Economics 2 Professor Christina Romer Spring 2016 Professor David - - PDF document

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Economics 2 Professor Christina Romer Spring 2016 Professor David Romer LECTURE 21 PLANNED AGGREGATE EXPENDITURE AND OUTPUT April 12, 2016 I. O VERVIEW OF S HORT -R UN F LUCTUATIONS II. T HE K EY R OLE OF D EMAND A. Evidence B. Source III. P

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Economics 2 Professor Christina Romer Spring 2016 Professor David Romer LECTURE 21 PLANNED AGGREGATE EXPENDITURE AND OUTPUT April 12, 2016 I. OVERVIEW OF SHORT-RUN FLUCTUATIONS

  • II. THE KEY ROLE OF DEMAND
  • A. Evidence
  • B. Source
  • III. PLANNED AGGREGATE EXPENDITURE (PAE)
  • A. Components
  • B. Short run versus long run
  • IV. DETERMINANTS OF EACH COMPONENT OF PAE
  • A. Planned investment (Ip)
  • B. Government spending (G) and net exports (NX)
  • C. Consumption (C)

V. DETERMINANTS OF SHORT-RUN OUTPUT

  • A. Equilibrium condition (Y=PAE)
  • B. Expenditure line (PAE)
  • C. Equilibrium and how the economy gets there
  • D. Short-run versus long-run equilibrium
  • VI. SHIFTS IN THE EXPENDITURE LINE
  • A. Crucial determinant of short-run fluctuations
  • B. Example: A decline in autonomous consumption
  • C. Multiplier effect
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LECTURE 21

Planned Aggregate Expenditure and Output

April 12, 2016

Economics 2 Christina Romer Spring 2016 David Romer

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SLIDE 3

Announcements

  • We have handed out Problem Set 5.
  • It is due at the start of lecture on Tuesday,

April 19th.

  • Problem set work session this Friday, April

15th, 4:30–6:30 p.m. in 648 Evans.

  • Research paper reading for next time.
  • Romer and Romer, “The Macroeconomic

Effects of Tax Changes.”

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SLIDE 4
  • I. OVERVIEW OF SHORT-RUN FLUCTUATIONS
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SLIDE 5

Real GDP in the U.S. since 1955

Source: Bureau of Economic Analysis

7.5 8.0 8.5 9.0 9.5 10.0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Real GDP (in logarithms)

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SLIDE 6

Short-Run Fluctuations

  • Times when output moves above or below

potential (booms and recessions).

  • Recessions are costly and very painful to the

people affected.

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SLIDE 7
  • II. THE KEY ROLE OF DEMAND
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Key Determinant of Output in the Short Run

  • In the short run, aggregate output is determined

by demand.

  • Three terms that mean the same thing:
  • Planned aggregate expenditure
  • Planned spending
  • Planned aggregate demand
  • All three terms refer to the total amount that

people in the economy plan to buy (or spend).

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SLIDE 9

Evidence on the Key Role of Demand

  • Historical experience
  • Academic research
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SLIDE 10

Why is output determined by demand in the short run?

  • Nominal rigidities (inflation doesn’t change

substantially in the short run).

  • Due to limited information, menu costs, long-term

contracts, or other factors.

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SLIDE 11
  • III. PLANNED AGGREGATE EXPENDITURE
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SLIDE 12

Components of Planned Aggregate Expenditure (PAE)

  • Consumption (C)
  • Planned investment (Ip)
  • Government purchases (G)
  • Net exports (NX)

PAE = C + Ip + G + NX

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SLIDE 13

Short Run versus Long Run

  • In the short run:
  • PAE can be anything.
  • Output responds to match PAE.
  • In the long run:
  • Output is at Y* (determined by normal

technology, capital, and employment).

  • PAE adjusts to equal Y*.
  • Movement in r brings this about.
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SLIDE 14
  • IV. DETERMINANTS OF EACH COMPONENT OF PAE
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SLIDE 15

Determinants of Planned Investment (Ip)

  • Real interest rate (r)
  • Expectations (“animal spirits”)
  • We talk about “planned investment” because we

are leaving out the unplanned investment in inventories that happens when PAE is different from actual output.

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SLIDE 16

Determinants of Government Purchases (G)

  • Politics
  • Wars, natural disasters
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SLIDE 17

Determinants of Net Exports (NX)

  • For now we are assuming they are just given.
  • Will discuss the economic determinants later in

the course.

