Download Fall 2014 Module 16 Income and Expenditures (Multiplier)

Aggregate Demand Aggregate Supply
Chapter One:
MPS, MPC, Spending Multiplier,
SRAS, LRAS, Segmented and
Extended Models
MPS, MPC, & the Spending
Multiplier
The GDP Formula:
C-Consumer Spending
I-Business Spending
G-Government
Spending
(XM)-Exports - Imports
Simplifying assumptions:
 No government sector
 No international sector
 Leaves us with C and I
Imagine your Grandma
gives you $1,000.
Nice
Grandma!
There are only 2 things to
do:
• Spend it
• Save it
Keynes discovered that we have
a fairly consistent tendency to
both spend and save a
proportion of each increase in
income.
Consumption Function
The 45 degree represents
equal spending and saving
• The fraction of TOTAL DI
(disposable Y) consumed is
called the Average Propensity to
Consume (APC)
• Just because consumers spend
a certain fraction of a given Y
doesn’t guarantee they will
spend the same fraction of any
change in Y that might occur.
• The fraction of any CHANGE in
income that is consumed is
called the Marginal Propensity to
Consume (MPC)
Savings Function
• The ratio of the change in
personal saving to the
change in disposable
personal income is the
Marginal Propensity to
Save (MPS)
• Economists assume the
MPC & MPS are constant
not only because it
simplifies economic
analysis but also because
it fits statistical evidence
MPS can be negative if you are
borrowing money
How much of your $1,000
will you spend?
• What’s your MPC? (the
fraction of any change in
disposable income spent for
consumer goods)
• Let’s say your MPC is .8
• You’ll spend $800 & save
$200
• Your income, when spent,
becomes another’s Y.
National Example:
Imagine businesses spend an extra $50
billion on Investment (business
spending)
How much will Real GDP increase?
• Something more the $50B
(WE cannot answer this question unless we
know the country’s MPC)
MPC =  Consumer Spending
Disposable Income
If consumers spend ~$75 of every extra
$100 then…
$75 = 3/4 or .75 MPC
$100
National Example:
Since households spend part but not all of the increased Y,
MPC must always be between 0 & 1.
--What’s left makes up the MPS
Marginal Propensity to Save: fraction of any change in
disposable income households save
MPS =  Household Saving
 Disposable Income
$25 = 1/4 or .25 MPS
$100
*The MPC + the MPS = 1
National Example
So with a .75 MPC…
I $50B
I spending becomes another’s Y
New Y = $50B
Save $12.5B
Spend $37.5B
New spending becomes another’s Y
New Y = $37.5B
Save $9.4B
Spend $28.1…
And so on, and so on, and so on…
National Example
New
Expenditures
Change in
Y
Change in C
(MPC = .75)
Change in S
(MPS = .25)
I increases by
$50 billion
$50
$37.5
$12.5
2nd round
$37.5
$28.1
$9.4
3rd round
$28.1
$21.1
$7
4th round
$21.1
$15.8
$5.3
5th round
$15.8
$11.9
$3.9
All remaining
rounds
$45.5
$35.6
$11.9
Total
$200
$150
$50
The Multiplier
• Vader finds this to be too
much work
• He came up with this super
cool formula.
• Multiplier = 1/MPS
• Once you got a number
from this multiply it by the
change in spending
• Try it with the last number.
So a $50B  in I will  I by
$50B but will also create
$150B in additional
spending (given a MPC
of .75)
MPS = .25 or 1/4
m=1 =4
1/4
Luke Skywalker says,
“All this investment gets
stuck back in the circular
flow and keeps making
flowing around.”
m x initial  in spending =
 GDP
4 x $50B = $200  in GDP
The Multiplier
• 1/MPS is called the Simple
multiplier because the only
leakage is savings
• In the real world, taxes and
imports are also leakages,
diluting the power of the
spending multiplier
• Currently the complex multiplier
for the United States is
estimated to be 2.
Short Run Aggregate Supply
In the SR, there is a positive
relationship between PL &
RGDP.
Why?
