Spending and output in the short run. Flashcards
What is the key assumption of the Keynesian model?
That prices are sticky i.e. demand is met at that particular price in the short run. That’s because it’s hard to continuously change price levels as demand changes, due to menu costs for example (the cost from changing prices).
What is the consumption function?
It relates spending of households to disposable income. Vertical intercept is exogenous consumption, gradient is MPC.
What is the difference between exogenous and induced consumption?
One is outside the model (independent of disposable income) and the other is dependent on disposable income (Y-T).
In what way is expenditure linked to aggregate output?
Changes in production and income affect aggregate spending. Basically, when you sub C-d into PAE, you introduce a relation to disposable income or in other words, output (GDP - remember your spending is someone else’s income which drives production). As a result, you introduce an exogenous component and an induced expenditure component (if they are dependent on income, or “output”, or not)
What is meant by equilibrium output?
When Y=PAE in the short run because firms produce output that is equal to their planned expenditure (investment in particular).
How does equilibrium relate to planned aggregate expenditure and output?
It gives you the ideal amount of outputs an economy should be producing. If there’s more spending on a product than there is on actually producing it (PAE > Y), then there’s not enough supply. Vice verse producing too much means there’s too much supply.
How does equilibrium relate to planned injections and withdrawals?
Similarly to PAE = Y, INJ = WD gives you idea of how much supply there should be.
Starting from the point of disequilibrium, how does an economy reach equilibrium?
Produce more or less until you reach the right level of demand, in other words when there’s an equality between injections and withdrawals. Withdrawals is like taking money out of consumption and saving whilst injection is buying shit. Basically, too much people saving means not enough selling with too much stock, so firms cut back on production (which is equivalent to reducing GDP).
What is the 45 degree diagram?
It relates PAE to GDP and shows that as GDP increases, PAE increases. All points on the line is when PAE = Y i.e. equilibrium.
What is meant by paradox of thrift?
When there’s too much saving so GDP falls to a level where firms produce to match the expenditure i.e. the equilibrium point where withdrawal = injections is lower.
How are output gaps created?
In the Keynesian model, the fall of exogenous planned expenditure means there’s lower GDP below it’s potential GDP. It is based on consumers’ willingness to consume. If they feel good about the economic situation, they will spend more. If not, they will try to save more but that just means dropped GDP and thus contractionary output gaps.
Why is the value of the multiplier greater than 1?
An initial change of spending is the producer’s income, and the producer than spend that money by their MPC. That spent money is then someone else’s income and they in turn spend that money received by their MPC. These MPC add up in an infinite series s = a/1-r which is greater than 1.
To derive, sub consumption function into PAE, assume that T is constant, and seperate it into exogenous (it’d be a constant) and induced consumption components. Make Y the subject and u get consumption function.
