Week 21 - Spending and Output Flashcards
What is a recessionary gap?
A recessionary gap occurs when available resources are underutilised, leading to higher unemployment and insufficient spending to support normal levels of production.
How did the Great Depression exemplify a recessionary gap?
During the Great Depression, unemployed resources (workers, factories) and a decline in public spending led to lower production and a vicious cycle of decreased spending and rising unemployment.
How did a decrease in spending affect the economy during the Great Depression?
As spending decreased, businesses reduced production and laid off workers, causing further reductions in income and spending, leading to a self-reinforcing cycle of economic decline.
Why was conventional economic policy ineffective during the Great Depression?
Conventional policies of the 1920s and 1930s failed because they did not address the fundamental issue of insufficient demand; they didn’t stimulate spending or employment to break the downward cycle.
How did John Maynard Keynes change economic thinking during the Great Depression?
John Maynard Keynes argued that government intervention through public spending and investment could increase demand and create jobs, breaking the recessionary gap and helping the economy recover.
How did John Maynard Keynes view the aftermath of World War I?
Keynes believed that the terms of the peace (especially German war reparations) would prevent economic growth and recovery, possibly leading to another war.
What is The General Theory of Employment, Interest, and Money (1936)?
It is Keynes’s best-known work, where he explored why economies could remain in a recessionary gap for long periods due to insufficient aggregate spending.
According to Keynes, why do economies experience recessionary gaps?
Keynes argued that aggregate spending in the economy is too low for full employment, preventing recovery and leading to prolonged economic stagnation.
What are stabilisation policies in Keynesian economics?
Stabilisation policies involve government intervention through spending or tax adjustments to substitute for lack of spending in other sectors, stimulating demand and promoting full employment.
What is the Keynesian model?
The Keynesian model is a foundational theory for understanding short-run economic fluctuations and stabilisation policies, focusing on how aggregate demand affects output and employment in the short run.
How do firms meet demand in the short run according to the Keynesian model?
In the short run, firms meet demand at preset prices, meaning that they typically do not adjust prices immediately in response to changes in demand.
What are menu costs in the context of the Keynesian model?
Menu costs are the costs associated with changing prices, including:
Determining the new price.
Incorporating the new price into business operations.
Informing consumers about the new price.
When do firms decide to change prices according to the Keynesian model?
Firms will change prices when the marginal benefits (e.g., increased revenue) of changing prices exceed the marginal costs (e.g., the costs of changing the prices and informing customers).
How has technology reduced menu costs in recent years?
Technology has helped reduce menu costs by:
Using barcodes and scanners to make price changes easier in stores.
Employing online surveys for real-time feedback.
What are examples of highly segmented pricing made possible by technology?
Examples of highly segmented pricing include:
Airlines using dynamic pricing to adjust fares based on demand and customer characteristics.
Online platforms like eBay and Priceline setting prices dynamically based on bidding and consumer preferences.
How have ride-sharing apps affected the way prices are set?
Ride-sharing apps like Uber and Lyft use algorithms to adjust prices in real-time based on demand, supply, and traffic conditions, offering highly flexible pricing.
What other costs remain when changing prices despite advances in technology?
Despite technological advances, businesses still face costs such as:
Competitive analysis to understand market conditions.
Deciding the new prices that maximise profit.
Informing consumers about price changes, which can require marketing efforts.
What is Planned Aggregate Expenditure (PAE)?
Planned Aggregate Expenditure (PAE) is the total planned spending on final goods and services in an economy.
What are the four components of Planned Aggregate Expenditure (PAE)?
The four components of PAE are:
Consumption (C) – Planned spending by households on goods and services.
Investment (I) – Planned spending by domestic firms on new capital goods.
Government Purchases (G) – Spending by federal, state, and local governments.
Net Exports (NX) – The difference between exports and imports (exports - imports).
What is the role of consumption (C) in Planned Aggregate Expenditure (PAE)?
Consumption (C) is the spending by households on goods and services, and it is a major determinant of aggregate demand in the economy.
