1. GT01003
Macroeconomics

4. Learning Objectives
1. Identify the key assumptions of the basic Keynesian
model
2. Explain how to develop a model of Planned Aggregate
Expenditure (PAE)
3. Analyze how an economy reaches short-run
equilibrium in the basic Keynesian model
 Do the analysis with both numbers and graphs

5. Learning Objectives
4. Show how a change in planned aggregate expenditure
can cause a change in the short-run equilibrium
output
 Explain how this is related to the income-expenditure
model
5. Explain why the basic Keynesian model suggests that
fiscal policy is useful

6. John Maynard Keynes (1883 –
1946)
 The idea that a decline in aggregate
spending may cause output to fall
below potential output was one of the
key insights of John Maynard Keynes.
 The goal of this lecture is to present a
theory/model of how recession and
expansion may arise from
fluctuations in planned aggregate
expenditure or total planned
spending.

7. Keynesian Model
 Building block for current theories of short-run economic
fluctuations and stabilization policies
 In the short run, firms meet demand at preset prices
 Firms typically set a price and meet the demand at that price
in the short run
 Menu price is the cost of changing prices
 Determining the new price
 Incorporating prices into the business
 Informing consumers of new prices
 Firms change prices when the marginal benefits exceed the
marginal costs
Key
Assumption

8. Keynesian Model
Will new technologies make the Keynesian theory less
relevant to the real world??
 Technology has reduced menu costs
 Bar codes and scanners reduce costs of changing prices in the store
 Online surveys
 Highly segmented airline pricing
 Internet mechanisms for setting price
 eBay ■ Priceline
 Other costs remain
 Competitive analysis ■ Deciding the new prices
 Informing consumers

9. New Technologies

10. New Technologies

11. New Technologies

12. Planned Aggregate Expenditure (PAE)
 Planned aggregate expenditure is planned spending on
final goods and services
 Four components of planned aggregate expenditure
 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) is exports minus imports

13. Planned Aggregate Expenditure (PAE)
 Actual spending equals planned spending for
 Consumption
 Government purchases of final goods and services
 Net exports
 Adjustments between actual and planned spending
are accomplished with changes in inventories
 The general equation for planned aggregate
expenditures is
PAE = C + IP + G + NX

14. Develop a Model of PAE:
Consumption Expenditures
 Consumption (C) accounts for two-thirds of total
spending
 Powerful determinant of planned aggregate spending
 Includes purchases of goods, services, and consumer
durables, but not houses
 Rent is considered a service
 C depends on disposable income, (Y – T)

15. Consumption, 1960 - 2007

16. Develop a Model of PAE:
Consumption Function
 The consumption function is an equation relating
planned consumption to its determinants, notably
disposable income (Y – T)
C = C + (mpc) (Y – T)
where C is autonomous consumption spending
mpc is the change in consumption for a given
change in (Y – T)
 Autonomous consumption is spending not related to the
level of disposable income
 A change in C shifts the consumption function

17. Develop a Model of PAE:
Consumption Function
C = C + (mpc) (Y – T)
 The wealth effect is the tendency of changes in asset
prices to affect household's wealth and this
consumption spending
 This effect is included in C
 C also captures the effects of interest rates on
consumption
 Higher rates increase the cost of using credit to purchase
consumer durables and other items

18. Develop a Model of PAE:
Consumption Function
C = C + (mpc) (Y – T)
 Marginal propensity to consume (mpc) is the
increase in consumption spending when disposable
income increases by $1
 mpc is between 0 and 1 for the economy
 If households receive an extra $1 in income, they spend
part (mpc) and save part
 (Y – T) is disposable income
 Output plus government transfers minus taxes
 Main determinant of consumption spending

19. Develop a Model of PAE:
Consumption Function
Disposable income (Y – T)
Consumptionspending(C)
C
C = C + (mpc) (Y – T)
Δ (Y – T)
Δ C
C
Intercept
Slope = Δ C / Δ (Y – T)
slope

20. Planned Aggregate Expenditure
(PAE)
 Two dynamic patterns in the economy
1. Declines in production lead to reduced spending
2. Reductions in spending lead to declines in production
and income
 Consumption is the largest component of PAE
 Consumption depends on output, Y
 PAE depends on Y

21. Planned Spending Example
PAE = C + IP + G + NX
C = C + mpc (Y – T)
PAE = C + mpc (Y – T) + IP + G + NX
 Suppose that planned spending components have the
following values
PAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20
PAE = 960 + 0.8 Y
C = 620 mpc = 0.8 T = 250
IP = 220 G = 330 NX = 20

22. Planned Spending Example
C = 620 + 0.8 (Y – 250)
PAE = 960 + 0.8 Y
 If Y increases by $1, C will increase by $0.80
 PAE increases by 80 cents
 Planned aggregate expenditure has two parts
 Autonomous expenditure, the part of spending that
is independent of output
 $960 in our example
 Induced expenditure, the part of spending that
depends on output (Y)
 0.8 Y in our example

23. Planned Expenditure Graph
Output (Y)
Plannedaggregateexpenditure(PAE)
960
PAE = 960 + 0.8Y
Slope = 0.8
4,800

25. Short-Run Equilibrium
 Short-run equilibrium is the level of output at which
planned spending is equal to output
 No change in output as long as prices are constant
 Our equilibrium condition can be written
Y = PAE
 Using our previous example, PAE = 960 + 0.8 Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800

