Macroeconomics Ch 10
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Transcript of Macroeconomics Ch 10
Keywords: Macroeconomic Equilibrium• A state of national economic
activity wherein aggregate
demand is met by aggregate
supply.
• Short-run macroeconomic
equilibrium occurs when the
quantity of GDP demanded
equals the quantity supplied,
which is where the AD and AS
curves intersect.
Keywords: Resource & Product Markets
• Resource market is the market where factors of
production are traded, for example: labor, capital, raw
materials, machinery etc.
• Product market - is the market where final products
which were produced by means of factors of
production are traded .
Introduction
Self-Adjustment or Instability focus on the adjustment
process – how markets respond to an undesirable
equilibrium:
– Why does anyone think the market might self-adjust
(returning to a desired equilibrium)?
– Why might markets not self-adjust?
– Could market responses actually worsen macro
outcomes?
The Circular Flow of Income (CFI)• The circular flow is a handy model
of macroeconomic activity that highlights the interaction between households and businesses through the product and resource markets.
• The household sector buys production from the business sector through the product markets. Expenditures by the household sector are consumption expenditures. Revenue going to the business sector is gross domestic product (GDP).
The Circular Flow of Income (con)• The business sector hires factor
services from the household sector
through the resource markets.
• Payments made by the business
sector are factor payments. Income
going to the household sector is
national income(NI).
Leakages
Leakage: Income not spent
directly on domestic
output in the national
product market but
instead diverted from the
circular flow of income;
for example, taxes ,
imports, and saving.
Injection
Injection: An addition of spending to
the circular flow of income. For
example, exports from the domestic
markets (X), investments (I) and
government expenditures (G).
L e a k a g e s & I n j e c ti o n s
Three points of leakages and injections that are linked
together are:
1- Taxes
2- Imports
3- Savings
1- Taxes
In reference to taxes paid to the government:
a)Sales taxes are taken out of the circular flow in product
markets.
b)Payroll taxes and income taxes are taken out of
paychecks, so households don’t spend that income.
Taxes are considered as a leakage from the CFI.
Ta x e s ( c o n )
however, this enables the government to provide public goods or quasi
public goods that would otherwise be unavailable to society. Along
with this, the money paid from taxes allows the government to
provide many benefits to society such as health care, infrastructure,
education, defense, etc. These provisions from the government allow
for the nation to prosper and are contribute to the national output of
the nation (GDP), hence these are considered injections into the CFI.
2- Imports
In reference to imports (income not spent directly on domestic output in the national
product market) , the domestic households buy imports from foreign countries,
which are considered to be leakages from the CFI because money is being allocated
towards the purchase of goods and services from foreign product markets.
However, as domestic markets purchase imports from the foreign markets, it allows
the foreign markets to have availability to money that they can then use to
purchase the exports from the domestic markets. The spending on domestic goods
and services by foreign markets allows for money to be put into the CFI, therefore it
is considered to be an injection because this money contributes to the national
output.
3 - Saving
In reference to savings:
a) Households savings (disposable income – household
consumption)
b) Firms savings (Depreciation allowances and retained
earnings)
They are considered as a leakage from the CFI because this
money is not used and is not put directly into the product
market.
Saving (con)
However, this capital that is saved is now available to the
firms and households to use as money for
investments, for lending, or for purchasing other goods
and services. Hence, as the firms and households put
money into the market for these various reasons, it is
considered an injection into the CFI because there is
now more money in the market and this money will
then contribute to the national output.
Leakages and Injections
Businesstaxes
Householdtaxes
ImportsSaving Businesssaving
INJECTIONS
ExportsGovernment spending
Investment
LEAKAGES
Productmarket
Factormarket
Business FirmsHouseholds(disposable
income)
M a c r o E q u i l i b r i u m
• Injections of investment, government
expenditures, and exports help offset leakages
from saving, imports, and taxes.
• Macroeconomic equilibrium is possible only
if ∑ Leakages equal ∑Injections.
M a c r o E q u i l i b r i u m ( c o n )
INJECTIONS
Investment Government spending
Exports
LEAKAGES
Consumer savingBusiness saving
Taxes Imports
•Macroeconomic equilibrium is possible only if leakages equal
injections.
Self-Adjustment?
Classical economists believed that (1) flexible interest
rates and (2) flexible prices equalize injections and
leakages. Consequently, this flexibility would lead to a
macroeconomic equilibrium.
1 - Flexible Interest Rates
Classical economists believed that If consumption
declines Savings picks up Interest rates will fall
Business investment (injections) will increase to
be equal to consumer saving (leakage)
Macroeconomic equilibrium will return.
• Keynes felt that this ignores expectations:
– Investment would fall in response to declining sales.
2- Flexible Prices
Classical economists believed that If demand for output falls
Prices will decline Consumers will buy more output
Macroeconomic equilibrium will return.
• Again Keynes disagreed with the result:
– If prices must be cut to move products, businesses are
likely to rethink present production and futur investment
plans.
T h e M u l ti p l i e r M o d e l
The multiplier model is an economic model that was first
proposed by John Keynes (the founders of modern
macroeconomics). The multiplier model is a model
of output determination -- it tells us what the level of
output (GDP) will be, based on the level of aggregate
demand when the price level is fixed The multiplier
model tells us how much the output (GDP) may change as
the aggregate demand [C + Iplanned + G + (EX – IM)]
shifts due to an initial change in its components .
