Chapter 11

Spending and Output

in the Short Run

McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, All Rights Reserved

 Learning Objectives
1. Identify the key assumptions of the basic Keynesian
model
2. Discuss the determination of planned investment and
planned aggregate expenditure
3. Analyze how an economy reaches short-run
equilibrium in the basic Keynesian model
4. Show how a change in planned aggregate expenditure
can cause a change in the short-run equilibrium output

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 Keynesian Model
Key assumption:
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

Eventually, firms change prices when the marginal

benefits exceed the marginal costs
Basic Keynesian model developed here ignores
this fact.

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 Planned Aggregate Expenditure
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

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 Planned Investment Example
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
Planned investment is $1.2 million
If actual sales are only $4.6 million
Unplanned inventory investment of $0.2 million
Actual investment is $1.4 million
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)
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

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 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)

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 Consumption, 1960 - 2007

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 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

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 Consumption Function
C = C + (mpc) (Y T)
C captures wealth effect
The effect of changes in asset prices on
consumption spending

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

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 More 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 minus net taxes

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 Consumption Function
Consumption spending (C)
C = C + (mpc) (Y T)
C
Intercept slope

C
C
(Y T) Slope = C / (Y T)

Disposable income (Y T)

LO 23 - 2 11-12
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 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
C = 620 mpc = 0.8 T = 250
IP = 220 G = 330 NX = 20

PAE = 620 + 0.8 (Y 250) + 220 + 330 + 20

PAE = 960 + 0.8 Y

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 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
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 Planned Expenditure Graph
Planned aggregate expenditure (PAE)

PAE = 960 + 0.8Y

960
Slope = 0.8

4,800

Output (Y)

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 Short-Run Equilibrium
Short-run equilibrium is the level of output at which
planned spending is equal to output

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

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 Short-Run Equilibrium Graph
Planned aggregate expenditure (PAE)
Y = PAE

PAE = 960 + 0.8Y

Slope = 0.8

960

45o
4,800

Output (Y)

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 Output Greater than Equilibrium

Suppose output
reaches 5,000
Y = PAE
Planned spending is
less than total output
PAE = 960 +
Unplanned inventory 0.8Y

PAE
increases
Businesses slow 96
0
down production
45o
Output goes down 4,800 5,000
Output (Y)

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 Output Less than Equilibrium

Suppose output is only

4,500
Y = PAE
Planned spending is
more than total output
PAE = 960 +
Unplanned inventory 0.8Y

PAE
decreases
Businesses speed up 96
0
production
Output goes up 4,700 4,800
Output (Y)

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 Lower Equilibrium
Planned aggregate expenditure Y = PAE
PAE = 960 + 0.8Y

PAE = 950 + 0.8Y

E
(PAE)

F
960
950

45o Recessionary gap

4,750 4,800
Y* Output Y
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 New Equilibrium

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
LO 23 - 4 11-21
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 Japan's Recession and East Asia
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 our major trading
partners

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 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

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 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

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 Government Spending
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
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 $10 Fiscal Stimulus
Planned aggregate expenditure Y = PAE
PAE = 960 + 0.8Y

PAE = 950 + 0.8Y

E
(PAE)

F
960
950

45o
4,750 4,800
Y* Output Y
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 Japanese Spending
In the 1990s Japan spent over $1 trillion on public
works
Highways, subways, and transportation projects
Concert halls
Re-laying cobblestone sidewalks
Projects did not end the recession
Prevented larger decrease in income
Eroded consumer confidence because there was
little demand
Consumers reduced spending in anticipation of
higher taxes in the future
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 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

LO 23 - 5 11-28
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 Tax Cuts Stimulate An Example
Original planned spending PAE = 960 + 0.8 Y
Autonomous consumption, C, decreases by 10.
Recessionary gap is $50.
PAE = C + 0.8 (Y T) + IP + G + NX
Tax cut to close the gap must be bigger than $10
Increase disposable income to cause initial increase
in spending to be $10
Taxes will have to go down by $12.5

LO 23 - 5 11-29
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 Chapter 23
Appendix A

An Algebraic Solution
of the Basic Keynesian Model

McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, All Rights Reserved

 The Basic Keynesian Model
PAE = C + IP + G + NX

C = C + mpc (Y T)
The consumption function is defined by
C, autonomous consumption
mpc, the marginal propensity to consume, a number
between 0 and 1
IP, G, T and NX are given

I=I planned investment T=T net taxes

G=G government purchases NX = NX
net exports

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 Find Short-Run Equilibrium Output

PAE = C + mpc (Y T) + I + G + NX

PAE = C mpc T + I + G + NX + mpc Y
Equilibrium condition is PAE = Y

Y = C mpc T + I + G + NX + mpc Y

Y mpc Y = C mpc T + I + G + NX

(1 mpc) Y = C mpc T + I + G + NX

C mpc T + I + G + NX
Y=
(1 mpc)

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 Short-Run Equilibrium Example

C mpc T + I + G + NX
Y=
(1 mpc)

C = 620 I = 220

G = 300 NX = 20

T = 250 mpc = 0.8

620 0.8 (250) + 220 + 300 +20

Y=
(1 0.8)

Y = 960 / 0.2 = 4,800

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 Chapter 23
Appendix B

The Multiplier in
the Basic Keynesian Model

McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, All Rights Reserved

 The Income and Expenditure Multiplier
Suppose autonomous spending decreases $10 and
mpc is 0.8
First decrease in spending is $10
Leads to a decrease in output of $10
Second decrease in spending is $8
Third decrease is $6.40, etc.
Sum of the decreases in spending
10 + 8 + 6.4 + 5.12 +
= 10 [1 + 0.8 + (0.8)2 + (0.8)3]

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 Income and Expenditure Multiplier
To find the sum of the series, we need a relationship
when x is between 0 and 1
1
1+x+x +x +x +=
2 3 4 = multiplier
(1 x)
In our case, x = 0.8
10 [1 + 0.8 + (0.8)2 + (0.8)3]

1 1
= 10 = 10
(1 x) (1 0.8)

= 10 (1 / 0.2) = 10 (5) = 50
In this case, the multiplier is 5
LO 23 - 4 11-36
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