26. Short-Run Equilibrium Search
Output (Y) PAE = 960 + 0.8 Y Y – PAE Y = PAE?
4,000 4,160 –160 No
4,200 4,320 –120 No
4,400 4,480 –80 No
4,600 4,640 –40 No
4,800 4,800 0 Yes
5,000 4,960 40 No
5,200 5,120 80 No
 Only when Y = 4,800 does planned spending equal
output

27. Short-Run Equilibrium Graph
Output (Y)
Plannedaggregateexpenditure(PAE)
960
PAE = 960 + 0.8Y
45o
Y = PAE
4,800
Slope = 0.8

28. Output Greater than Equilibrium
 Suppose output reaches
5,000
 Planned spending is
less than total output
 Unplanned inventory
increases
 Businesses slow down
production
 Output goes down
PAE
Output (Y)
96
0
PAE = 960 +
0.8Y
45o
Y = PAE
4,800 5,000

29. Output Less than Equilibrium
 Suppose output is only
4,500
 Planned spending is
more than total
output
 Unplanned inventory
decreases
 Businesses speed up
production
 Output goes up
PAE
Output (Y)
96
0
PAE = 960 +
0.8Y
Y = PAE
4,8004,700

31. Planned Spending and
the Output Gap
Output Y
Plannedaggregateexpenditure
(PAE)
960
E
PAE = 960 + 0.8Y
45o
Y = PAE
4,800
Y*
Recessionary gap
PAE = 950 + 0.8Y
950
F
4,750

32. Planned Spending and
the Output Gap
 Autonomous consumption, C, decreases by 10
 Causes a downward shift in the planned aggregate
expenditures curve
 The economy eventually adjusts to a new lower level of
equilibrium spending an output, $4,750
 Suppose that the original equilibrium
level, $4,800, represented potential output, Y*
 A recessionary gap develops
 Size of the recessionary gap is 4,800 – 4,750 = $50
 Entire decrease is in Consumption spending
 Same process applies to a decrease in IP, G, or NX
–

33. Planned Spending and
the Output Gap
 Japanese recession in 1990s reduced Japanese imports
 East Asian economies developed by promoting
exports
 The decrease in exports to Japan decreased planned
aggregate expenditures in these countries
 The decrease in planned spending caused the economies
to contract to a new, lower level of planned spending and
output
 Japan exported its recession to its neighbors
 US recessions have similar effects on its major trading
partners

34. Planned Spending and
the Output Gap: US Recession 2001
 Robust investment spending, 1995 – 2000
 High growth economy
 New technologies: internet, fiber optics, genetic
engineering
 Not as promising as anticipated
 Recession caused by a decline in autonomous
spending
 Less investment in 2001
 Terrorist attack 9/11
 Travel spending decreased
 Recovery began 2002

35. Income-Expenditure Multiplier
 The income – expenditure multiplier shows the effect
of a one-unit increase in autonomous expenditure on
short-run equilibrium output
 Previous example
 Initial planned expenditure = 960 + 0.8 Y
 New planned expenditure = 950 + 0.8 Y
 Equilibrium changed from $4,800 to $4,750
 A $10 change in autonomous expenditures caused a $50
change in output
 Multiplier = 5
 The larger mpc, the greater the multiplier

37. Stabilization Policy
 Stabilization policies are government actions to
affect planned spending with the intention of
eliminating output gaps
 Expansionary policies increase planned spending
 Contractionary policies decrease planned spending
 Two major stabilization tools are fiscal policy and
monetary policy
 Fiscal policy uses changes in government
spending, transfers, or taxes
 Monetary policy uses changes in the money supply

38. Fiscal Policy and Recessions
 Government spending is part of planned spending
 Changes in government spending will directly affect planned
aggregate expenditures
 Suppose planned spending decreases $ 10 from
Y = 960 + 0.8 Y to
Y = 950 + 0.8 Y
 Equilibrium Y decreases from $4,800 to $4,750
 Recessionary gap is $50
 Stabilization policy indicates a $10 increase in government
spending will restore the economy to Y* at $4,800

39. How can the Government eliminate
an Output Gap?
Output Y
Plannedaggregateexpenditure
(PAE)
960
PAE = 960 + 0.8Y
45o
Y = PAE
F
PAE = 950 + 0.8Y
95
0
4,750
E
4,800
Y*

40. Example: Japanese Spending
 In the 1990s Japan spent over $1 trillion on public
works
 Highways, subways, and transportation projects
 Concert halls
 Re-laying cobblestone sidewalks

41. Taxes and Transfers
 Planned aggregate expenditures are affected by taxes
and transfers
 The effect is indirect, channeled through the effects on
disposable income
 Lower taxes or higher transfers increase disposable
income
 Increases in disposable income lead to higher C

42. Fiscal Policy as a Stabilization Tool:
Three Qualifications
 The use of fiscal policy to stabilize the economy is
more complicated than suggested by the basic
Keynesian model.
 Three qualifications must be made to the use of fiscal
policy as a stabilization tool.
1. Fiscal policy may affect potential output as well as
potential spending
2. Large and persistent government budget deficits
reduce national saving and growth
3. The relative inflexibility of fiscal policy

43. Spending and Output in the Short
Run
Short-Run Spending and Output
Planned
Aggregate
Expenditures
(PAE)
Consumption
Function
Short-Run
Equilibrium
Changes in
Equilibrium
Output Gaps
Multiplier
Fiscal Policy
Limitations
Keynesian Model