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Spending, Output, and Fiscal Policy
Saturday, April 9, 2016

4:40 PM

• The idea that a decline in aggregate spending may cause output to fall below
potential output was one of Keynes's insights
• Too little spending leads to a recessionary output, too much creates an
expansionary gap

The Keynesian Model's Crucial Assumption: Firms Meet Demand at
Preset Prices

• In the short run, firms meet the demand for their products at preset prices
○ Firms do not respond to every change in the demand for their products by
changing their prices
○ Instead, they set a price for some period and meet the demand at that
price
§ By "meeting the demand" we mean that firms produce just enough
to satisfy their customers at the prices that have been set
○ Fluctuations in spending will have powerful effects on the nation's real
GDP
• Menu Costs: the costs of changing prices
○ Prices should be changed if the benefit of doing so outweighs the menu
costs associated with making the change
• Planned Aggregate Expenditure (PAE): total planned spending on final goods
and services - together, these four types of spending sum to aggregate spending
○ Consumption expenditure is spending by households on final goods and
services
§ Largest component of PAE
§ The higher the private sector's disposable income, the higher the
level of consumption spending
○ Investment is spending by domestic firms on new capital goods
§ Also spending on new houses and apartments and increases in
inventories
○ Government purchases are purchases by federal, state, and local
governments of final goods and services
○ Next exports equal exports minus imports
○ PAE = C + I + G + NX
• Output is determined by planning aggregate expenditure
○ Planned can differ from actual output
• Consumption function: C = Cbar + (mpc)(Y - T)

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governments of final goods and services
○ Next exports equal exports minus imports
○ PAE = C + I + G + NX
Output is determined by planning aggregate expenditure
○ Planned can differ from actual output
Consumption function: C = Cbar + (mpc)(Y - T)
○ C = consumption spending
○ (Y-T) = disposable income
○ Cbar = amount of consumption
Autonomous Consumption (Cbar): consumption spending that is not related to
the level of disposable income
○ I
...
optimism about future leads to increased consumption
○ Takes into account the effects of the real interest rates have on
consumption
Wealth Effect: the tendency of changes in asset prices to affect households'
wealth and thus their consumption spending
Marginal Propensity to Consumer (mpc): the amount by which consumption
rises when disposable income rises by $1
○ We assume that 0 < mpc < 1
○ If people receive an extra dollar of income, they will consume part of the
dollar and save the rest
○ Their consumption will increase, but by less than the full dollar of extra
income
Declines in production (which imply declines in the income received by
producers) lead to reduced spending
Reductions in spending lead to declines in production and income
Autonomous Expenditure: the portion of planned aggregate expenditure that is
independent of output
○ Does not vary when output varies
Induced Expenditure: the portion of planned aggregate expenditure that
depends on output Y
○ The numerical value of induced expenditure depends on the numerical
value taken by output
Expenditure Line: a line showing the relationship between planned aggregate
expenditure and output
○ Slope = mpc for specific numerical example
○ Vertical intercept = autonomous expenditure
○ Increases in autonomous expenditure will shift the expenditure line up
while decreases will shift the line down

Short-Run Equilibrium Output

• Short-run Equilibrium Output: the level of output at which output Y equals
planned aggregate expenditure PAE
○ The level of output that prevails during the period in which prices are
predetermined

while decreases will shift the line down

Short-Run Equilibrium Output

• Short-run Equilibrium Output: the level of output at which output Y equals
planned aggregate expenditure PAE
○ The level of output that prevails during the period in which prices are
predetermined
○ Y = PAE
• Graphical approach:
○ Blue line is the expenditure line, showing the amount of output people
want to purchase at any given level of output
○ Red dashed line, extending from origin, shows all of the points at which
the variable on the y-axis (Y) equals the variable on the x-axis (PAE)
○ Intersection is where Y = PAE

Planned Spending and the Output Gap

• When output is below potential, Okun's law tells us that unemployment has
now risen above the natural rate
• Income-Expenditure Multiplier: the effect of a one-unit increase in autonomous
expenditure on short-run equilibrium output
• Arises because of a given initial increase in spending raises the incomes of
producers, which leads them to spend more, raising the incomes and spending
of other producers, and so on
• Increases in autonomous expenditure shifts the expenditure line upward
○ Increases short-run equilibrium output
• Decreases in autonomous expenditure shift the expenditure line downward
○ Decreases short-run equilibrium output
• Decreases in autonomous expenditure that drive actual output below potential

of other producers, and so on
• Increases in autonomous expenditure shifts the expenditure line upward
○ Increases short-run equilibrium output
• Decreases in autonomous expenditure shift the expenditure line downward
○ Decreases short-run equilibrium output
• Decreases in autonomous expenditure that drive actual output below potential
output are a source of recessions

Fiscal Policy and Recessions

• Stabilization Policies: government policies that are used to affect planned
aggregate expenditure, with the objective of eliminating output gaps
• Expansionary Policies: government policy actions intended to increase planned
spending and output
• Contractionary Policies: government policy actions designed to reduce planned
spending and output
• Fiscal Policy: decisions about how much the government spends and how much
tax revenue it collects
• Government purchases of goods and services, being a component of planned
aggregate expenditure, directly affect total spending
• Net Taxes (T) = total taxes - transfer payments - government interest payments
• Tax policy, as part of fiscal policy, involves total taxes and transfer payments
○ Taxes or transfers do not affect planned spending directly
○ Instead they work indirectly by changing disposable income in the private
sector
• The Economic Stimulus Act of 2008 called for tax cuts, rebates, and spending
increases
• Fiscal policy may affect potential output as well as planned aggregate
expenditure
○ Supply-siders: the only effects of fiscal policy that matter are effects on
potential output
• When thinking about stabilization policies, remember the need to avoid large
and persistent budget deficits
○ Reduce national saving which is important for long-term economic growth
○ Makes increased spending or tax cuts unattractive
• Fiscal policy is not always flexible enough to be useful for stabilization, but most
economists still think it's important
○ Automatic Stabilizers: provisions in the law that imply automatic increases
in government spending or decreases in taxes when real output declines
○ Although fiscal policy may be difficult to change quickly, it may still be
useful for dealing with prolonged episodes of recession



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