ECON 1 Section 19 Demand and Output in the Short Run. ECON 1 Section 19 Page 1 GSI: R. Estopina
Contact Details GSI: Ramon Estopina Office Hours: No OH this Thursday!! Office: Evans 508-7 Email: estopina@haas.berkeley.edu Handouts (only sections 104 & 133) after class in: http://www.ocf.berkeley.edu/~jaychen/econ1/ Please read: Read before downloading!. ECON 1 Section 19 Page 2 GSI: R. Estopina
Section 19 Agenda Administrative Stuff (10 min) Recap Quiz (10 min) Problem 25.6 (10 min) Problem 25.7 (10 min) Problem 25.9 (10 min) Re-cap (2 min) ECON 1 Section 19 Page 3 GSI: R. Estopina
Administrative Stuff PS #3 ready today from Econ-1 website!!! Due next Wednesday 13 th. Remember, no class next Monday!! -Veterans Day Holiday. Opportunity to catch-up and get ready for Midterm. ECON 1 Section 19 Page 4 GSI: R. Estopina
Review of Last Lecture - 11/4 th Chapter 25: AD: planned vs actual spending. Consumption Function and MPC Autonomous vs Induced spending Keynesian Model Assumptions Keynesian Cross Diagram Shifts in AD Equilibrium Output Potential Output Gaps (recessionary/expansionary) Paradox of thrift & multiplier ECON 1 Section 19 Page 5 GSI: R. Estopina
Recap Quiz - 1 Total planned spending on final goods and service is called 1) total spending. 2) total consumption. 3) aggregate expenditures. 4) aggregate consumption. 5) aggregate demand. ECON 1 Section 19 Page 6 GSI: R. Estopina
Recap Quiz - 2 A firm's actual investment will exceed its planned investment when 1) it sells less than it planned. 2) It sells more than it planned. 3) interest rates rise. 4) interest rates fall. 5) the economy experiences an unexpected expansion. ECON 1 Section 19 Page 7 GSI: R. Estopina
Recap Quiz - 3 The largest component of aggregate demand is 1) consumption. 2) investment. 3) government purchases. 4) exports. 5) imports. ECON 1 Section 19 Page 8 GSI: R. Estopina
Recap Quiz - 4 The objective of stabilization policies is to 1) affect aggregate supply. 2) eliminate output gaps. 3) increase potential GDP. 4) keep inflation constant. 5) cause business cycles ECON 1 Section 19 Page 9 GSI: R. Estopina
Recap Quiz - 5 The value of the MPC is assumed to be 1) less than 1. 2) greater than 1. 3) less than 0. 4) equal to 1. 5) constant. ECON 1 Section 19 Page 10 GSI: R. Estopina
Important to remember: Equation 1 of the day: Aggregate Demand (AD): total planned spending on final goods and services. AD C + I p + G + NX ECON 1 Section 19 Page 11 GSI: R. Estopina
Important to remember (2) Remember: Planned may differ from actual for firms: difference is change in inventories. Firm sells less than expected: inventories grow (Increase in inventories is counted as actual investment) I > I p Firm sells more than expected: inventories decline I p > I ECON 1 Section 19 Page 12 GSI: R. Estopina
Important to remember (3) Components of AD. A) CONSUMPTION FUNCTION:TCC + constant term capturing factors other than disposable income c MPC (marginal propensity to consume): amount C raises when disposable income rises; assume 0 < c < 1C ECON 1 Section 19 Page 13 GSI: R. Estopina c(y)
Important to remember (4) B) Rest of factors are exogenous.ttp ECON 1 Section 19 Page 14 GSI: R. Estopina IIGGNXNX
Important to remember (5) Combining all equations: AD C + I p + G + NX AD C + c ( Y T ) + I + G + NX D + + + + Composed of: Autonomous AD & Induced AD c ECON 1 Section 19 Page 15 GSI: R. Estopina A(C-cTIGNX)Y
Important to remember (6) In equilibrium Y AD, so: Y+ + + + c Y1 )XN + + + 1 c Multiplier: ult1m 1 c 1 1 MPC ECON 1 Section 19 Page 16 GSI: R. Estopina (C-cTIGNX)Y(C-cTIG.