How is investment (I) defined in the context of PAE?
Investment (I) refers to the planned spending by domestic firms on new capital goods such as machinery, buildings, and equipment.
What is included in government purchases (G) for PAE?
Government purchases (G) include spending by federal, state, and local governments on goods and services, such as infrastructure and defence.
How is net exports (NX) calculated in PAE?
Net exports (NX) are calculated as the difference between exports (goods and services sold to other countries) and imports (goods and services purchased from other countries):
NX = Exports - Imports.
How is unplanned inventory investment related to sales?
Unplanned inventory investment occurs when actual sales are different from expected sales, leading to either a surplus or shortage in inventory, which affects total investment.
What components of PAE always match actual spending?
Actual spending always equals planned spending for:
Consumption (C)
Government purchases (G)
Net exports (NX)
How are adjustments made when actual spending differs from planned spending?
Adjustments occur through changes in inventories:
If actual sales are lower than expected → Unplanned inventory increase
If actual sales are higher than expected → Unplanned inventory decrease
What is the general equation for Planned Aggregate Expenditure (PAE)?
PAE = C + IˆP + G + NX
where IˆP is planned investment, and the other components represent consumption, government spending, and net exports.
How does planned investment (Iᵖ) differ from actual investment?
Planned investment (Iᵖ) includes intended spending on capital goods and inventories, while actual investment includes unplanned inventory changes due to unexpected shifts in sales.
What portion of total spending does Consumption (C) account for?
Consumption (C) makes up two-thirds of total spending, making it a powerful determinant of Planned Aggregate Expenditure (PAE).
What types of purchases are included in Consumption (C)?
Consumption (C) includes:
Goods (e.g., food, clothing)
Services (e.g., rent, healthcare)
Consumer durables (e.g., cars, appliances)
Does NOT include new houses (which are part of investment).
How is rent classified in consumption expenditures?
Rent is considered a service and is included in Consumption (C).
What is the key determinant of Consumption (C)?
Consumption (C) depends on Disposable Income (Y – T), which is the income people have after taxes to spend or save.
What is the Consumption Function?
The Consumption Function is an equation that relates planned consumption (C) to disposable income (Y – T) and other factors.
C = C̅ + (mpc) (Y - T)
where:
C̅ = Autonomous consumption (spending independent of income)
mpc = Marginal Propensity to Consume (how much consumption changes with income)
Y - T = Disposable income (income after taxes)
What is autonomous consumption (C̅)?
Autonomous consumption (C̅) is the level of consumption that occurs even when disposable income is zero (e.g., spending on necessities using savings or credit).
What is the Marginal Propensity to Consume (mpc)?
mpc is the fraction of each additional dollar of disposable income that is spent on consumption.
It follows the rule:
0 < mpc < 1
For example, if mpc = 0.8, then 80% of additional income is spent, and 20% is saved.
What happens when C̅ (autonomous consumption) changes?
A change in C̅ shifts the entire consumption function up or down.
Increase in C̅ → Consumption function shifts up (higher spending at all income levels).
Decrease in C̅ → Consumption function shifts down (lower spending at all income levels).
What is the Wealth Effect in consumption?
The Wealth Effect is the tendency of changes in asset prices (such as stocks, bonds, or real estate) to affect household wealth and thus influence consumption spending.
Rising asset prices → Households feel wealthier → Increase in consumption
Falling asset prices → Households feel poorer → Decrease in consumption
The Wealth Effect is included in C̅ (autonomous consumption).
How do interest rates affect autonomous consumption?
Higher interest rates → Increase borrowing costs → Decrease in autonomous consumption (C̅)
Lower interest rates → Reduce borrowing costs → Increase in autonomous consumption (C̅)
This especially affects spending on consumer durables (cars, appliances) and housing.
How does a change in C̅ (autonomous consumption) impact the consumption function?
Increase in C̅ → Upward shift in the consumption function → More spending at all income levels.
Decrease in C̅ → Downward shift in the consumption function → Less spending at all income levels.
