Keynesian Economics: Understanding Output Fluctuations and Stabilization Policies - Prof. , Study notes of Microeconomics

Download Keynesian Economics: Understanding Output Fluctuations and Stabilization Policies - Prof. and more Study notes Microeconomics in PDF only on Docsity! CH 11  The basic Keynesian model shows how fluctuations in planned aggregate expenditure, or total planned spending, can cause actual output to differ from potential output. Too little spending leads to a recessionary output gap; too much spending creates an expansionary output gap. This model relies on the crucial assumption that firms do not respond to every change in demand by changing prices. Instead, they typically set a price for some period, then meet the demand forthcoming at that price. (LO1)  Planned aggregate expenditure is total planned spending on final goods and services. The four components of total spending are consumption, investment, government purchases, and net exports. Actual investment may differ from planned investment because firms may sell a greater or lesser amount of their production than they expected. If firms sell less than they expected, for example, they are forced to add more goods to inventory than anticipated. And because additions to inventory are counted as part of investment, in this case actual investment (including inventory investment) is greater than planned investment. (LO2)  The consumption function summarizes the relationship between disposable income and consumption spending. The amount by which consumption rises when disposable income rises by one dollar is called the marginal propensity to consume (mpc). The marginal propensity to consume is always greater than zero but less than one.(LO2)  An increase in real output raises planned aggregate expenditure, since higher output (and, equivalently, higher income) encourages households to consume more. Planned aggregate expenditure can be broken down into two components: autonomous expenditure and induced expenditure. Autonomous expenditure is the portion of planned spending that is independent of output; induced expenditure is the portion of spending that depends on output. (LO2)  In the period in which prices are fixed, short-run equilibrium output is the level of output that just equals planned aggregate expenditure. Short-run equilibrium can be determined numerically by a table that compares alternative values of output and the planned spending implied by each level of output and by using equations. Short-run equilibrium output also can be determined graphically in a Keynesian-cross diagram. (LO3)  Changes in autonomous expenditure will lead to changes in short-run equilibrium output. In particular, if the economy is initially at full employment, a fall in autonomous expenditure will create a recessionary gap and a rise in autonomous expenditure will create an expansionary gap. The amount by which a one-unit increase in autonomous expenditure raises short-run equilibrium output is called the multiplier. An increase in autonomous expenditure not only raises spending directly, it also raises the incomes of producers, who in turn increase their spending, and so on. Hence the multiplier is greater than one: A one-dollar increase in autonomous expenditure tends to raise short- run equilibrium output by more than one dollar.(LO4)  To eliminate output gaps and restore full employment, the government employs stabilization policies. The two major types of stabilization policy are monetary policy and fiscal policy. Fiscal policy refers to the decisions governments make about how much to spend and tax. For example, an increase in government purchases raises autonomous expenditure directly, so it can be used to reduce or eliminate a recessionary gap. Similarly, a cut in taxes or an increase in transfer payments increases the public's disposable income, raising consumption spending at each level of output by an amount equal to the marginal propensity to consume times the cut in taxes or increase in transfers. Higher consumer spending, in turn, raises short-run equilibrium output. (LO5) p. 324  Three qualifications must be made to the use of fiscal policy as a stabilization tool. First, fiscal policy may affect potential output as well as aggregate spending. Second, large and persistent government budget deficits reduce national saving and growth; the need to keep deficits under control may limit the use of expansionary fiscal policies. Finally, because changes in fiscal policy must go through a lengthy legislative process, fiscal policy is not always flexible enough to be useful for short-run stabilization. However, automatic stabilizers—provisions in the law that imply automatic increases in government spending or reductions in taxes when output declines—can overcome the problem of legislative delays to some extent and contribute to economic stability. (LO5)  automatic stabilizers provisions in the law that imply automatic increases in government spending or decreases in taxes when real output declines  autonomous consumption consumption spending that is not related to the level of disposable income  autonomous expenditure the portion of planned aggregate expenditure that is independent of output  consumption function the relationship between consumption spending and its determinants, in particular, disposable income  contractionary policies government policy actions designed to reduce planned spending and output  expansionary policies government policy actions intended to increase planned spending and output  expenditure line a line showing the relationship between planned aggregate expenditure and output  fiscal policy decisions about how much the government spends and how much tax revenue it collects.  income-expenditure multiplier the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output  induced expenditure the portion of planned aggregate expenditure that depends on output Y  marginal propensity to consume (mpc) the amount by which consumption rises when disposable income rises by $1; we assume that 0 < mpc < 1  menu costs the costs of changing prices  planned aggregate expenditure (PAE) total planned spending on final goods and services  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 3. Shift the AD and/or AS curves in the appropriate fashion; 4. Find the economy's new short-run equilibrium; 5. Compare the new short-run equilibrium with the initial long-run equilibrium to show how output and the price level were affected.  