Short run spending and output

created: 2020-04-13 · modified: 2020-09-09

Keynesian Model

Keynesian model is building block for theories of short-run economic fluctuations and stabilization policies
Model assumes in the short run that firms meet the demand for their products at preset prices
- Firms don’t respond to every change in demand by changing prices
- Instead the set a price for some period of time and simply change the quantity to meet demand at that price
- This is because prices should be changed only if the benefit exceeds the cost of “changing the menu”
- Prices will change in the long run
New tech has reduced menu costs, but the cost of analyzing new prices is expensive and part of menu costs

Model hypothesizes that output at each point in time is determined by total amount that people wish to spend on final goods/services
This known as Planned Aggregate Expenditure (PAE)
- Consumer expenditure (C)
  - Household spending on durables, services, etc
- Planned investment expenditures ( $I^P$ $I^{P}$ )
  - Spending on new capital goods, new residential buildings, inventory increases
- Gov. expenditures (G)
  - Federal, state, local spending
- Expenditures on new exports ( $NX$ $N X$ )
  - Exports/imports
PAE formula $PAE = C + I^P + G + NX$
Actual expenditures $Y = C + I + G + NX$

In Keynesian model output is determined by PAE, but actual expenditures may not equal PAE
$I = I^P + \delta\text{Inv}$ , where $I$ is actual investment, $I^P$ planned investment, $\delta\text{Inv}$ is unintended change in inventories
If inventories larger than expected, $\delta\text{Inv} > 0$ $δ Inv > 0$
- Actual investment $>$ planned investment
- Actual expenditure $>$ PAE
If inventories smaller than expected, $\delta\text{Inv} < 0$ $δ Inv < 0$
- Actual investment $<$ planned investment
- Actual expenditure $<$ PAE

Consumption (C) accounts for two thirds of total spending
Primary determinant of $C$ is disposable income $Y-T$
Consumption function is relationship between consumption spending and its determinants, specifically disposable (after-tax) income
Given by $C = \bar{C} + c(Y-T)$ $C = \overset{ˉ}{C} + c (Y - T)$
- $T$ is net taxes
- $c$ is marginal propensity to consume (MPC)
- $\bar{C}$ is constant, autonomous part of consumption that doesn’t depend on disposable income

With the consumption function, the PAE has the form $\text{PAE} = \bar{C} + \text{mpc}(Y-T) +I^P + G + NX$

Achieved when output (actual expenditure) equals planned spending $Y=PAE$ $Y = P A E$
- For example, when output is less than planned spending (which includes both anticipated consumer spending and planned investment by the company), production is increased to match this expected spending
Level of output that prevails during time when prices are predetermined
All else equal, a decline/increase in autonomous spending causes short-run equilibrium output to fall/rise and creates a recessionary/expansionary gap
Decrease/increase in autonomous spending can be caused by reduction/increased in autonomous $C$ , $I^P$ , $G$ , or $NX$

Measures effect of one unit increase in autonomous expenditure on short-run equil. output
Change in equilibrium $Y$ is multiple of change in autonomous spending because of the linear relationship and slope determined by mpc
Multiplier given by $1/(1-MPC)$
Also known as govt. expenditure multiplier

Stabilization policies: govt. policies used to affect PAE with object of eliminating output gaps
- Expansionary policies: increase planned expenditure
- Contractionary policies: decrease planned expenditure
- Fiscal policies: changes in govt spending, transfers, or taxes
  - Govt expenditures: direct effect on PAE
  - Taxes and transfer payments: indirect effect on PAE
- Monetary policies: changes in money supply
  - Money supply or nominal interest rate