MBA Lecture 5
Transcript of MBA Lecture 5
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Spending and
Output in theShort Run: Part 2
Lecture 4
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MBA Lecture 4 Slide 2
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Contents
1. Short-Run Equilibrium Output
(Keynesian Cross)
2. Income-Expenditure Multiplier
3. Stabilizing Planned Spending
4. Role of Fiscal Policy
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Short-run equilibrium
Keynesian Assumption
Producers meet demand at preset
prices in the short-run
Short-run equilibrium: Y = PAE
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Short-run equilibrium
Short-run Equilibrium OutputThe level of output at which output
(Y ) equals planned aggregate
expenditure (PAE)
Short-run equilibrium output is the
level of output that prevails during
the period in which prices arepredetermined
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Determination of Short-Run
Equilibrium Output (Keynesian Cross)
Output Y
Plann
ed
aggreg
ate
ex
penditure
PAE
960
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
45o
Y = PAE
4,800
Equilibrium PAEintersects the 45o line @ 4,800
Disequilibrium < 4,800, PAE > Y > 4,800, PAE < Y
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A Decline In Planned
Spending Leads To A Recession
Output Y
Plann
ed
aggreg
ate
ex
penditure
PAE
960
E
Expenditure line
PAE = 960 + 0.8Y
45o
Y = PAE
4,800
Y*
Recessionary gap
F
Expenditure line
PAE = 950 + 0.8Y
A decline in autonomous
aggregate expenditure (C)
shifts the expenditure line
down
950
4,750
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Planned Aggregate Expenditure
ObservationsOther factors remaining constant, a
decline in autonomous spending
causes short-run equilibrium output tofall and creates a recessionary gap.
A decrease in autonomous spending
can be caused by a reduction in C, IP
, G,and/orNX.
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Planned Aggregate Expenditure
ObservationsOther factors remaining constant, an
increase in autonomous spending causes
short-run equilibrium output to rise andcreates an expansionary gap.
An increase in autonomous spending can
be caused by an increase in C, IP
, G,and/orNX.
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Planned Aggregate Expenditure
Income-Expenditure Multiplier
The effect of a 1-unit increase in autonomous
expenditure on short-run equilibrium output,
or
Change in the equilibrium level of output for
one unit change in autonomous expenditure
For example, a multiplier of 5 means that a 10-
unit decrease in autonomous expenditure
reduces short-run equilibrium output by 50
units
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Income-Expenditure Multiplier
The Multiplier
Recall
PAE = 960 + 0.8Y, equilibrium Y = 4,800
C fell by 10PAE = 950 + 0.8Y, equilibrium Y = 4,750#
The Multiplier: 1/ (1 - MPC)
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Income-Expenditure Multiplier
The Multiplier Effect
The decrease in the equilibrium Ywas
5 times the fall in C.
The income-expenditure multiplierequaled 5.
The size of the multiplier is influenced
by the MPC.The Multiplier: 1/ (1 - MPC)
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Stabilizing Planned Spending
In the Keynesian Model:Recessionary and expansionary
gaps are caused by inadequate or
excessive spending, respectively.Stabilization policies are used to
affect planned aggregate
expenditures to eliminate outputgaps.
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Stabilizing Planned Spending
Stabilization Policies
Government policies that are used
to affect planned aggregate
expenditure, with the objective of
eliminating output gaps
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Stabilizing Planned Spending
Expansionary PoliciesGovernment policy actions intended to
increase planned spending and output
Contractionary PoliciesGovernment policy actions designed to
reduce planned spending and output
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Stabilizing Planned Spending
Tools of Stabilization Policy
Fiscal policy
Monetary policy
S bili i Pl d S di
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
Tools of fiscal policyGovernment spending
Direct effect on PAE
Taxation
Indirect effect on PAE
Transfer payments
Indirect effect on PAE
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
Tools of fiscal policy
Government spending
We saw that 10 units decrease inautonomous spending resulted a 50
units decline in short-run equilibrium
output (multiplier effect).
St bili i Pl d S di
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
Tools of fiscal policy
Government spending
Thus, to cover that 50 units fall in outputgovt. can increase its expenditure by tenunits (e.g., military expenditure).
Govt. expenditure is a part of autonomousexpenditure.Autonomous expenditure as well as output
then will return to its original level.
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An Increase In Government
Purchases Eliminates A Recessionary Gap
Planned
aggreg
ate
ex
penditure
PAE
960
Expenditure line
PAE = 960 + 0.8Y
E
An increase in Gshifts the
expenditure line upward
Output Y
Y = PAE
F
45o
4,800
Recessionary gap
Expenditure line
PAE = 950 + 0.8Y
950
4,750
Y*
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
Taxes, Transfers, and Aggregate
SpendingTaxes and transfers affect PAEindirectly
ExampleUsing a tax cut to close a recessionary
gap
Stabilizing Planned Spending:
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
ExampleAssumeRecessionary gap = 50
MPC = 0.8, multiplier = 5Use a tax cut to eliminate the gapThe tax cut must increase PAEby 10For every dollar reduction in taxes,
consumption will increase by 80cents (MPC = 0.8)
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
Example: Assume
Recessionary gap = 50
MPC = 0.8, multiplier = 5
Use a tax cut to eliminate the gap
Change in spending (10) = tax cut x MPC(0.8)
Tax cut = change in spending / MPC = 10/0.8= 12.5
A tax cut of 12.5 will raise PAEby 10 (12.5 x0.8) = 10
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MB MC Stabilizing Planned Spending:
The Role of Fiscal Policy
The same results could be obtained byincreasing transfer payments by 12.5
units.80% of 12.5 ( = 10) will be consumed.Consumption expenditure will increase
and, therefore, PAE will be increased by
10.