Spending and Output in the Short Run

Published: 2021-09-11 01:15:09
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Chapter 8: Spending and Output in the Short RunPlanned 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 spendingIn 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 functionHow 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 taxesY – T = disposable income, [pic 2]> 0, 0 mpc 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.)

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