Spending and Output in the Short Run

Chapter 8: Spending and Output in the Short Run

Planned aggregate expenditure (PAE): total planned spending on final goods and services.

Key assumption of the basic Keynesian model:

In the short run, firms meet the demand for their products at pre-set prices. Firms set their prices and then sell as much as consumers want at the given price.

Four components of planned aggregate expenditure:

• Consumption (C): spending by households on durable goods, semi-durable goods, non-durable goods, and services.

• Investment (I): spending by firms on new capital goods and changes in inventories, and spending by households on new residential housing.

• Government purchases (G): spending by governments on goods and services, such as roads, military equipment, teacher salaries, etc.

• Net exports (NX): spending by foreigners on Canadian exports minus spending by Canadians on foreign imports.

Planned spending vs. actual spending

In any given time period, the investment a firm plans to make may not be equal to the investment a firm actually makes. The discrepancy comes from changes to inventories.  

Some parts of investment (purchases of new buildings and equipment) are under direct control of firms. But changes to inventories are only partly controlled by firms.  

Later, we’ll see that planned investment is related to the expected interest rate. For now we assume that the interest rate is constant, so assume that planned investment is constant; investment does not depend on GDP.

Example: IP = 100.

The consumption function

How do households decide how much to consume?

Household consumption depends on:

• household income

        as income ↑, consumption ___

• household wealth

        as wealth ↑, consumption ___

• interest rates

        as interest rates ↑, consumption ___

We focus on income, as it is the most important factor.

Consumption function: there will be some consumption even when income is zero (achieved through borrowing); as income rises, consumption also rises, but not one-for-one, since some of the increase in income is saved.

[pic 1]

where C = consumption, Y = income, T = net taxes

Y – T = disposable income, [pic 2]> 0, 0 < mpc < 1.

Example: C = 200 + 0.8 (Y – T) 

If disposable income = 0, consumption = 200.  

As disposable income rises, 80 cents out of every dollar increase goes to consumption.  

So if disposable income is 100, consumption is 200 + 80 = 280.  

If disposable income is 500, consumption is 200 + 400 = 600.

[pic 3]

[pic 4]

The fraction of a change in disposable income that is consumed is mpc. In our example, mpc = 0.8, so if Y ↑ $1 ⇒ C ↑ 80 cents.  This is the marginal propensity to consume: the tendency to consume out of an additional dollar. (The average propensity to consume is consumption divided by disposable income.)

Since all income is either consumed or saved, then the remaining 20 cents must go to saving.  

Planned aggregate expenditure is equal to consumption plus planned investment plus government purchases plus net exports.

PAE = C + IP + G + NX

Example:

C = 200 + 0.8 (Y – T) 

IP = 100

G = 100

T = 100

NX = 0

C = 200 + 0.8 (Y – 100)

= 200 + 0.8Y – 80

= 120 + 0.8Y

PAE = 120 + 0.8Y + 100 + 100 + 0

PAE = 320 + 0.8Y

Part of this is autonomous expenditure, the portion of PAE that is determined outside the model. The rest is induced expenditure, the portion of PAE that is determined within the model (because it depends on output).

[pic 5]

[pic 6]

Short-Run Equilibrium Output

In equilibrium, there is no tendency for change.

Therefore, what firms have produced (aggregate output ≡ Y) must be equal to what agents in the economy plan to spend (planned aggregate expenditure ≡ PAE ≡ C + IP + G + NX).  

So, in equilibrium, Y = PAE and therefore Y = C + IP + G + NX.  

Output equals planned aggregate expenditure only when planned investment and actual investment are equal.

How does the economy get to the equilibrium?