Week 21 - Chapter 25: Spending and Output

Question 1

The Keynesian Model

Answer 1

A macroeconomic theory that emphasizes the role of aggregate demand in determining the overall level of economic activity, especially in the short run.
States that in the short run, firms meet demand at pre-set prices - menu costs mean that firms set a price and meet the demand of this price in the short run.

Question 2

When will firms change prices

Answer 2

When marginal benefit of changing the prices exceed the marginal costs.

Question 3

How has technology reduced menu costs

Answer 3

Barcodes and scanners and internet mechanisms for price setting (e.g., eBay/Priceline) mean that changing prices is a lot easier and less costly.

Question 4

Planned aggregate expenditure (PAE)

Answer 4

Total planned spending on final goods and services.

Question 5

What is PAE made up of

Answer 5

• Consumption (C) by households
• Planned investment (I) – planned spending by domestic firms on new capital goods.
• Government purchases (G) – federal, state and local governments making purchases.
• Net exports (NX) – total of exports minus imports.

Question 6

PAE formula

Answer 6

PAE = C+I+G+NX

Question 7

What are the 2 parts of PAE

Answer 7

Autonomous expenditure: part of spending that is independent of output.
Induced expenditure: part of spending that depends on output.

Question 8

Importance of consumption in PAE

Answer 8

Makes up 2/3 of total spending meaning it is a powerful determinant of PAE.
Consumption depends on disposable income (after tax income people are able to spend: Y-T).

Question 9

Consumption function

Answer 9

C = C̄ + (mpc) (Y – T)
C̄: autonomous consumption
mpc: Marginal propensity to consume
Y: income
T: taxes
Graphically, C̄ is the intercept and mpc is the gradient.

Question 10

Autonomous consumption (C̄)

Answer 10

Spending not related to the level of disposable income (Y-T).

Question 11

Marginal propensity to consume (mpc)

Answer 11

The increase in consumption spending when disposable income increases by $1 e.g., if households receive an extra $1 in income, they spend part of it (mpc) and save the other part.
mpc is always between 0 and 1.

Question 12

Wealth effect

Answer 12

The tendency of changes in asset prices to affect household’s wealth and therefore their consumption spending.

Question 13

Dynamic patterns in the economy

Answer 13

1. Declines in production lead to reduced spending.
2. Reductions in spending leads to declines in production and income.

Question 14

Short run equilibrium

Answer 14

Short run equilibrium is where the level of output is equal to planned aggregate expenditure.
PAE = Y.

Question 15

Self correction back to equilibrium

Answer 15

• If output > equilibrium:
  − planned spending is less than output
  − unplanned inventory increases
  − business production slows down
  − output goes down
• If output < equilibrium
  − planned spending is more than output
  − unplanned inventory decreases
  − business production speeds up
  − output goes up

Question 16

How can a fall in spending lead to a recession

Answer 16

A fall in spending leads to a decrease in planned aggregate expenditure which then causes a larger decrease in equilibrium output than the original fall in spending which creates a recessionary gap as Y<Y*.

Question 17

Income-expenditure multiplier (IEM)

Answer 17

• The effect of a one-unit increase in autonomous expenditure on short-run equilibrium output.
• E.g., PAE going from 960+0.8Y to 950+0.8Y causes equilibrium output to decrease from $4,800 to $4,750. $10 change in autonomous consumption causes a $50 change in equilibrium output - multiplier = 5.
  The larger the mpc, the greater the multiplier.

Question 18

Income expenditure multiplier (IEM) formula

Answer 18

IEM = 1/ (1-mpc)