What was the percentage decline in stock prices between March 2000 and October 2002?
Stock prices fell 49% during this period.
How much wealth did households have in stocks in 2000?
Households owned $13.3 trillion in stocks in 2000.
How much household wealth was destroyed by the stock market decline?
The decline potentially wiped out $6.5 trillion in household wealth.
How does a $1 decrease in wealth impact consumption spending?
A $1 decrease in wealth reduces consumption by 3 to 7 cents.
This implies a potential drop in consumer spending of $195 – $455 billion due to the decline in stock wealth.
Despite the stock market crash, what happened to consumption spending?
Surprisingly, consumption spending continued to increase, likely due to factors such as:
Low interest rates → Encouraged borrowing and spending
Housing wealth effect → Rising home prices helped offset stock losses
Government policies → Tax cuts and stimulus efforts boosted disposable income
What happened to consumer spending between 2000–2002 despite the stock market decline?
Consumer spending increased, even though stock prices fell sharply.
What factors contributed to the increase in consumer spending during 2000-2002?
After-tax income increased → More disposable income for households
Interest rates decreased → Lower borrowing costs encouraged spending
Housing wealth increased → Rising home values offset stock market losses
How did lower interest rates affect consumer behaviour?
Lower borrowing costs → More spending on durable goods (cars, appliances, etc.)
What happened to housing prices between 2000–2002?
Housing prices rose by 20%, boosting household wealth and partially offsetting stock market losses.
Why did housing wealth help sustain consumer spending?
Homeowners felt wealthier → Continued spending despite stock market losses
Increased home equity → Borrowing against home value (home equity loans) supported consumption
What is the Marginal Propensity to Consume (MPC)?
The mpc measures how much consumption increases when disposable income (Y - T) rises by $1.
MPC is between 0 and 1:
If mpc = 0.8, then for every $1 increase in income, consumption rises by 80 cents, and savings rise by 20 cents.
What happens if mpc is high?
Higher MPC → More of each additional dollar is spent → Stronger effect on GDP growth.
If mpc is too low, people save more and spend less, weakening economic growth.
What is disposable income (Y - T) in the consumption function?
Disposable income is:
(Y-T) = Total income + government transfers - Taxes
More after-tax income = More consumption
What factors can shift autonomous consumption (C̅)?
Wealth Effect: Rising asset values (stocks, housing) increase C̅.
Interest Rates: Lower rates make borrowing cheaper, boosting C̅.
Consumer Confidence: Higher confidence leads to more spending.
What is Planned Aggregate Expenditure (PAE)?
PAE is the total planned spending on final goods and services in an economy.
It determines the short-run fluctuations in GDP.
The equation for PAE is:
PAE = C + IˆP + G + NX
C = Consumption
I^P = Planned Investment
G = Government Purchases
NX = Net Exports (Exports - Imports)
What are the two dynamic patterns in the economy related to PAE?
Declines in production lead to reduced spending
Fewer goods produced → Lower wages → Less income → Lower spending.
Reductions in spending lead to declines in production and income
If consumers and businesses cut spending → Firms sell less → They cut production and lay off workers → Incomes fall further → More spending cuts.
This creates a vicious cycle of economic decline.
Why is consumption (C) the most important component of PAE?
Consumption is the largest part of spending (about 2/3 of total PAE).
C depends on output (Y): Higher income leads to more spending.
MPC (Marginal Propensity to Consume) determines how much extra income is spent rather than saved.
How does income (Y) affect PAE?
Higher Y (income/output) → Higher consumption → Higher PAE → More production & jobs.
Lower Y → Lower consumption → Lower PAE → Less production & layoffs
In recessions, spending cuts reduce income, worsening the downturn.
In booms, higher spending increases income, boosting the economy.
What is short-run equilibrium in the economy?
Short-run equilibrium occurs when planned spending (PAE) equals actual output (Y).
This means firms are producing exactly what people plan to buy—no unplanned inventory changes.
The equilibrium condition is:
Y = PAE
What happens when Y > PAE?
