Chap 25 Macro
Keynes identified three factors that affect consumption Disposable income, expected future income and wealth or credit
For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services.
Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone.
The Keynesian perspective focuses on aggregate demand.
Firms produce output only if they expect it to sell.
Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will shift out to the right.
Spending on new capital goods is called investment expenditure.
The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and cyclical unemployment occur
will consider some of the shortcomings of the Keynesian approach and why it is not especially well-suited for long-run macroeconomic analysis.
In the same way (though not shown in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output.
As a consequence, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.
stagflation is an unhealthy combination of high unemployment and high inflation.) Perhaps most important, stagflation was a phenomenon that could not be explained by traditional Keynesian economics.
Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the Oil Crisis of the mid-1970s, which first brought stagflation into our vocabulary. The second is changes in people's expectations about inflation.
Expectations of future profits: The clearest driver of the benefits of an investment is expectations for future profits. When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.
Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.
aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure.
aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports).
The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, government still plays a significant role in the economy
government provides important public services such as national defense, transportation infrastructure, and education.
These costs of changing prices are called menu costs—like the costs of printing up a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.
pg 593 graph about wages and sticky prices
real-world AS curve is very flat at levels of output far below potential ("the Keynesian zone"), very steep at levels of output above potential ("the neoclassical zone") and curved in between ("the intermediate zone"). This is illustrated in Figure 25.7. The typical aggregate supply curve leads to the concept of the Phillips curve.
pg 596 Phillips Curve
Suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap.
recessionary gap. The economy is in equilibrium but with less than full employment, as shown at Y1 in the Figure 25.3. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.
macroeconomic externality, where what happens at the macro level is different from and inferior to what happens at the micro level. For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. But if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding (which would be shown as a movement along the AD curve in response to a lower price level).
A key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.
The first building block of the Keynesian diagnosis is that recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment.
As Keynes recognized, the events of the Depression contradicted Say's law that "supply creates its own demand."Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.
As a result, a situation of excess supply—where the quantity supplied exceeds the quantity demanded at the existing wage or price—exists in markets for both labor and goods, and Q1 is less than Q0 in both Figure 25.4 (a) and Figure 25.4 (b). When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage.
Bureau of Labor Statistics and found that, during the Great Recession, 60% of job losses were in medium-wage occupations. Most of them were replaced during the recovery period with lower-wage jobs in the service, retail, and food industries.
Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. The level of demand for a nation's exports tends to be most heavily affected by what is happening in the economies of the countries that would be purchasing those exports.
Conversely, the quantity of a nation's imports is directly affected by the amount of income in the domestic economy: more income will bring a higher level of imports.
Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks.
First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Second, the macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand.
The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment
If aggregate demand was originally at ADi in Figure 25.11, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment. In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a "Goldilocks" level of aggregate demand: not too much, not too little, but looking for what is just right.
While the availability of the factors of production determine a nation's potential GDP, the amount of goods and services actually being sold, known as real GDP, depends on how much demand exists across the economy.
Keynes argued that, for reasons we explain shortly, aggregate demand is not stable—that it can change unexpectedly
prices and wages are "sticky," making it difficult to restore the economy to full employment and potential GDP.
Keynes emphasized one particular reason why wages were sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions.
Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways
Keynes noted that while it would be nice if the government could spend Additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways
Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input will yield higher profits.
Keynes noted, business investment is the most variable of all the components of aggregate demand.
Investment falls into four categories: producer's durable equipment and software, new nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings). The first three types of investment are conducted by businesses, while the last is conducted by households.
Keynes's treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected benefits of the investment (expectations of future profits) and the costs of the investment (interest rates).
a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years,but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).
Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right.
Wages in the service, retail, and food industries are at or near minimum wage and tend to be both downwardly and upwardly "sticky." Wages are downwardly sticky due to minimum wage laws; they may be upwardly sticky if insufficient competition in low-skilled labor markets enables employers to avoid raising wages that would reduce their profits. At the same time, however, the Consumer Price Index increased 11% between 2007 and 2012, pushing real wages down.
Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than either supply curve (labor or specific good). In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP,
Exports and imports can also be affected by relative prices of goods in domestic and international markets. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.
PG 591 good chart
Not only could AD be stimulated by more government spending (or reduced by less government spending), but consumption and investment spending could be influenced by lowering or raising tax rates. Indeed, Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.
Recall that exports are products produced domestically and sold abroad while imports are products produced abroad but purchased domestically. Since aggregate demand is defined as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.
During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.
The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation.
Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked. He argued that individual markets for goods and services were appropriate and useful, but that sometimes that level of aggregate demand was just too low. When 10 million people are willing and able to work, but one million of them are unemployed, he argued, individual markets may be doing a perfectly good job of allocating the efforts of the nine million workers—the problem is that insufficient aggregate demand exists to support jobs for all 10 million.
Thus, he believed that, while government should ensure that overall level of aggregate demand is sufficient for an economy to reach full employment, this task did not imply that the government should attempt to set prices and wages throughout the economy, nor to take over and manage large corporations or entire industries directly.
Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers. Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too.
When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources: managers must analyze the competition and market demand and decide what the new prices will be, sales materials must be updated, billing records will change, and product labels and price labels must be redone. Second, frequent price changes may leave customers confused or angry—especially if they find out that a product now costs more than expected.
Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. rates of saving declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so rates of saving increased while consumption declined.
The reason for the expenditure multiplier is that one person's spending becomes another person's income, which leads to additional spending and additional income, and so forth, so that the cumulative impact on GDP is larger than the initial increase in spending.
While the multiplier is important for understanding the effectiveness of fiscal policy, it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in recent discussions of the effectiveness of the Obama administration's fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009.