Economics 2 Professor Christina Romer Spring 2020 Professor David - - PDF document

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Economics 2 Professor Christina Romer Spring 2020 Professor David - - PDF document

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Economics 2 Professor Christina Romer Spring 2020 Professor David Romer LECTURE 20 PLANNED AGGREGATE EXPENDITURE AND OUTPUT April 9, 2020 I. O VERVIEW OF S HORT -R UN F LUCTUATIONS II. T HE K EY R OLE OF D EMAND A. Terminology B. Evidence C.

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Economics 2 Professor Christina Romer Spring 2020 Professor David Romer LECTURE 20 PLANNED AGGREGATE EXPENDITURE AND OUTPUT April 9, 2020 I. OVERVIEW OF SHORT-RUN FLUCTUATIONS II. THE KEY ROLE OF DEMAND

  • A. Terminology
  • B. Evidence
  • C. 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)
  • 1. Factors that affect consumption
  • 2. The “consumption function”

V. DETERMINANTS OF OUTPUT IN THE SHORT RUN

  • A. 45-degree line (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. The multiplier effect
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LECTURE 20

Planned Aggregate Expenditure and Output

April 9, 2020

Economics 2 Christina Romer Spring 2020 David Romer

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SLIDE 3

Announcements

  • We have posted a revised syllabus on the course

website.

  • Weekly problem sets and a change in lecture

schedule.

  • We have posted Problem Set 5, Part 1.
  • It is due at 2 p.m. on Thursday, April 16th.
  • 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 United States, 1950–2019

Source: FRED (Federal Reserve Economic Data); data from Bureau of Economic Analysis.

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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

Deviation of GDP from Potential and the Unemployment Rate

Source: FRED; data from Bureau of Labor Statistics.

Percent

Unemployment Rate Deviation of GDP from Potential

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SLIDE 8
  • II. THE KEY ROLE OF DEMAND
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Key Determinant of Output in the Short Run

  • In the long run, aggregate output is equal to

potential output.

  • Potential output is determined by normal

capital, labor, and technology.

  • In the short run, aggregate output can be above,

below, or equal to potential output.

  • Short-run output is determined primarily by

demand.

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SLIDE 10

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).

  • In the short run, if planned aggregate expenditure

changes, output changes.

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SLIDE 11

Evidence on the Key Role of Demand

  • Historical experience.
  • Academic research.
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Why is Output Determined by Demand in the Short Run?

  • Nominal rigidity (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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  • III. PLANNED AGGREGATE EXPENDITURE
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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 15

Short Run versus Long Run

  • In the short run:
  • PAE can be more than, less than, or equal to

Y*.

  • 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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  • IV. DETERMINANTS OF EACH COMPONENT OF PAE
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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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Determinants of Government Purchases (G)

  • Politics.
  • Wars, natural disasters.
  • We take G as given.
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SLIDE 19

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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Determinants of Consumption (C)

  • Real interest rate (r): A rise in the real interest rate

reduces consumption.

  • Expectations (“consumer confidence”)
  • Wealth: A rise in wealth increases consumption.
  • Disposable (or after-tax) income: A rise in

disposable income increases.

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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 22

Consumption Function C = C + c·(Y−T)

  • Autonomous consumption: The part of

consumption that does not vary with income (C). It is positive.

  • Marginal propensity to consume (MPC): The

change in consumption due to a change in disposable income (c). It is between 0 and 1.

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Consumption Function C = C + c·(Y−T)

slope = c Y−T C C C

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Consumption and Disposable Income

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

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  • V. DETERMINATION OF OUTPUT IN THE SHORT RUN
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45-degree Line

  • Captures the equilibrium condition that Y = PAE.
  • Also reflects the empirical reality that output

responds to planned spending in the short run.

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SLIDE 27

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).

  • Recall that PAE = C + Ip + G + NX.
  • PAE is a function of Y because one component

(Consumption) depends on Y.

  • The sensitivity of PAE to Y is the same as the

sensitivity of C to Y (it is the MPC).

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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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Determination of Output in the Short Run

  • Output in the short run is determined by the

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

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Determination of Short-Run Output

Y PAE PAE Y=PAE Y1

Sometimes called the “Keynesian Cross” diagram.

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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 33

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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  • 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
  • utput will change.
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SLIDE 36

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).

  • It reduces planned aggregate expenditure at a

given level of Y.

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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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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 39

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 40

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 42

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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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.