T h e M u l ti p l i e r M o d e l ( c o n )
The term multiplier refers to the way that an initial
increase in aggregate demand causes a wave effect
that leads to more and more spending and raises
the GDP by a multiple of that initial increase in
spending. The multiplier answers the question: “if
autonomous expenditure rise for some exogenous
reason, how much does total real income (GDP) rise
in equilibrium? ”.
The Multipl ier Process
The main reason why this happens is because when you
spend money, the person who receives that money from
you as payment will turn around and spend some of it. And
the same thing will happen when that person spends his
money -- the person he paid the money to will turn around
and spend some it, too. The chain of spending continues
until there's nothing left to spend.
The Multipl ier Process ( c o n )
This multiplier process works both ways, (1) A drop in consumer
spending (2) An increase in unsold inventories firms will react
by (3) Reducing prices and (4) Cutting back the production
(investment spending) which will leads to (5) A reduction in
wages (household incomes) and (6) An increase in unemployment
rate (7) More lost income (8) Even less consumption.
Accordingly, what started off as a relatively small spending shortfall
escalated quickly into a much larger problem.
The Marginal Propensity to Consume (MPC)
The key concept in the multiplier model is the marginal propensity to
consume (MPC) The fraction of an extra dollar of a person's disposable
income that the person will spend on consumer goods.
Multiplier: The multiple by which an initial change in spending will alter total
expenditure after an infinite number of spending cycles.
11-
MultiplierMPC
The Total Change in Spending
The total change in spending is equal to the initial
change in spending multiplied by the multiplier:
1 1-
Total change initial changein spending in spendingMPC
H y p o t h e ti c a l E x a m p l e # 1 First off, suppose everyone has the same MPC = (0.75) - I withdraw $100 from my savings account and spend it all on a leather jacket.- Biff, the leather jacket salesman, since he has MPC = 0.75, spends (0.75)* $100
= $75 (on a hat).- Cheryl, the hat salesperson, spends (0.75)*$75 = $56 (on a puppy).- Ralph, the dog breeder, spends (0.75)*$56 = $42 (on a haircut) - Olga, the hairstylist, spends (0.75)*$42 = $32 (on food). - and so on.
• Note that each subsequent amount spent is 75% of the previous amount. • After many more iterations the amount spent will be so tiny (75% of a
fractional cent) that we can forget about it. But by then the total increase in spending will have been quite large (∑ spending = [1 /(1-MPC)] * 100 = $400).
Hypothetical Example # 2
2. $100 billion in unsold goods appear
4. Income reduced by $100 billion 5. Consumption reduced by $75 billion
6. Sales fall $75 billion7. Further cutbacks in employment or wages
8. Income reduced by $75 billion more
9. Consumption reduced by $56.25 billion more
Factor markets
Product markets
Business firms
Households
10. And so on
3. Cutbacks in employment or wages
1. Investment drops by $100 billion
10-31
Hypothetical Example (con)Spending Cycles Change in
Spending During Cycle
Cumulative decrease in Spending
First cycle $100.00 $100.00 Second cycle 75.00 175.00 Third cycle 56.25 231.25 Fourth cycle 42.19 273.44 Fifth cycle 31.64 305.08 Sixth cycle 23.73 328.81
Nth cycle 400.00
Hypothetical Example (con)
• An initial drop in spending of $100 billion would decrease total spending by:
1 1-
1 $100 1- 0.75
4 $100
$400
Total change initial changein spending in spendingMPC
billion
billion
billion
Shifts in Aggregate Demand
• The primary cause of shifts in the economy is
aggregate demand. In fact, unlike the aggregate
demand curve, the aggregate supply curve does not
usually shift independently. This is because the
equation for the aggregate supply curve contains no
terms that are indirectly related to either the price
level or output.
AD Shifts & Multiplier Effects
The decline (or increase) in
household income caused by
investment cutbacks (or increase)
will cause an initial shift of the AD
curve (AD0 AD1) to the left (or
right) which in its turn trigger the
multiplier process, causing an
induced shift (multiplier effects)
of the AD curve (AD1 AD2).
Consequently, we have a new AD
curve and a new equilibrium.
Conclusions of Keynes• The basic conclusion of Keynesian analysis is
that the economy is vulnerable to changes in
spending behavior and won’t self-adjust to a
desired macro equilibrium.
• The responses of market participants are
likely to worsen rather than improve market
outcomes.
The Consumption Function
The consumption function is a mathematical formula laid out by Keynes. The formula was designed to show the relationship between real disposable income and consumer spending.
Where:C = Consumer spendinga = Autonomous consumption, or the level of consumption that would still exist even if income was $0.b = Marginal propensity to consume (MPC), which is the ratio of consumption changes to income changes.YD = Real disposable income.
DC a bY
The Consumption Function (con)
• A sudden change in government spending or exports
could get the multiplier ball rolling.
• The multiplier process could also originate with a
change in consumer spending due to changes in the
consumption function. Because consumer spending (C)
outweighs other components of aggregate demand
(AD), the threat of unexpected changes in consumer
behavior is serious.
Changes in The Consumption Function
• When consumer confidence changes, the value of
a changes and the consumption function shifts.
• A change in consumer confidence also change the
value of b, altering the consumer’s willingness to
spend out of each additional dollar in income.
Consumer Confidence
Consumer confidence is affected by various financial, political, and international events.
Source: University of Michigan