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15. Principles of Economics (Brief Edition)_2e (18)

Chapter 18: Spending, Output, and Fiscal Policy.1. Identify the key assumptions of the basic Keynesian model and. explain how this affects firms production decisions.2. Discuss the determination of planned investment and aggregate. consumption spending and how these concepts are used to develop a. model of planned aggregate expenditure.3. Analyze how an economy reaches short-run equilibrium in the basic. Keynesian model, using both numbers and graphs.4. Show how a change in planned aggregate expenditure can cause a. change in short-run equilibrium output and how this is related to the. income-expenditure multiplier.5. Explain why the basic Keynesian model suggests that fiscal policy is. useful as a stabilization policy, and discuss the qualifications that arise. in applying fiscal policy in real-world situations. McGraw­Hill/Irwin Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved. John Maynard Keynes. (1883 – 1946).• After World War I, Keynes recognized that the. terms of the peace would lead to another war. Keynesian Model.• Building block for current theories of short-run. economic fluctuations and stabilization policies.• In the short run, firms meet demand at preset. prices. – Firms typically set a price and meet the demand at. that price in the short run. • Menu costs are the costs of changing prices.• Firms change prices when the marginal benefits. exceed the marginal costs. 18­2Planned Aggregate Expenditure.• Planned aggregate expenditure (PAE) is total. planned spending on final goods and services.• Four components of planned aggregate. expenditure. – Consumption (C) by households. – Investment (I) is planned spending by domestic. firms on new capital goods. – Government purchases (G) are made by federal,. state, and local governments. – Net exports (NX) equals exports minus imports PAE = C + IP + G + NX. 18­3 Consumption Function.• The consumption function is an equation. relating planned consumption to its. determinants, notably disposable income (Y – T). C = C + (mpc) (Y – T), where. C is autonomous consumption spending. mpc is the change in consumption for a given. change in disposable income. 0 < mpc < 1. – Autonomous consumption is spending not. related to the level of disposable income. • A change in C shifts the consumption function. 18­4 Consumption Function. C = C + (mpc) (Y – T).• The wealth effect is the tendency of changes in. asset prices to affect households wealth and. thus their consumption spending. – This effect is included in C.• Autonomous consumption also captures the. effects of interest rates on consumption. – Higher rates increase the cost of using credit to. purchase consumer durables and other items. 18­5 More on the Consumption. Function. C = C + (mpc) (Y – T).• Marginal propensity to consume (mpc) is the. increase in consumption spending when. disposable income increases by $1. – mpc is between 0 and 1 for the economy. – If households receive an extra $1 in income, they. spend part (mpc) and save part.• (Y – T) is disposable income. – Output plus government transfers minus taxes. – Main determinant of consumption spending. 18­6Planned Aggregate Expenditure. (PAE).• Two dynamic patterns in the economy. 1. Declines in production lead to reduced spending. 2. Reductions in spending lead to declines in production. and income.• Consumption is the largest component of PAE. – Consumption depends on output, Y. – PAE depends on Y.• Planned aggregate