + 200 + 0.8Y = 250 + 0.8Y

Y = PAE PAE = C + I P

C = C + cY
I P = 200

C = 50 + 0.8Y

Y = 250 + 0.8Y Y (1 0.8) = 250 1 1 250 = Ye = 250 = 5 250 = 1250 (1 0.8) 0.2

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45-degree line PAE

Y = 250 + 0.8Y

1,250

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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

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New Functions T = T + tY 2. Tax Function: There is an exogenous component to taxes part that is proportional to income tY
T =t Y

and a

We can define as the marginal tax rate (how much tax is paid on an additional dollar of income).
M = m(Y T ) 3. Import Function: Imports are proportional to disposable income

We can define to import

M =m (Y T )

as the marginal propensity

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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

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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

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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 )])

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Equilibrium in Four Sector Model PAE 45-degree line

PAE = C + I P + G + NX

Ye

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Injections and Withdrawals Not surprisingly, we can re-write the condition for equilibrium in terms of injections and withdrawals.
Y = PAE
PAE = C + I P + G + NX Y = C + I P + G + NX

Subtract T and C from both sides; 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

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Withdrawals and Injections Diagram

INJ P ,WD
S +T + M

IP +G+ X

Ye

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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 , T , I P , G, X

A change in one of the parameters: c, m, t

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Example: Increase in PAE

IP

45 degree line
PAE1

PAE0

Y0e

Y1e

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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.

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Level of PAE is Consistent with GDP equal to Potential Output PAE

PAE0

Y*

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Decline in Planned Spending leads to Contractionary Gap PAE

PAE0

PAE1

Y1e

Y*

e * Contractionary gap = Y1 Y < 0

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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)

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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

Y0e

Y1e

Y
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The Multiplier An additional dollar of exogenous PAE generates more that a dollars 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

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Size of the Multiplier Suppose MPC = 0.75 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 0.75 0.25

C , I , G, X

Multiplier =

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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

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

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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)

..

c(c c 100)

100 + c 100 + c 2 100 + c 3 100 + .........

or
100[1 + c + c 2 + c 3 + .........]

or
1 100[ ] 1 c

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Does Let

[1 + c + c + c + .........] Really
2 3

Equal

1 1 c ?

S = 1 + c + c 2 + c 3 + .........

Multiply both sides by c

cS = c1 + cc + cc 2 + cc 3 + .........

or
cS = c + c 2 + c 3 + c 4 + .........

Subtract cS from S
S cS = 1 + c + c 2 + c 3 + ......... (c + c 2 + c 3 + .....)
S cS = 1 1 S= 1 c

Done

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

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