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Lectures 9 & 10
Spending and Output in the Short-Run (continued) Reference: Bernanke, Olekalns and Frank - Chapter 5 Key Issues 45-degree diagram Equilibrium and disequilibrium Injections and withdrawals Multiplier
Review In Week 4 we developed a simple algebraic model of output. It consists of: An equilibrium condition: output that equals planned aggregate expenditure A definition of PAE:
PAE = C + I P + G + NX
Y = PAE
Two Sector Model Assumptions (simplifying): no government sector no foreign sector (i.e. a closed economy) Planned aggregate expenditure
PAE = C + I P
Consumption function (no taxes, so consumption depends on total, not disposable income)
C = C + cY
IP
C, I, PAE
C = C + cY
IP
Y
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45-Degree Diagram How can we represent equilibrium diagrammatically? Equilibrium is where PAE 20 10 10 20 Y
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Y = PAE
Y = PAE
PAE
PAE1
450
Y1
IP
Ye
Y
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Equilibrium GDP in the 2-Sector Model: The Algebra Equilibrium Condition Definition of PAE Consumption Function (Substitution) (Collect terms in Y) Equilibrium GDP
Y = PAE PAE = C + I P
C = C + cY
Y = C + cY + I P
Y (1 c) = C + I P
Ye = 1 [C + I P ] 1 c
Injections and Withdrawals There is an alternative way to look at the equilibrium condition for GDP.
Y = PAE Y =C+IP
or
S = IP
C = C + cY
Y C cY = I P C + (1 c)Y = I P
so
S = IP S = C + (1 c)Y
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I P,S S = C + (1 c)Y
IP Ye
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Equilibrium We have two equivalent equilibrium conditions for the level of GDP: Y = PAE INJ P = WD If these conditions hold there will be no tendency for GDP to change, i.e. Y = Y e . What happens if these conditions are not met?
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Disequilibrium Suppose that the level of GDP is such that either: PAE > Y and or PAE < Y and
INJ P < WD INJ P > WD
In either case there will be a tendency for the level of GDP to change.
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Y0
Adjustment to Equilibrium Firms will experience an unplanned decline in their inventories To re-build their inventories firms will increase their level of production This will cause GDP to increase and it will move towards its equilibrium value, where PAE cuts the 45-degree line GDP will increase until PAE=Y.
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Y0
Ye
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INJ P < WD
I P,S
S = C + (1 c)Y
IP Ye
Y1
Adjustment to Equilibrium Firms will experience an unplanned increase in their inventories To reduce their inventories firms will revise downward their production plans This will cause GDP to fall and it will move towards its equilibrium value, where INJ P = WD
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Paradox of Thrift Suppose there is an exogenous increase in agents desire to save This can be represented by an upward shift in the saving function
S
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IP Ye
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IP
e Ynew
Ye
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Numerical Example for 2-Sector Model Equilibrium Condition Definition of PAE Consumption Function Some Numbers Find
Ye?
PAE = 50 + 200 + 0.8Y = 250 + 0.8Y
Y = PAE PAE = C + I P
C = C + cY
I P = 200
C = 50 + 0.8Y
Y = 250 + 0.8Y Y (1 0.8) = 250 1 1 250 = Ye = 250 = 5 250 = 1250 (1 0.8) 0.2
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1,250
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1. Consumption Function:
C = C + c(Y T )
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New Functions T = T + tY 2. Tax Function: There is an exogenous component to taxes part that is proportional to income tY
T =t Y
and a
We can define as the marginal tax rate (how much tax is paid on an additional dollar of income).
M = m(Y T ) 3. Import Function: Imports are proportional to disposable income
M =m (Y T )
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Some Simplifications
C = C + c(Y T )
T = T + tY M = m(Y T )
Consumption
C = C + c(Y T tY ) = C cT + c(1 t )Y
Imports
M = m(Y T ) = m(Y T tY ) = mT + m(1 t )Y
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M = mT + m(1 t )Y
NX = X M
Substitute
PAE = C cT + c(1 t )Y + I P + G + X + mT m(1 t )Y
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Ye
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Injections and Withdrawals Not surprisingly, we can re-write the condition for equilibrium in terms of injections and withdrawals.
Y = PAE
PAE = C + I P + G + NX Y = C + I P + G + NX
IP +G+ X
Ye
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IP
45 degree line
PAE1
PAE0
Y0e
Y1e
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PAE and the Output Gap Output gap = Actual output less Potential output Output gap = Y Y * We can use our model to understand contractionary (negative) and expansionary (positive) output gaps We will focus on a contractionary output gap since it is relevant to current economic circumstances. We need to indicate potential output in our model.
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Y*
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PAE1
Y1e
Y*
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Investment ($ mill)
Investment
GDP
GDP ($ mill)
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The Multiplier In the following diagram compare the relative sizes of the change in Y caused by the change in PAE. PAE
PAE1
PAE0
PAE
Y0e
Y1e
Y
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The Multiplier An additional dollar of exogenous PAE generates more that a dollars worth of GDP How much more? 2-Sector Model Equilibrium GDP
Y e 1 = >1 C 1 c
Ye =
1 [C + I P ] 1 c
or
Y e 1 = >1 P I 1 c
since
0 < c <1
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1 1 1 = = =4 1 c 1 0.75 0.25
C , I , G, X
Multiplier =
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PAE
1 100 100
2
c 100 c 100
4
c(c c 100)
..
c (c 100)
c(c c 100)
What is the Total Effect on GDP? Rounds 1 2 3 c 100 c (c 100) PAE 100 c 100 c (c 100) Y 100 Total Increase in GDP
4
c(c c 100)
..
c(c c 100)
or
100[1 + c + c 2 + c 3 + .........]
or
1 100[ ] 1 c
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Does Let
[1 + c + c + c + .........] Really
2 3
Equal
1 1 c ?
S = 1 + c + c 2 + c 3 + .........
or
cS = c + c 2 + c 3 + c 4 + .........
Subtract cS from S
S cS = 1 + c + c 2 + c 3 + ......... (c + c 2 + c 3 + .....)
S cS = 1 1 S= 1 c
Done
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Recap We have a model that can determine the level of GDP (in the short-run). We have a model that can explain short-run fluctuations in GDP. Finally we now have a framework for thinking about macroeconomic policy. Well Done.
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