AF1605 Introduction to Economics

Topic 8: Spending and Output in the Short Run

Lecturer: Chau Tak Wai

School of Accounting and Finance

2
Spending and Output in the Short Run

v Overview of Classical and Keynesian Economics

v The Keynesian model of output determination

v Investment decision

v Fiscal policy
 3 Overview of Classical and Keynesian Economics

v The Keynesian model of output determination

- One of the most important economic models in economic history.
- Some economists refer the Keynesian model as the “multiplier model” while
others call it “aggregate expenditure model”.

v The Classical versus Keynesian controversy

- Dispute over how an economy adjusts during a recession and finds its way
back to full employment.
Increase consumption,
Classical view In the event of production and investment
Emphasize on
“Price adjustment unemployment, prices, and quickly return the
supply side
mechanism” wages, and interest economy back to its full
rates would all fall employment equilibrium

People’s income fall Further into recession instead of

Keynesian view
during recession ® going back to full employment
“Income adjustment Emphasize on
mechanism” spending & saving ¯, -> Fiscal and monetary policies
investment and demand side
are needed to push it back to
production ¯ full employment.
4 Keynesian Model

v Assume that in the short run, firms change their production level without
changing their prices. In other words, the price level of the economy
(GDP deflator) remains unchanged when there are changes in the
aggregate output (real GDP).

v Note: short run in macroeconomics is NOT in the same meaning as in

microeconomics.

v The aggregate expenditure model, also known as the Keynesian model or

the multiplier model, focuses on the effect of planned aggregate
expenditure (PAE) on the level of aggregate output (real GDP) while the
price level (P) remains unchanged.

v PAE = C + IP + G + NX and all variables are in real terms (at constant price
level).
 5 Actual vs Planned

v According to the circular flow of incomes and expenditures, actual output

always equals to actual income and actual expenditure.

v However, actual output may not be equal to planned expenditure.

v When actual output (Y) is higher than the planned aggregate expenditure
(PAE), there is unplanned inventory accumulation, which becomes a positive
unplanned investment.
Actual Y ($100) > Planned AE ($85)
→ Actual I ($40) = Planned I ($25) + Unplanned I ($15)
→ There are $15 unplanned inventory accumulation.

v When actual output (Y) is lower than the planned aggregate expenditure
(PAE), there is unplanned inventory depletion, which becomes a negative
unplanned investment
Actual Y ($100) < Planned AE ($105)
→ Actual I ($40) = Planned I ($45) + Unplanned I (-$5)
→ There are $5 unplanned inventory depletion.
 Autonomous vs Induced
6

v Autonomous expenditure is the component of aggregate expenditure that

does not change when real GDP changes.

v Induced expenditure is the component of aggregate expenditure that

increases with real GDP.

v In this simple model, we assume:

Consumption Consists of an autonomous component and

an induced component
Planned Investment Autonomous
Government spending Autonomous
Exports Autonomous
Imports Induced
 Consumption
7
v Consumption function is the relationship between consumption expenditure
and disposable income, other things remaining the same.
v Disposable income (Yd ) is aggregate income (= aggregate output Y) minus net
taxes.
v Net taxes are taxes paid to the government minus transfer payments received
from the government.
v In this simple model, net taxes consist of lump-sum tax (T0) and proportional
income tax (t × Y) where t is income tax rate
v Consumption function : C = a + b × Yd where Yd is disposable income.
v a : autonomous consumption
v b × Yd : induced consumption
v b is known as the marginal propensity to consume, generally less than 1.

v Yd = Y – T = Y – T0 – t × Y
v C = a + b (Y – T0 – t × Y) = (a – b T0) + b (1 – t) Y
v Saving (S) = Yd – C
 Consumption
8

v C = a + b × Yd where b is
known as marginal propensity
to consume (MPC).

v MPC is the slope of the

consumption function.

Change in consumption expenditure

MPC =
Change in disposable income

𝚫𝑪
v 𝑴𝑷𝑪 =
𝚫𝒀𝒅
 Consumption
9

v Along the 45° line,

consumption expenditure
equals disposable income.

v When the consumption

function is above the 45° line,
consumption is larger than
disposable income and saving
is negative (dissaving occurs).

v When the consumption

function is below the 45° line,
consumption is less than
disposable income and saving
is positive.
 Consumption
10

v Factors that influence autonomous

consumption (shift the consumption
function) include:
v Interest rate
v Wealth
v Expected future income

v Consumption function shifts up if

v interest rate decreases
v wealth and/or expected future
income increases.

v Consumption function shifts down if

v interest rate increases
v wealth and/or expected future
income decreases.
11 Imports

v Marginal propensity to import (MPM) (denoted as m) is the fraction of an

increase in GDP that is spent on imports.

v 𝒎 = 𝚫𝑴/𝚫𝒀

v Assuming all imports belong to induced expenditure: Imports (M) = mY.

v For simplicity, there is no autonomous part.

v Also note that it depends on Y, not disposable income Yd.