Firms produce when it is
profitable to do so:
Per unit profit =
P per unit - cost per unit
therefore profitability must  in
order to  the quantity
supplied nationally
Short Run Aggregate Supply
3 Reasons profitability might :
1. Misperceptions Theory:
when there is a general 
in prices, firms may be
initially confused regarding
whether consumers
willingness to pay more
reflects an  in D in their
market or inflation  
production thinking D for
product has 
Short Run Aggregate Supply
2. Price Stickiness:
If PL  then P per output  BUT costs fall less
rapidly. Result: profit per unit  so quantity
supplied 
If PL , P per unit of output , costs rise less rapidly,
profit per unit , and quantity supplied 
Short Run Aggregate Supply
3. Nominal wages are “sticky”
(slow to rise & especially
slow to fall)
-- when wages  faster than
output prices, profitability 
and firms  production (move
downward along the SRAS curve)
-- when wages  slower than
output prices, profitability  and
firms  production (move upward
along the SRAS curve)
GDP Deflator: 2000 = 100
SRAS
PL
11.9
8.9
1929
In the Great Depression,
from 1929 to 1933:
when deflation occurred
and the aggregate PL
fell from 11.9 in 1929
to 8.9 in 1933, firms
responded by reducing
the quantity of aggregate
output supplied from
$865 billion to $636 billion
measured in 2000 dollars.
1933
$636
$836
RGDP
(Billions of 2000 dollars)
Shifts in the SRAS
1.
Changes in input prices:  in input
prices are an  in the costs of
production
a) Domestic resource availability
(land, labor, capital,
entrepreneurial ability) ex.
Nominal wages  due to
increased health care premiums;
costs ; production  (SRAS
shifts left)
b) Prices of imported resources
obvious ex:
oil
c) Market power -- monopolies
artificially constrict production of
a necessary input
Shifts in the SRAS
2. Changes in productivity:
workers produce more
output with the same
quantity of inputs
(increased profit level)
SRAS shifts right
3. Changes in the legal
institutional environment
a) business taxes &
subsidies
b) government regulation
3 Ranges of the Segmented AS Curve
AS
PL
(3)
(2)
(1)
RGDP
1. Keynesian
2. Intermediate
3. Classical
Long Run Aggregate
Supply
Imagine:
If ALL prices drop by 50%
(retail, input, wages,
etc.), what will happen
to production?
Nothing
LR Aggregate Supply
The upward slope of
the SRAS is due to
sticky wages / other
prices, BUT wages
always adjust / are
renegotiated in the
LR
LR -- ALL inputs are
flexible & PL has NO
effect on quantity of
output supplied
LR Aggregate Supply
o Even nominal wages
adjust proportionately
o LRAS’s position on
the horizontal axis
represents the speed
limit or potential (noninflationary) level of
output (i.e. full
employment)
LR Aggregate Supply
Actual RGDP is
almost always
above or below FE
(Full Employment)
[i.e. at a SR
equilibrium]
Potential output for
the U.S. has grown
steadily over time
LR Aggregate Supply
Shifts in LRAS due to:
1.  in labor force
2.  in physical capital
3.  in natural
resources
4.  in human capital
5.  in technology
Moving from the SR to the
LR
If the economy is almost
always on its SRAS, why is
LRAS relevant?
Over time, the SRAS will shift
to restore the LR
equilibrium
Actual output = potential
output
Moving from the SR to the
LR
LRAS
SRAS’
• Higher than FE output is only
possible b/c nominal wages are
lower than PL
• Eventually employees negotiate
higher wages
• Input costs 
• SRAS shifts left
*workers can negotiate raises b/c
unemployment is very low
*reverse process for a recessionary
gap
PL
SRAS
Pop Quiz
“Along” or “of” SRAS?
1. CPI leads to increased output
Along SRAS (PL )
2.  in legally mandated retirement benefits paid to workers
leads producers to reduce output
Of SRAS ( in input prices)
3. Suppose the economy is initially at potential output & the
quantity of total output supplied increases. What information
would you need to determine whether this was a shift of
SRAS or a movement along SRAS?
(wither PL: if  probably on SRAS;
if same or  definitely a shift of SRAS)