Transcript Chapter 10 Presentation - Kellogg Community College

Macroeconomics
Unit 10
Self-Adjustment or Instability?
Introduction
In this unit we examine what happens when more money is
available for consumers and businesses to spend. We will also
examine the impact of changes in government spending.
The two major problems at equilibrium will be explored – one
leading to a recession and the other leading to inflation.
How do we get the economy back to where we want it to be?
Concept 1: Leakages and Injections
Within the circular flow, not all income
generated becomes spending.
A leakage is income not spent directly
on domestic output but instead diverted
from the circular flow. Consumer
savings, imports, consumer taxes are
leakages.
Business saving (retained earnings) and
business taxes are also leakages.
Concept 1: Leakages and Injections
Also within the circular flow, additional
spending is occurring using income not
currently generated. This type of spending
relies upon savings, credit, and government
transfer payments.
An injection is an addition of spending to the
circular flow of income. Business investment
(spending of retained earnings) and exports
are injections. When consumers spend their
savings, the amount spent is considered an
injection.
Concept 1: Leakages and Injections
If leakages and injections are in balance then the circular flow
is intact. Frequently they are out of balance, with leakages
exceeding injections.
Increased government spending, lower tax rates to increase
consumer spending, or increased transfer payments are
needed to increase the injections into the circular flow.
The stability of the economy is dependent upon leakages and
injections being in balance.
Concept 2: The Multiplier Process
As economic slowdowns begin and output declines, businesses
begin laying off people and cutting back on production. Laid off
people spend less money, so they demand less goods and
services.
Business inventories continue to increase as consumer
spending declines. Additional workers are laid off and
production is reduced. The increase in unemployment causes
more people to spend less on goods and services.
Other consumers worried about their jobs reduce their
spending as well and increase saving.
Concept 2: The Multiplier Process
The Marginal Propensity to Consume (MPC) provides us with a
clue as to how consumers will react to continued job layoffs and
spending reductions. The MPC may change from .95 to .75 or
lower as this multiplier process continues.
An initial $100 billion reduction in consumer spending may end
up affecting the economy by $400 billion or more depending
upon the MPC.
Concept 2: The Multiplier Process
3. Income reduced by $100 billion
4. Consumption reduced by $75 billion
Households
7. Income reduced by
$75 billion more
8. Consumption reduced
by $56.25 billion more
Factor
markets
Product
markets
6. Further cutbacks in
employment or wages
2. Cutbacks in employment or wages
9. And so on
Business
firms
5. Sales fall $75 billion
1. $100 billion in unsold goods appear
The Multiplier Process
The multiplier is a multiple by which an initial change in
spending will alter total spending after an infinite number of
spending cycles.
The formula for the multiplier is:
Multiplier = 1 / (1 – MPC)
The Multiplier Process
We can use the multiplier to predict the total change in
spending based upon the initial reduction in spending.
Total change in spending =
multiplier X initial change in spending
Concept 2: The Multiplier Process
For example, the MPC = .75, what is the multiplier?
Multiplier =
1/ (1 – MPC) = 1/ (1 - .75) = 4
Using the multiplier value of 4, we can then determine the effect
of a reduction in spending.
Concept 2: The Multiplier Process
If the initial change in spending = $100 billion, what will the total
change be if the MPC = .75?
Total change = multiplier X initial change
Multiplier = 1 / (1 - .75) = 4
Total change = 4 X $100 billion
Total change = $400 billion per year
An initial spending reduction of $100 will produce further
spending reductions of $300 billion, for a total of $400 billion!
Concept 2: The Multiplier Process
The $100 billion dollar reduction in spending, which takes our
economy from full employment to a GDP gap, results in a $400
billion reduction, further widening the gap.
The process will continue to occur and amplify unless there is a
change in consumer confidence or government intervention.
The AD curve continues to shift to the left as less output is
demanded.
Concept 2: The Multiplier Process
The value of the multiplier is dependent upon the marginal
propensity to consume (MPC). If the MPC = .75, the multiplier
is 4. If the MPC = .90, the multiplier is 10. So why is this
important?
Simply because the larger the multiplier, the larger the effect of
an initial spending decrease (or increase). If the amount of the
initial spending decrease is $100 billion, and our multiplier is 4,
the total amount of the spending decrease is $400 billion. But if
the multiplier is 10, then the initial spending decrease of $100
billion totals $1 trillion after the multiplier effect!