12 PAE function and Equilibrium Output

v Planned Aggregate Expenditure (PAE) is then a function of real output (Y).

v 𝑃𝐴𝐸 𝑌 = 𝐶 𝑌 + 𝐼 ! + 𝐺 + 𝑋 − 𝑀 𝑌 .
v We postpone our discussions on the autonomous components Ip to a later
section.
v G is determined by the government policy and budget constraint.
v X is determined by foreign demand on domestic goods.

v The economy is in equilibrium if PAE(Ye) = Ye.

v Note that the current output Y may not be the equilibrium output.
v Equilibrium output may also not be the potential output (or full employment
output).
v Thus, be careful to distinguish current output, equilibrium output and potential
output, what adjustments are associated to them.
13 Adjustment to Equilibrium

v When PAE(Y) > Y, there will be an

unplanned decrease in inventories
(inventory depletion). Firms will
increase production and real GDP
increases.

v When PAE(Y) < Y, there will be an

unplanned increase in inventories
(inventory accumulation). Firms will cut
production and real GDP decreases.

v When PAE(Y) = Y, there are no

unplanned inventory changes. Firms do
not change their production plans and
real GDP attains its equilibrium. This is
where the PAE line cuts the 45-degree
(Y=Y) line.
 Equilibrium Output
14

v PAE = C + Ip + G + X – M where Ip is planned investment

v PAE(Y) = a – b T0 + b (1 – t) Y + Ip + G + X – m Y
v PAE(Y) = (a – b T0 + Ip + G + X) + [b (1 – t) – m] Y

v PAE(Y) = A + qY where A = (a – b T0 + Ip + G + X) and q = [b (1 – t) – m]

v Equilibrium occurs when planned aggregate expenditure (PAE) equals real GDP (Y).

v Ye = PAE(Ye)
v Ye = A + qYe

v At equilibrium:
𝐴
𝑌! =
1−𝑞

𝒆
𝒂 − 𝒃𝑻𝟎 + 𝑰𝒑 + 𝑮 + 𝑿
𝒀 =
𝟏 − [𝒃 𝟏 − 𝒕 − 𝒎]
 A Numerical Example
15
v Given the following information:
v Autonomous consumption (a) = 200
v Marginal propensity to consume (b) = 0.7
v Lump-sum tax (T0) = 150
v Proportional tax rate (t) = 0.2
v Planned Investment (Ip) = 300
v Government Expenditure (G) = 375
v Exports (X) = 80
v Marginal propensity to imports (m) = 0.06

v PAE(Y) = a + b [(1 – t) Y - T0] + Ip + G + X – m Y

= 200 + 0.7[0.8Y – 150] + 300 + 375 + 80 - 0.06 Y
= 200 – 105 + 300 + 375 + 80 + (0.56 - 0.06) Y
= 850 + 0.5Y

v Equilibrium Output Ye is given by Ye = PAE(Ye)

´ Ye = 850 + 0.5Ye
´ Ye = 1700
 Self-Assessment Exercise
16

v From the example in the previous slide, PAE(Y) = 850 + 0.5Y

v The equilibrium output Ye =1700.
v If the current output Y = 1600, what is the unplanned investment?
v A. -100
v B. -50
v C. 50
v D. 100

v Furthermore, how will it adjust itself to the equilibrium output level?

 The Expenditure Multiplier
17

v Recall: the intersection of the PAE(Y)

line and the 45 degree Y=Y line gives
the equilibrium output level.

v When the level of autonomous

expenditure (e.g., I, G or X) increases,
A increases, shifting up the PAE line
by the change in A.
(Note: A is the intercept of the PAE(Y)
function.)

v As long as q is between 0 and 1, from

the diagram, the increase in
equilibrium output is higher than the
increase in A, which is known as the
multiplier effect.
 The Expenditure Multiplier
18

