Study guide: The Short Run

📋 Course Outline

1. GDP Components and Circular Flow
2. Goods Demand and Consumption
3. Equilibrium Output and Multiplier
4. Investment and Saving Equilibrium
5. Thrift and Strategic Dilemmas
6. Limits of Fiscal Policy

📖 1. GDP Components and Circular Flow

🔑 Key Concepts & Definitions

• Net exports: Also called the trade balance, exports minus imports.
• Fixed investment: The sum of non-residential investment and residential investment.
• Inventory investment: The difference between goods produced and goods sold in a given year.
• Government spending: Purchases of goods and services by federal, state, and local governments, excluding government transfers.

📝 Essential Points

• With fixed prices and wages, changes in demand change production, changes in production change income, and changes in income change demand.

📌 Economic investment adds to global potential output, whereas financial investment refers to investment from a financial perspective and is not included in the economic definition.

📌 A trade surplus occurs when exports exceed imports, whereas a trade deficit occurs when imports exceed exports.

📖 2. Goods Demand and Consumption

🔑 Key Concepts & Definitions

• Goods demand: Total goods demand is the identity $Z \equiv C + I + G + X - IM$, where consumption is final consumption.
• Disposable income: Disposable income is income remaining after taxes are paid and government transfers are received, defined as $Y_D \equiv Y - T$, where T is taxes minus government transfers.
• Consumption function: Describes consumption as a function of disposable income and is a behavioural equation representing consumer behaviour.

★ Must-know

📐 Formula - The linear consumption function is $C = c_0 + c_1Y_D$, where $0 < c_1 < 1$, c1 is the propensity to consume, and c0 is consumption when disposable income is zero.

📌 Endogenous variables are determined by other variables within the model, whereas exogenous variables are taken as given and are not explained within it.

Further detail

📌 In a closed economy, $X = IM = 0$ and goods demand is $Z \equiv C + I + G$.

• A change in c0 shifts consumption at every given level of disposable income, while consumption increases less than one-for-one as disposable income rises under the short-run assumption that c1 is below 1.

• The propensity to consume is not unique across income groups and is lower for relatively richer households.

• Investment, government spending G, and taxes T are assumed exogenous in this chapter, with G and T chosen by the government.

📖 3. Equilibrium Output and Multiplier

🔑 Key Concepts & Definitions

• Autonomous spending: Autonomous spending is $c_0 + I + G - c_1T$ and does not depend on output.
• Multiplier: The multiplier is $\frac{1}{1-c_1}$ and is larger when the propensity to consume c1 is closer to 1.

★ Must-know

📌 In goods-market equilibrium, all demanded goods are supplied, so production equals demand: $Y = Z$.

📐 Formula - With a closed economy and the linear consumption function, equilibrium output is $Y = \frac{1}{1-c_1}(c_0 + I + G - c_1T)$.

• An increase in autonomous spending raises demand, production, and income in successive rounds, with each further demand increase equal to c1 times the preceding income increase.

Further detail

• When c1 equals 0.6, the multiplier is 2.5, so an increase in autonomous spending of €1 billion raises output by €2.5 billion.

📐 Formula - The cumulative increase after n + 1 rounds is the geometric series $1 + c_1 + c_1^2 + \cdots + c_1^n$, whose limit is $\frac{1}{1-c_1}$.

• With a propensity to consume of 0.8, a demand increase of 100 raises equilibrium output by $100 \times \frac{1}{1-0.8} = 500$.

• The multiplier depends on the propensity to consume, which can be estimated using econometrics, the set of statistical methods used in economics.

📌 The model treats output adjustment as instantaneous, but in reality its duration depends on how and when firms revise production schedules.

• Unplanned inventory investment is the difference between planned expenditure $Z = C + I + G$ and actual expenditure $Y = C + I + G$; goods-market equilibrium occurs when unplanned inventory investment is zero.

💡 Memory Hook

Higher demand raises production and income, which feeds back into further demand.

📖 4. Investment and Saving Equilibrium

🔑 Key Concepts & Definitions

• Private saving: Private saving is the part of disposable income that is not consumed, defined as $S \equiv Y_D - C = Y - T - C$.
• Public saving: Public saving is defined as taxes minus government spending, $T - G$; positive public saving is a budget surplus and negative public saving is a budget deficit.
• Propensity to save: The propensity to save is $1-c_1$ and lies between 0 and 1 when the propensity to consume c1 lies between 0 and 1.

★ Must-know

📐 Formula - Starting from $Y = C + I + G$, the goods-market equilibrium condition can be written as $S = I + G - T$, or equivalently $I = S + (T-G)$.

📌 Goods-market equilibrium can be stated equivalently as production equaling demand or as investment equaling saving, with public saving included in the latter relation.

Further detail

• John Maynard Keynes articulated the alternative investment-equals-saving approach in The General Theory of Employment, Interest and Money (1936).

💡 Memory Hook

Production equals demand in the goods-market view; investment equals saving in the alternative view.

📖 5. Thrift and Strategic Dilemmas

🔑 Key Concepts & Definitions

• Paradox of thrift: Attempts by individuals to save more can reduce aggregate demand and output, potentially lowering total saving.
• Fallacy of composition: The assumption that what is true of the parts must always be true of the whole.

📝 Essential Points

• In the model, a decrease in c0 and/or c1 represents consumers' decision to save more and leads to lower output.

• At equilibrium, saving cannot change when investment, taxes, and government spending remain fixed, because $I = S + (T-G)$.

• Keynes noted the appearance of the paradox in Bernard Mandeville's The Fable of the Bees: or, Private Vices, Publick Benefits (1714).

• In the prisoners' dilemma described, defection is a strictly dominant strategy for both prisoners, and mutual defection is the only Nash equilibrium, but it is not a strong Nash equilibrium.

💡 Memory Hook

Collective attempts to save more can reduce demand, output, and total saving.

📖 6. Limits of Fiscal Policy

★ Must-know

• The model implies that the government can use G or T to affect the level of output it wants, but it omits important real-world constraints.

Further detail

• Changing government spending or taxes is not easy, and changes in investment and imports can make policy effects difficult to assess.

• Expectations may affect the outcomes of fiscal policy.

• Fiscal-policy effects on output may be unsustainable in the medium run.

• Cutting taxes or increasing government spending can lead to large budget deficits and public debt in the long run.