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Effects of the Collapse in Spending on Durables


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In the aftermath of the terror attack on the World Trade Center on September 11, 2001, businesses postponed undertaking investment projects. How could they know whether building a factory or expanding capacity was worthwhile until the uncertainty created by September 11 was resolved? Households also cut back on their purchases of durables. Who wants to be without cash and in deeper debt should the situation grow truly serious? The effect of these decisions is now beginning to show up in the macroeconomic data. On October 25 the U.S. Commerce Department said orders to factories for cars, trucks, television sets and other durable goods dropped 8.5 per cent in September, the biggest decline since January. The drop in orders suggests more declines to come in production, and the 12-month decline in U.S. manufacturing proedution is the longest since World War II. The number of Americans receiving unemployment insurance benefits has already risen to 3.65 million, its highest level since the deep recession of 1980-1982.

The mechanism by which falling spending on durables--either investment goods or consumption goods--by businesses and households leads to declines in real GDP and recession is straightforward, and can be read off of the income-expenditure diagram in chapter 9. The terror attack on the World Trade Center created fear and uncertainty. These led to declines in the baseline level of consumption spending in the consumption function, C0, and in the baseline level of investment spending, I0. These are two key components of autonomous spending A, which determines where the planned-expenditure line meets the y-axis.

Falling Spending on Durables Reduces the Equilibrium Level of Real GDP

Thus the planned-expenditure function is shifting downward. As it shifts downward, its intersection with the 45-degree inventory-balance equilibrium condition line shifts leftward by a multiple of the downward shift in planned expenditure. Equilibrium real GDP and national income falls because of the decline in autonomous spending.

This process is not over all at once. It takes time--and we are now living through its beginnings.

What can the government do to cure the resulting recession? The Federal Reserve can try to boost investment spending by lowering interest rates and making it cheaper and easier to borrow money. The Congress and the President can try to shift the planned-expenditure line up directly by increasing government spending and lowering taxes. But these take time to take effect: just as the recession is likely to gather strength over the next year or so, stimulative government policies put into effect this fall are unlikely to have their effects before next summer.

Previous Handouts

2001-10-28: What Kind of Stimulus (Chapter 13: Stabilization Policy. Chapter 9: Income-Expenditure and the Multiplier.)
2001-10-21: Federal Reserve Reaction to the Terror Attack on the World Trade Center (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)
2001-10-14: Why a Stimulus Package Might Be Desireable (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)

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