$ % %
v At equilibrium: 𝑌 = = &') &'* +,
&'(
𝒆 𝚫𝐀 𝚫𝐀
v If A increases by 𝚫𝑨, Δ𝒀 = =
𝟏'𝐪 𝟏'𝒃 𝟏'𝒕 +𝒎
𝟏 𝟏
v Aggregate expenditure multiplier = =
𝟏'𝐪 𝟏'𝒃 𝟏'𝒕 +𝒎
v The multiplier is generally larger than 1.
v A change in A will lead to a change in Ye by more than the change in A.
v In another word, to change Ye by a certain target amount, you need only to
increase A = a-bT0+Ip+G+X by a lower amount.
v In the numerical example above, PAE(Y) = A + qY = 850 + 0.5Y.
Since q=0.5, the aggregate expenditure multiplier is 2.
v The multiplier effect is positively related with the marginal propensity to
consume (b) and negatively related with proportional tax rate (t) and marginal
propensity to import (m).
 The Expenditure Multiplier
19
v How does the multiplier work?

v Suppose q = 0.5.

v Starting with an increase in planned investment (Ip) by $100.

v (1) it increases A and PAE by $100.
v (2) Such an increase will deplete the inventory. Firm will react by increasing
the output. Suppose the firms fully catch up with the increase by
increasing output (Y) by $100.
v (3) Increase in output means an increase in income of households. This
drives an increase in both consumption and imports. The resulting impact
is to increase PAE by $100 x 0.5=$50.
v (4) Repeating (2), when firms will increase production (by the same
amount) to replace the depleted inventory, raising Y by $50.
v (5) As in (3), consumption and imports will increase by $50 x 0.5 =$25.
v (6) Repeating (2), output will increase by $25.
v (7) Continues until a new equilibrium is reached.
20 The Expenditure Multiplier

v Total increase in GDP

= $100 + $50 + $25 + $12.5 + ….

= $100 (1 + 0.5 + 0.52 + 0.53 + 0.54 + …. )

= $100 × 1
1 – 0.5
= $200

v Multiplier = 2

v A change in one component of A (e.g. Ip, G, X) will not be restricted to

that component. It will spill over to consumption (and imports to a
lesser extent) as income of people changes when output changes.
 Self Assessment Exercise
21

v Suppose now the government has a target to increase the equilibrium

output (Ye) of the economy by $100 billion. The government is going to
achieve the target by increasing the government expenditure (G). How
much increase in government expenditure is needed to achieve this
target?

v A. $0

v B. $50 billion

v C. $100 billion

v D. $200 billion
 The Expenditure Multiplier
22
𝟏 𝟏
v Aggregate expenditure multiplier = =
𝟏'𝐪 𝟏'𝒃 𝟏'𝒕 +𝒎
v The multiplier effect is positively related with the marginal propensity to
consume (b) and negatively related with proportional tax rate (t) and marginal
propensity to import (m).
v Economic reasoning (for an increase in A):
v A higher in marginal propensity to consume (b) means that the increase in
consumption is higher for a unit increase in income, leading to a higher effect of
the second and subsequent rounds of the change in PAE and Y.
v A higher proportional tax rate (t) means a lower disposable income increase, and
thus a lower consumption increase, leading to a lower effect of the second and
subsequent rounds of the change in PAE and Y.
v A higher marginal propensity to imports (m) means for a given increase in income,
more of the increase in consumption is on imports, thus the increase in
expenditure on domestic goods is lower, leading to a lower effect on the second
and subsequent rounds of the change in PAE and Y.
23 Investment Decision

v Here we take a deeper look at the decision on investment Ip.

v Use the cost-benefit analysis to decide whether to undertake an
investment project (e.g. acquiring a new machine).
v Benefit from investment:
v To receive a stream of income in the future.
v We have to convert the stream of future income into its equivalent
present value (PV).
v Cost of investment:
v For simplicity, assume all the cost of investment is paid today only.
 Discounting and Present Value
24
v There is an issue of time value of money.
v Generally there is a risk-free option to transfer money between time, so
one dollar now is NOT the same as one dollar some time in the future.
v Suppose there is an interest rate (r) that one can save or borrow money
towards the future without risk.
$1 today → $1 × (1 + r) received after 1 year
$1 today → $1 × (1 + r) × (1 + r) received after 2 years
$1 today → $1 × (1 + r)n received after n year

$1 / (1 + r) today → $1 received after 1 year

$1 / (1 + r)2 today → $1 received after 2 years
$1 / (1 + r)n today → $1 received after n years

v Present value of $1 to be received after n years = $1

(1 + r)n
 Investment Decision
25

v The present value of the stream of future income can be calculated as:

Y1 Y2 Y3 Yn
PV = + + + … +
(1+r) (1+r)2 (1+r)3 (1+r)n

where Yi is future income in year i, r is the interest rate for discounting.

v Net present value (NPV) equals the present value of future income from
the investment project minus its cost.