Output (Y) is greater than planned spending (PAE) → Firms overproduce goods.
Unplanned inventory accumulation → Firms cut production to adjust → GDP falls toward equilibrium.
What happens when Y < PAE?
Output (Y) is less than planned spending (PAE) → Firms underproduce goods.
Unplanned inventory depletion → Firms increase production to meet demand → GDP rises toward equilibrium.
What is the assumption about prices in short-run equilibrium?
Prices are fixed (sticky prices) → Firms adjust output, not prices to reach equilibrium.
This is why changes in demand directly affect production and employment in the short run.
What role do spending changes play in short-run equilibrium?
If consumption (C), investment (I), government spending (G), or net exports (NX) increase, then PAE rises, leading to higher output (Y).
If spending falls, then output falls as firms cut production.
What happens when actual output (Y) is greater than planned aggregate expenditure (PAE)?
Firms produce more than consumers, businesses, and the government plan to spend.
This leads to unplanned inventory accumulation—products sit unsold.
Firms respond by cutting back production, reducing future output.
In the equation PAE = 960 + 0.8Y, what is the planned aggregate expenditure when Y = 5,000?
PAE = 960 + 0.8(5,000)
= 960 + 4,000 = 4,960
Planned spending is $4,960
Since output is $5,000, planned spending is $40 less than output
This leads to unplanned inventory increase of $40 million (or billion)
What does the unplanned inventory accumulation signal to businesses?
It signals that goods are being overproduced relative to demand.
Businesses respond by slowing production in future periods.
This reduces GDP and employment, moving the economy back toward equilibrium.
What does the 45° line (Y = PAE) represent in the graph?
It represents all points where output equals planned spending—short-run equilibrium.
Any point above the PAE line but below the 45° line means output > PAE, leading to excess production.
The economy will adjust downward toward equilibrium at the intersection.
What happens when actual output (Y) is less than planned aggregate expenditure (PAE)?
Firms produce less than what households, businesses, government, and foreign buyers want to spend.
This leads to unplanned inventory depletion—goods are selling faster than expected.
Firms respond by increasing production, which raises output and income.
In the equation PAE = 960 + 0.8Y, what is planned spending when Y = 4,500?
PAE = 960 + 0.8(4,500)
= 960 + 3600
= 4,560
Planned spending is $4,560
Since output is only $4,500, there is an unplanned inventory drop of $60
What does unplanned inventory depletion signal to businesses?
It signals that goods are being underproduced relative to demand.
Businesses respond by increasing production to meet higher-than-expected demand.
This leads to rising GDP and employment, moving the economy toward equilibrium.
What role does the 45° line (Y = PAE) play in this scenario?
The 45° line shows points where actual output equals planned spending.
When the economy is below the line, planned spending > output, and the economy expands.
The economy will move upward toward equilibrium, where the PAE curve intersects the 45° line.
What does a fall in planned spending (PAE) imply in the Keynesian model?
A decrease in autonomous spending (e.g., from 960 to 950) shifts the PAE curve downward.
Planned expenditure is now lower at every level of output.
This results in a new equilibrium at a lower level of output, creating a recessionary gap.
What is a recessionary gap?
A recessionary gap is the difference between the potential output (Y*) and the actual output when the economy is in equilibrium below full employment.
It occurs when PAE is too low to support full employment output.
Given PAE = 950 + 0.8Y, what is the new short-run equilibrium output (Y)?
Y = 950 + 0.8Y
0.2Y = 950
Y = 4,750
New output is 4,750, down from the previous 4,800
This 50-unit decline represents a recessionary gap
What causes a fall in autonomous planned spending (e.g., from 960 to 950)?
A drop in consumer confidence
Lower government purchases
Decreased investment by firms
Fall in exports
Wealth losses or increased taxes
How can policy respond to close a recessionary gap?
Fiscal policy: increase government spending or cut taxes
Monetary policy: lower interest rates to stimulate investment/consumption
Goal: shift PAE upward, restoring equilibrium at full employment
What happens when autonomous consumption (C̅) decreases by 10?