ECON 1 Section 19 Page 17 GSI: R. Estopina Box 25.2 (F&B page 667) From Example 25.2 (F&B page 664) we have: 620 /c 0.8 / 220 / 300 / 20 / 250 We know the definition of Aggregate Demand is: AD C + I p + G + NX And, in the SHORT RUN:250TT20XNNX300GG220IIT)0.8(Y620T)c(YCCp + + CIGXNT
Box 25.2 (Conclusion) Substituting the components: AD [620 + 0.8(Y-250)] + 220 + 200 + 20 And finally: AD 960 + 0.8Y In addition, from the short term equilibrium: YAD So the previous equation will be: Y 960 + 0.8Y Solving for Y: Y 960 / 0.2 4,800 ECON 1 Section 19 Page 18 GSI: R. Estopina
ECON 1 Section 19 Page 19 GSI: R. Estopina Problem 25.6 (F&B page 684) For the following economy, find Autonomous aggregate demand The multiplier SR equilibrium output Output gap. 12,000*Y2,000TT200XNNX2,500GG1,500IIT)0.5(Y3,000Cp +
Problem 25.6 (cont d) A) The relationship between aggregate demand and output is given by: AD C + I AD 3000 + 0.5( Y 2000) + 1500 + 2500 + 200 AD 6200 + 0.5 Y p + G + NX Autonomous aggregate demand equals 6200, the part of aggregate demand that does not depend on output. ECON 1 Section 19 Page 20 GSI: R. Estopina
Problem 25.6 (cont d) To find short-run equilibrium output, use the equation YAD and solve for Y: Y Y 0.5 Y Y AD 6200 + 6200 12,400 0.5 Y What is the Output Gap? Remember last class: Y*-Y ECON 1 Section 19 Page 21 GSI: R. Estopina
Problem 25.6 (cont d) So we have: SR equilibrium output (Y) 12,400 Potential output (Y*) 12,000 Output gap is 400. Is this a recessionary or expansionary gap? Expansionary, Y > Y* ECON 1 Section 19 Page 22 GSI: R. Estopina
Problem 25.6 (cont d) The multiplier can be found by the formula of the multiplier (obviously) 1/(1-c) 21 There is another way to solve it (more complicated), but I know you are curious. ECON 1 Section 19 Page 23 GSI: R. Estopina 11c10.5
Problem 25.6 (cont d) Imagine that autonomous aggregate demand rises from 6200 to 6300. Now the equation YAD becomes Y 6,300 + 0.5Y Solving for output yields Y 12,600, an increase of 200 over the solution found before. We have shown that an increase in autonomous aggregate demand of 100 raises short-run equilibrium output by 200. Therefore the multiplier must equal 2. ECON 1 Section 19 Page 24 GSI: R. Estopina
Problem 25.6 (Conclusion) By how much would autonomous AD have to change to eliminate the output gap? As the multiplier is 2, to eliminate the output gap of 400, autonomous aggregate demand would have to change by 200, that is, autonomous aggregate demand would have to fall. If autonomous aggregate demand falls from 6200 to 6000, then short-run equilibrium output equals 12,000 and the output gap is eliminated. ECON 1 Section 19 Page 25 GSI: R. Estopina
Problem 25.7 (F&B page 685) Following with the previous problem but now 0. A) What would be the SR equilibrium output? We proceed as before: AD C + I p + G + NX AD 3000 + 0.5( Y 2000) + 1500 + 2500 + 0 AD 6000 + 0.5 Y ECON 1 Section 19 Page 26 GSI: R. Estopina NX
Problem 25.7 (cont d) Then we apply the definition of short-run equilibrium output, Y AD. Y AD Y 6000 + 0.5 Y 0.5 Y 6000 Y 12,000 ECON 1 Section 19 Page 27 GSI: R. Estopina
Problem 25.7 (cont d) B) Economic recovery abroad increases the demand for the country s exports. As a result 100. Output?XN What happens to the SR Equilibrium ECON 1 Section 19 Page 28 GSI: R. Estopina
Problem 25.7 (cont d) NXAD An increase of by 100 implies that autonomous aggregate demand rises by 100, so now we have: Y Y 0.5 Y Y AD 6100 6100 + 6100 12,200 + 0.5 0.5 Y Y So the increase in net exports of 100 has increased output by 200. ECON 1 Section 19 Page 29 GSI: R. Estopina
Problem 25.7 (cont d) C) Now assume foreign economies are slowing and the demand for the Ncountry s Xexports is reduced. As a result -100. Output? What happens to the SR Equilibrium ECON 1 Section 19 Page 30 GSI: R. Estopina
Problem 25.7 (cont d) A decrease of by 100 implies that autonomous aggregate demand falls by 100, so now we have: 5900 + 0.5 Y Y AD Y 5900 + 0.5 Y 0.5 Y 5900 Y 11,800 So the decline in net exports of 100 lowers output by 200. ECON 1 Section 19 Page 31 GSI: R. Estopina NADX