Y1 Y2 Y3 Yn
NPV = + + + … + – cost
(1+r) (1+r)2 (1+r)3 (1+r)n
 Investment Decision
26
v The investment project should be undertaken if its NPV is positive.
v Notice that one can always not to use the money on this investment
project, but to save the money to earn interest at the interest rate r.
v In another word, the net present value for putting money in the bank to
earn interest at r is always 0, which is always one of your options.

v Example:
v An investment project has a cost of $5 million to be paid at the beginning of
year 1.
v The project is expected to generate $1.9 million of income at the end of year 1,
$1.8 million of income at the end of year 2, and $1.7 million of income at the
end of year 3.
v NPV equals +$0.0024 million at discount rate of 4% and the project should be
invested.
v NPV equals –$0.0893 million at discount rate of 5% and the project should not
be invested.
 Investment Decision
27

Y1 Y2 Y3 Yn
NPV = + + + … + – cost
(1+r) (1+r)2 (1+r)3 (1+r)n

v Other factors remain unchanged, a project is more likely to be invested

(i.e. having a positive NPV) if there is:
v Lower interest rate for discounting.
v Larger expected future income (i.e., larger Y1, Y2, ….).
v Lower cost of investment.

v The higher the interest rate, the higher the amount of interest you need
to give up (if you use your own savings) or you need to pay (if you borrow
money), so the higher the opportunity cost of investment.
v The net present value approach has taken this aspect into account.
28
Fiscal Policy
v Another issue is: the equilibrium output level (Ye) may not be the same as
the potential output level (or full employment output level).

a – b T0 + Ip + G + X
v At equilibrium: Y =
1 – b (1 – t) + m
A
=
1 – b (1 – t) + m
v If the PAE, in particular, A is not large enough (e.g., insufficient planned
investment), equilibrium output will be less than full employment output
and there is unemployment.

v If A is too large (e.g., excess planned investment), equilibrium output

exceeds full employment output and there is inflationary pressure.

v Government may use fiscal policy or monetary policy to try to bring the
economy back to the full employment level.
29 Fiscal Policy
v Fiscal policy is the management of planned aggregate expenditure (PAE)
through changes in government expenditure (G) and/or taxation (T).

v Expansionary fiscal policy

v When there is unemployment, increase in G or decrease in T can help
to stimulate GDP.

v Contractionary fiscal policy

v When there is inflationary pressure, decrease in G or increase in T can
help to reduce the pressure.

v Another policy is known as monetary policy, which involves the

influencing money supply and interest rate to stimulate/cool down
consumption and investment (C and Ip in this model). Further details will
be discussed in Topic 9.
30 Fiscal Policy

a – b T0 + Ip + G + X
v At equilibrium: Y =
1 – b (1 – t) + m

+1
v Government expenditure (G) multiplier =
1 – b (1 – t) + m

–b
v Lump-sum tax (T0) multiplier =
1 – b (1 – t) + m
 Government Budget Deficit
31
v When tax revenue exceeds government expenditure, the government can enjoy a
budget surplus.
v Government budget deficit occurs when government expenditure exceeds tax
revenue.
v Example: Budget deficit of the U.S. government:
32 Government Budget Deficit

v The government can finance the budget deficit by issuing bonds (debt
financing) and/or issuing money (money financing).

v Problem of debt financing:

v The increased borrowing by government will push up interest rate
and “crowd out” private investment.

v Problem of money financing:

v Too much money in the economy will bring inflationary pressure.
 33

Source: https://www.statista.com/chart/17832/countries-with-the-highest-government-debt-as-a-percentage-of-gdp/
 34 Views on Fiscal Policy

v The Keynesian view

v The Keynesian view is that fiscal stimulus – an increase in government
expenditure or a decrease in tax revenues – boosts real GDP and stimulates
employment. The positive effects of fiscal stimulus make it a powerful tool
in the fight against recession.

v The Mainstream view

v The mainstream view is that Keynesians overestimate the multiplier effects
of fiscal stimulus and their effects are small and slow.
v In particular, price of inputs (e.g. wage, interest rate) may change in an
opposite direction to these policies, impeding its subsequent effects.
(Note: Keynesian model assumes constant prices.)
v The durable results of a fiscal stimulus are a bigger government and a
greater burden of government debt on future generations.