In the absence of stabilization policy, output gaps will be closed through the economy's self- correcting property. The need to engage in active stabilization policy depends on the size of the output gap and the nature of the shock that created the output gap. (LO4)  Active fiscal policy and monetary policy are helpful when a recession is caused by negative demand shocks. Active fiscal policy and monetary policy can be costly when a recession is caused by negative price shocks. (LO5) s aggregate demand (AD) curve a curve that shows the amount of output consumers, firms, government, and customers abroad want to purchase at each price level, holding all other factors constant aggregate supply (AS) curve a curve that shows the relationship between the amount of output firms want to produce and the price level, holding all other factors constant change in aggregate demand a shift of the AD curve change in aggregate supply a shift of the AS curve demand shocks changes in planned spending that are not caused by changes in output or the price level exchange rate effect an increase in the price level causes the dollar to appreciate, which reduces net exports expected price level the price level expected to prevail when the economy is at potential output interest rate effect an increase in the price level results in higher money demand and a higher interest rate, causing both planned consumption and planned investment to fall long-run equilibrium a situation in which the AD and AS curves intersect at potential output Y* price shocks changes in input prices that are not caused by changes in output or the price level self-correcting property the fact that output gaps will not last indefinitely, but will be closed by rising or falling prices short-run equilibrium CH 14  The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. A rise in the value of a currency relative to other currencies is called an appreciation; a decline in the value of a currency is called a depreciation. (LO1)  Supply and demand analysis is a useful tool for studying the determination of exchange rates in the short run. The equilibrium exchange rate, also called the market equilibrium value of the exchange rate, equates the quantities of the currency supplied and demanded in the foreign exchange market. (LO1)  A currency is supplied by domestic residents who wish to acquire foreign currencies to purchase foreign goods, services, and assets. An increased preference for foreign goods, an increase in the domestic GDP, an increase in the real interest rate on foreign assets, or a decrease in the real interest rate on domestic assets all will increase the supply of a currency on the foreign exchange market and thus lower its value. A currency is demanded by foreigners who wish to purchase domestic goods, services, and assets. An increased preference for domestic goods by foreigners, an increase in real GDP abroad, an increase in the domestic real interest rate, or a decrease in the foreign real interest rate all will increase the demand for the currency on the foreign exchange market and thus increase its value. (LO1)  When the exchange rate is flexible, a tight monetary policy increases the demand for the currency, reduces the supply of currency, and causes it to appreciate. The stronger currency reinforces the effects of the tight monetary policy on aggregate demand by reducing net exports. Conversely, easy monetary policy lowers the real interest rate and weakens the currency, which in turn stimulates net exports.(LO2)  The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. The real exchange rate incorporates both the nominal exchange rate and the relative levels of prices among countries. An increase in the real exchange rate implies that domestic goods and services are becoming more expensive relative to foreign goods and services, which tends to reduce exports and increase imports. Conversely, a decline in the real exchange rate tends to increase net exports.(LO3)  A basic theory of nominal exchange rate determination in the long run, the purchasing power parity (PPP) theory, is based on the law of one price. The law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations. According to the PPP theory, we can find the nominal exchange rate between two currencies by setting the price of a commodity in one of the currencies equal to the price of the commodity in the second currency. The PPP theory correctly predicts that the currencies of countries that experience significant inflation will tend to depreciate in the long run. However, the fact that many goods and services are not traded internationally, and that not all traded goods are standardized, makes the PPP theory less useful for explaining short-run changes in exchange rates. (LO4) p. 421  The higher the real interest rate in a country, and the lower the risk of investing there, the higher its net capital inflows. The availability of capital inflows expands a country's pool of saving, allowing for more domestic investment and increased growth. A drawback to using capital inflows to finance domestic capital formation is that the returns to capital (interest and dividends) accrue to foreign financial investors rather than domestic residents. (LO5)  The trade balance, or net exports, is the value of a country's exports less the value of its imports in a particular period. Exports need not equal imports in each period. If exports exceed imports, the difference is called a trade surplus, and if imports exceed exports, the difference is called a trade deficit. (LO5, LO6)  A low rate of national saving is the primary cause of trade deficits. A low-saving, high- spending country is likely to import more than a high-saving country. It also consumes more of its domestic production, leaving less for export. Finally, a low-saving country is likely to have a high real interest rate, which attracts net capital inflows. Because the sum of the trade balance and net capital inflows is zero, a high level of net capital inflows always accompanies a large trade deficit. (LO6)  appreciation an increase in the value of a currency relative to other currencies  capital inflows purchases of domestic assets by foreign households and firms  capital outflows purchases of foreign assets by domestic households and firms  depreciation a decrease in the value of a currency relative to other currencies  fixed exchange rate an exchange rate whose value is set by official government policy  flexible exchange rate an exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market  foreign exchange market the market on which currencies of various nations are traded for one another  international capital flows purchases or sales of real and financial assets across international borders  law of one price if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations  market equilibrium value of the exchange rate the exchange rate that equates the quantities of the currency supplied and demanded in the foreign exchange market  net capital inflows capital inflows minus capital outflows  nominal exchange rate the rate at which two currencies can be traded for each other  purchasing power parity (PPP) the theory that nominal exchange rates are determined as necessary for the law of one price to hold  real exchange rate the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency  trade balance the value of a country’s exports less the value of its imports in a particular period (quarter or year)  trade deficit when imports exceed exports, the difference between the value of a country’s imports and the value of its exports in a given period  trade surplus