Problem 25.7 (Conclusion) How these results help explain the tendency of recessions and expansions to spread across countries? The example shows that a weak economy in one country, by reducing that country s imports from a second country, can create economic weakness in the second country as well. Similarly, an expansion that increases a country s purchases of foreign products strengthens the economies of its trade partners. ECON 1 Section 19 Page 32 GSI: R. Estopina
Problem 25.9 (F&B page 685) For the following p economy, find how much would Gov. purchases have to change to eliminate any output gap (this 5is fiscal policy). + ECON 1 Section 19 Page 33 GSI: R. Estopina C400.8(YT)II70GG120NXNX10TT150Y*80
Problem 25.9 (cont d) We solve for short-run equilibrium output via the usual two steps. First, find the relationship of aggregate demand to output: AD AD C + I G Y AD 120 + 0.8 Y p + 40 + 0.8( + NX 150) + 70 + 120 + 10 ECON 1 Section 19 Page 34 GSI: R. Estopina
Problem 25.9 (cont d) Second, use the condition Y AD to solve for short-run equilibrium output: Y Y 0.2 Y Y AD 120 600 + 120 0.8 Y The output gap is Y*-Y 580-600 -20, so there is an expansionary gap of 20. ECON 1 Section 19 Page 35 GSI: R. Estopina
Problem 25.9 (cont d) To answer the question about the effects of fiscal policy we need to know the multiplier for this economy. In this case: 1 1 c 1 1 0.8 5 ECON 1 Section 19 Page 36 GSI: R. Estopina
Problem 25.9 (cont d) Now we can find the appropriate fiscal policies to eliminate the output gap. Because actual output exceeds potential output by 20, and the multiplier is 5, a decrease of 4 in government purchases (from 120 to 116) will eliminate the output gap. You can verify this directly by setting 116 and re-solving for short-run equilibrium output.g ECON 1 Section 19 Page 37 GSI: R. Estopina
Problem 25.9 (cont d) By how much would taxes have to change? (Assume MPC 0.8) For the case of a tax change we have to be careful. A change in taxes of T does not change autonomous aggregate demand by T, because consumers do not spend 100% of any tax cut (or reduce spending by 100% of any tax increase). A change in taxes of T instead changes autonomous aggregate demand by c T, where c is the marginal propensity to consume (MPC) out of disposable income. ECON 1 Section 19 Page 38 GSI: R. Estopina
Problem 25.9 (cont d) In the case of government spending, eliminating the output gap requires reducing autonomous aggregate demand by 4. To reduce autonomous aggregate demand by 4 via a tax change, Gov. will increase taxes by 5. Since the MPC 0.8, a tax increase of 5 will lead consumers to reduce their spending by 4, as desired. You can also verify it by setting 115 and solving for short-run equilibrium output.t ECON 1 Section 19 Page 39 GSI: R. Estopina
Problem 25.9 (cont d) What happens if now Y*630? If potential output is 630, then the output gap is Y*-Y30, that is, there is a recessionary gap of 30. As the multiplier is 5, this gap can be eliminated by raising government purchases by 6. AD YAD AD126+0.8YGAD120+0.8Y An increase in shifts the expenditure line upwards. 600 Y*630 Output ECON 1 Section 19 Page 40 GSI: R. Estopina
Problem 25.9 (Conclusion) Alternatively, cut taxes by 6/0.8 7.5. Because the MPC is 0.8, a cut in taxes of 7.5 will also stimulate autonomous aggregate demand by 6 and output by 6*5 30. The Keynesian cross diagram in this case shows the expenditure line rising too, rather than falling, to restore YY*. ECON 1 Section 19 Page 41 GSI: R. Estopina
Problems for next sections!!! For next section: Chapter 26: Problems 3, 8, 9. Remember: This is not mandatory. It won t be graded. Only for those of you that need improvement in Exam grades. ECON 1 Section 19 Page 42 GSI: R. Estopina
Next class Next Class: Section 20 Wednesday, Nov 13 th No class next Monday. Veterans Day Holiday. Due PS#4!!!! If you want more practice, work on Next Sections Problems (although you probably have enough). Read ch. 26 & 27. You can download handouts this afternoon. Thank you for coming on time!!! Enjoy the long weekend & C-U Wednesday!!. ECON 1 Section 19 Page 43 GSI: R. Estopina