Price Level (average price)
Multiplier Effects
$100 billion decrease in spending/MPC = .75
C = $300 billion
P0
AS
I = $100 billion
m
D
F
B
C
AD2
2600
2800
QF = 3000
Real Output (in billions of dollars per year)
AD0
AD1
Concept 3: Recessionary GDP Gap
AD shifts left from point F at full employment to point D. At this
point a recessionary gap has formed. If prices fall a new
equilibrium is found at point B.
As the initial spending reduction is amplified by the multiplier
process, AD shifts again to the left further increasing the
recessionary gap to point M. Once again if prices have fallen
again the new equilibrium point is found at point C.
Even with lower average prices on goods and services,
consumers are reluctant to increase spending.
Concept 3: Recessionary GDP Gap
As long as the supply curve remains upward sloping and
unchanged, a recessionary GDP will occur between the current
level of output, and the necessary level for full employment.
Cyclical unemployment will increase as a result of more people
losing their jobs due to declining output. Output continues to
decline as more people lose their jobs and total consumer
spending declines.
PRICE LEVEL (average price)
Concept 3: Recessionary GDP Gap
Output is reduced along with prices
in a recessionary gap
AS
AD2
m
P0
a
c
PE
AD0
Recessionary
GDP gap
REAL OUTPUT
QE
QF
Unemployment & Inflation
In order to reduce or eliminate the recessionary GDP gap,
aggregate demand must increase. Consumers need to
increase their spending on goods and services; additional
business and government spending is also desired.
As aggregate demand increases, so do average prices. Rising
average prices causes inflation.
Inflation is the tradeoff associated with increasing
aggregate demand.
Concept 4: Inflationary GDP Gap
The multiplier process can also be applied to situations where
excessive aggregate demand occurs. In this situation, we have
demand-pull inflation. Can we really have too much aggregate
demand? Yes! In this case demand is above our full
employment level of output. Equilibrium GDP is above the full
employment GDP.
Sudden increases in consumer spending, business investment,
or government spending when the economy is at full
employment can cause an inflationary GDP gap.
Excessive demand causes average prices to rise.
Price Level (average price)
Demand-Pull Inflation - Inflationary GDP Gap
C
I
AS
= $300 billion
= $100 billion
P6
P0
w
r
a
AD5
AD0
QF
Real Output
QE
AD6
Concept 4: Inflationary GDP Gap
The inflationary gap first occurs as initial spending increases
and shifts AD to the right. The multiplier effect further shifts AD
to the right causing prices to increase further.
In addition to increased consumer spending or an increase in
business investment, changes in business inventories are
monitored.
Dramatic reductions in business inventories are a sign that
inflation is approaching.
Instability
According to Keynes, the economy is vulnerable to abrupt
changes in spending behavior and won’t self-adjust.
Initial shifts in AD are magnified as they move through the
economy. The multiplier provides us with the net effect of an
AD shift.
Recurring business cycles occur due to shifts in AD and the
multiplier effect. The shifts in AD may be due to sudden
economic shocks, war, politics, or waning consumer
confidence.
Concept 5: Consumer Confidence
An important consideration associated with closing
recessionary GDP gaps is consumer confidence.
Consumer confidence is a measurement of consumer
attitudes towards economic conditions. Two commonly
discussed surveys of consumer confidence are the Conference
Board survey and the survey conducted by the University of
Michigan.
Both surveys are conducted monthly and are designed to
measure consumer attitudes toward the economy. For more
information about the surveys, go to http://www.conferenceboard.org/ or http://www.reuters.com/universitymichigan and
http://www.sca.isr.umich.edu/
Concept 5: Consumer Confidence
Changes in consumer confidence affect consumption.
Specifically, changes in consumer confidence causes a shift in
autonomous (non-income) consumption.
An increase in consumer confidence causes autonomous
consumption to increase. This will cause an upward shift in the
consumption function. As the consumption function shifts
upward, the aggregate demand curve shifts to the right.
Naturally, declining consumer confidence causes the opposite
effect. Autonomous consumption declines, the consumption
function shifts downward, and the aggregate demand curve
shifts to the left.
Summary
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Leakages.
Injections.
Multiplier effect.
Using the multiplier to calculate total changes in spending.
Employment/Inflation tradeoff.
Recessionary GDP gap.
Inflationary GDP gap.
Instability.
Consumer confidence.