The PAE curve shifts downward by 10 units at every level of output.
This leads to a lower short-run equilibrium level of output.
In this case, output falls from $4,800 to $4,750.
What is the size of the recessionary gap if potential output Y* = 4,800 and new output = 4,750?
Recessionary gap = 4,800 – 4,750 = $50
This gap represents underutilised resources in the economy.
What causes the entire decrease in output in this example?
The entire decrease is due to a fall in autonomous consumption spending (C̅).
Does the same process apply if the decrease occurs in planned investment (Iᵖ), government purchases (G), or net exports (NX)?
Yes.
A decrease in any autonomous component of PAE causes a downward shift in the PAE curve.
This results in a lower output equilibrium and potentially a recessionary gap.
What does this tell us about the economy’s sensitivity to changes in spending?
Even a small decrease in autonomous spending can cause a multiplied drop in output, highlighting the importance of consumer confidence, investment stability, and government spending.
What was the main trigger of the 2007–2009 U.S. recession?
The bursting of the housing price bubble in the summer of 2006, which led to falling home prices, mortgage defaults, and a financial market crisis.
How much did house prices increase annually from 2001–2006?
On average, 8.2% per year.
How does the 2001–2006 housing price growth compare to past periods?
The last similar boom was from 1976–1979, when house prices grew at 4.9% annually on average.
What is the Rule of 72 and how does it apply to the housing market pre-2006?
The Rule of 72 estimates how long it takes an investment to double. At 8.2% growth, housing prices would double in ~10 years; at 4.9%, it would take 15–19 years.
By how much did housing prices fall after the bubble burst?
A 6% decline from 2006–2007, and a total decline of over 20% from 2007–2009.
How did the housing market collapse affect the financial sector?
It triggered a financial market crisis due to the collapse of mortgage-backed securities and increased defaults, severely impacting banks and lending institutions.
How did businesses and households respond to the financial crisis?
They reduced spending due to difficulty borrowing and uncertainty about the economy’s future.
What happened to planned aggregate expenditure (PAE) during the recession?
PAE declined, causing a downward shift in the PAE line in the Keynesian cross model.
What is a recessionary gap, and how does it relate to this period?
A recessionary gap is when actual output falls below potential output. The U.S. experienced this as demand declined and unemployment rose.
What role did uncertainty play in deepening the recession?
Economic uncertainty led to a drop in investment and consumption, exacerbating the decline in aggregate demand.
What were the main demand-side effects of the COVID-19 recession?
Lockdowns, fear, and health concerns caused a sharp reduction in consumer spending.
How did stock market declines during COVID-19 affect consumption?
Falling stock prices reduced household wealth, leading to a drop in autonomous consumption.
How did uncertainty affect business investment during the COVID-19 recession?
Heightened uncertainty and fear led firms to delay or cancel investment plans.
What were the key supply-side effects of the COVID-19 recession?
Many businesses, especially in hospitality, retail, and services, were forced to shut down due to health restrictions.
Why couldn’t firms respond to changes in inventory investment during the COVID-19 recession?
Disruptions in operations and supply chains made it difficult for firms to adjust production in response to falling demand.
What evidence is there about the primary cause of the fall in output during COVID-19?
Although there were supply restrictions, evidence suggests that the major driver of the drop in GDP was a fall in Planned Aggregate Expenditure (PAE).
How did supply restrictions influence what was produced during COVID-19?
Supply constraints shifted the composition of output—certain goods became scarcer while demand shifted toward essentials.
What is a recessionary gap and how did it relate to COVID-19?
A recessionary gap is when actual GDP falls below potential GDP, which occurred during the pandemic due to a sharp drop in output.
Which sectors were hit hardest on the supply side during the COVID-19 recession?
Hospitality, retail, and personal services, as they were directly affected by lockdown policies.
What is the role of PAE in the context of the COVID-19 recession?
A major decline in PAE led to lower output and a recessionary gap, suggesting demand-side shocks were dominant.