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SLIDE 18

Determinants of Consumption (C)

  • Real interest rate (r)
  • Expectations (“consumer confidence”)
  • Wealth
  • Disposable income
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SLIDE 19

Consumption and Disposable Income

  • Aggregate income: Same as aggregate output (Y)
  • Aggregate tax payments: Same as government tax

revenues (T)

  • Aggregate disposable income: Y−T
  • Consumption function: C = f(Y−T)
  • Sometimes written in the particular form:

C = C + c·(Y−T)

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SLIDE 20

Consumption Function C = C + c·(Y−T)

slope = c Y−T C C C

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SLIDE 21

Consumption Function C = C + c·(Y−T)

  • Autonomous consumption: The part of

consumption that does not vary with income (C).

  • Marginal propensity to consume (MPC): The

change in planned consumption due to a change in disposable income (c).

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SLIDE 22

Consumption and Disposable Income

Source: Frank, Bernanke, Antonovics, and Heffretz, “Principles of Economics.”

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SLIDE 23
  • V. DETERMINATION OF SHORT-RUN OUTPUT
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SLIDE 24

45-degree Line

  • Captures the equilibrium condition that Y=PAE.
  • Also reflects the empirical/behavioral reality that
  • utput responds to planned spending in the short

run.

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SLIDE 25

45-degree Line

PAE Y Y=PAE 45°

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Expenditure Line

  • Captures the fact that planned aggregate spending

is a function of total income (which is the same as total output).

  • PAE = C + Ip + G + NX, where C = f(Y−T).
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Expenditure Line

Y C PAE = C + Ip + G + NX PAE

The slope of the expenditure line (PAE) is the MPC.

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SLIDE 28

Determination of Short-Run Output

  • Output in the short run is determined by the

intersection of the 45-degree line and the expenditure line.

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SLIDE 29

Determination of Short-Run Output

Y PAE PAE Y=PAE Y1

Sometimes called the “Keynesian Cross” diagram.

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SLIDE 30

How does the economy get to short-run equilibrium? Y PAE PAE Y=PAE Y1 Y3 Y2

At Y2, unintended inventory investment leads firms to cut production. At Y3, unintended negative inventory investment leads firms to increase production.

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SLIDE 31

Long-Run Equilibrium

Y PAE PAE Y=PAE Y*

In the long run, PAE=Y and PAE cross at Y* (potential output).

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SLIDE 32
  • VI. SHIFTS IN THE EXPENDITURE LINE
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Crucial Determinant of Short-Run Fluctuations: Shifts in the Expenditure Line

  • Expenditure line (PAE) shows how planned

spending varies with output.

  • Anything that changes planned spending other

than output, will shift the curve.

  • If the expenditure line shifts, short-run

equilibrium output will change.

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SLIDE 34

Example: A Fall in Autonomous Consumption

  • A fall in consumption not caused by a fall in
  • utput.
  • A decline in the intercept of the consumption

function (C).

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Great Crash of the Stock Market in October 1929

Source: Federal Reserve Bank of St. Louis, FRED.

50 100 150 200 250 300 350 400

Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20 Dec-21 Dec-22 Dec-23 Dec-24 Dec-25 Dec-26 Dec-27 Dec-28 Dec-29 Dec-30 Dec-31 Dec-32 Dec-33 Dec-34 Dec-35

Dow Jones Industrial Average (Index) September 1929

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SLIDE 36

Why might a fall in stock prices reduce consumer spending (at a given level of output)?

  • Reduction in wealth makes consumers feel poorer.
  • Fall in stock prices makes consumers pessimistic

(lowers consumer confidence).

  • Stock price volatility causes uncertainty and leads

to “wait and see” behavior.

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SLIDE 37

The Collapse of Consumer Spending in Late 1929

Source: Christina Romer, “The Great Crash and the Onset of the Great Depression.”

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SLIDE 38

A Fall in Autonomous Consumption

Y−T C C1 C1 C2 C2

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SLIDE 39

A Fall in Autonomous Consumption

Y PAE1 PAE Y=PAE Y* PAE2 Y2

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Real GDP, 1909–1939

Source: Christina Romer, “The Prewar Business Cycle Reconsidered,” and BEA.

400 500 600 700 800 900 1000 1100 1200 1300

1909 1911 1913 1915 1917 1919 1921 1923 1925 1927 1929 1931 1933 1935 1937 1939

Real GDP in Chained 2009 Dollars

1929

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SLIDE 41

The Multiplier Effect

Y PAE1 PAE Y=PAE Y* PAE2 Y2

The initial drop in PAE is magnified by the fact that as Y declines, C declines further.

Initial drop in PAE due to the drop in C Decline in Y is larger because

  • f the multiplier effect
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SLIDE 42

Multiplier Effect

  • A change in PAE changes output by more than the

initial change in PAE.

  • Why? Because changes in output affect consumer

spending and reinforce (or multiply) the initial change in PAE.

  • Existence of the multiplier effect explains why

moderate changes in planned spending cause more substantial changes in output.