Explain why the basic Keynesian model suggests that fiscal policy is useful as a stabilization policy, and discuss the.. qualifications that arise in applying fiscal policy in real-worl[r]
(1)Spending, Output, and Fiscal
Policy
(2)Learning Objectives
1 Identify the key assumptions of the basic Keynesian model
and explain how this affects the production decisions made by firms
2 Discuss the determinations of planned investment and
aggregate consumption spending and how these concepts are used to develop a model of planned aggregate
expenditure
3 Analyze, using graphs, how an economy reaches short-run
equilibrium in the basic Keynesian model
7 Show how a change in planned aggregate expenditure can
cause a change in short-run equilibrium output and how this is related to the income-expenditure multiplier
5 Explain why the basic Keynesian model suggests that fiscal policy is useful as a stabilization policy, and discuss the
(3)Recessionary Gap
•
Great Depression
– Available resources are unemployed
– Public’s willingness or ability to spend declines
•
A decrease in spending leads to lower
production
– Laid-off workers reduce their spending
– Insufficient spending to support the normal level of
production
•
Conventional economic policy of the 1920s and
1930s would not solve this problem
– John Maynard Keynes revolutionized economic
(4)John Maynard Keynes (1883 –
1946)
•
After World War I, Keynes recognized that the
terms of the peace would lead to another war
– German war reparations would prevent growth and
recovery
•
The General Theory of Employment, Interest,
and Money
(1936) is his best-known work
– Problem was explaining why economies kept a
recessionary gap for long periods
• Aggregate spending is too low for full employment • Stabilization policies use government spending or
(5)Keynesian Model
•
Building block for current theories of short-run
economic fluctuations and stabilization policies
•
In the short run, firms meet demand at preset
prices
– Firms typically set a price and meet the demand at
that price in the short run
• Menu costs are the costs of changing prices
– Determining the new price
– Incorporating prices into the business – Informing consumers of new prices
•
Firms change prices when the marginal benefits
(6)Technology of Changing Prices
•
Technology has reduced menu costs
– Bar codes and scanners reduce costs of changing
prices in the store
– Online surveys
•
Highly segmented airline pricing
•
Internet mechanisms for setting price
– eBay ■ Priceline
•
Other costs remain
– Competitive analysis ■ Deciding the new
prices
(7)Planned Aggregate Expenditure
•
Planned aggregate expenditure (PAE) is total
planned spending on final goods and services
•
Four components of planned aggregate
expenditure
– Consumption (C) by households
– Investment (I) is planned spending by domestic
firms on new capital goods
– Government purchases (G) are made by federal,
state, and local governments
(8)Planned Investment Example
•
Fly-by-Night Kite produces $5 million of kites
per year
– Expected sales are $4.8 million and planned
inventory increase is $0.2 million
– Capital expenditure of $1 million is planned
• Total planned investment is $1.2 million
•
If actual sales are only $4.6 million
– Unplanned inventory investment of $0.2 million
– Actual investment is $1.4 million
•
If actual sales are $5.0 million
– Unplanned inventory decrease of $0.2 million
(9)Planned Aggregate Expenditure
(PAE)
•
Actual spending equals planned spending for
– Consumption
– Government purchases of final goods and services
– Net exports
•
Adjustments between actual and planned
spending are accomplished with changes in
inventories
•
The general equation for planned aggregate
expenditures is
(10)Consumption Expenditures
•
Consumption (
C
) accounts for two-thirds of total
spending
– Powerful determinant of planned aggregate
expenditure
– Includes purchases of goods, services, and
consumer durables, but not new houses
• Rent is considered a service