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Chapter 8

Chapter 8

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ECON 1100
Eveline Adomait

Chapter 8: Spending and Output in the Short Run The Keynesian Model’s Crucial Assumption: Firms Meet Demand at Preset Prices - In the short-run firms meet the demand for their products at preset prices - Firms do not respond to every change in demand, they generally set a price for some period and then meet demand at that price - Meeting the demand means that firms produce just enough to satisfy their consumers at the prices that have been set Menu Costs: the costs of changing prices Planned Aggregate Expenditure - Increases in output which imply increases income cause consumption to rise - The graphical solution is based on the Keynesian Cross which shows the relationship of PAE on output - Short-run equilibrium output is determined at the intersection of the two lines, when S-RE output differs from potential output an output gap exists - Increases in autonomous expenditure shift the expenditure line upward, increasing the S-RE output - Decreases in autonomous expenditure shift the expenditure induce declines in the S-RE output, also it can drive the actual output below potential output which can cause a recession PAE: total planned spending on final goods/services (PAE=C+I +G+NX)  C=consumer expenditure, I=private-sector investments, G=government purchases, NX=net exports Disposable Income: income that includes the addition of transfers and the deduction of taxes Net Taxes: taxes – transfers Consumption Function: the relationship between consumption spending and it determinants, such as disposable (after tax and transfer) income (C=C+mpc (Y-T)) Wealth Effect: the tendency of changes in asset prices to affect households’ wealth and thus there spending on consumption goods/services Asset Price Bubble: occurs when the price of a financial/real asset/asset category rises much more rapidly than prices in general and by much more than can be explained by fundamental factors Marginal Propensity to Consume (MPC): the amount by which consumption rises when disposable income rises by $1, we assume that 0
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