Transcript MGMT 510 Week 2

MGMT 510
Lecture 2
Presented By:
Prof. Dr. Serhan Çiftçioğlu
Types of Contracts
Some economists believe that the presence of
contracts
a)
b)
Explicit contracts
Implicit contracts
Between suppliers (producers) and their
customers create price stickiness, meaning
price rigidity in goods and services market.
 Due to these factors, producers do not change prices
easily in the short run even when the demand for the
products change. And they wait until the end of their
explicit contracts to announce new prices.
 Another factor for producers not changing prices
immediately in response to changing conditions of
demand is the fact that they cannot easily know
whether a given change in demand is permanent or
transitory. That’s why they may prefer to wait and
then make a price adjustment.
Price/Wage rigidity
 Similarly presence of wage contracts between firms
and labour unions which usually fixes wage rate over
the duration of wage contract creates an important
reason for the wage rigidity. In other words, even
when demand for their output falls and firms lower
their output, they may not be able to reduce wages or
even fire labour force due to the presence of wage
contracts.
 Therefore the assumptions of short run price and
wage rigidity in Keynesian model seem to be realistic.
Price/Wage rigidity (Cont’d)
 However we note that even in Keynesian
theory firms can change prices if there is an
increase in their unit cost of production. For
example, if the price of energy, raw materials,
wage rate ( or other input prices)
unexpectedly increases even in the short run
firms can increase prices.
 Therefore short run price rigidity is particularly
valid in relation to changing conditions of
demand.
How about the assumption that the economy
operates below full employment or potential
output?
 This is important in the sense that simple Keynesian
model particularly attempts to explain the short run
behaviour of the national income (GDP),
unemployment rate, interest rates, trade balance,
private consumption and savings, price level
investment, budget balance of government and other
variables particularly for economies which are facing
unemployment above the natural rate of
unemployment and their output level is below their
potential or full employment level. Therefore in such
economies there are idle resources such as labour
and capital. This is an important assumption of the
model which helps us to remember the characteristics
of economies for which Keynesian model can be
particularly used to analyse.
(cont’d)
 As a corollary of the first three assumptions,
Keynesian model finally assumes that: in the
short run output (National income or GDP) is
only determined by the level of aggregate
demand (total expenditure or spending) for
domestic output. This is our starting point in
developing mathematical, graphical, and
economic aspects of simple Keynesian
model.
Aggregate Demand
 We note that:
 AD = Aggregate demand on domestic
output or total expenditures or total spending
on domestic output
 AD = C + I + G + E – M
 E – M = X  Net exports or trade balance
 AD = C + I + G + X
Keynesian model says:
 In the short run (during which prices and wages are
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fixed in responses to changes in aggregate demand)
:
Y = AD
Output (GDP) is given by the level of the AD.
But this means:
∆ AD  ∆Y in the short run
Therefore to understand the factors responsible for
short run fluctuations in economies, according to
Keynesian model we need to understand the factors
responsible for fluctuations in AD:
 Since AD = C + I + G + X in the short run
any change in Y must be due to changes in
C, I, G, and X. In other words:
∆C
∆I
∆ Y – (In the short run)
∆G
∆X
 Therefore in developing simple Keynesian
model, we have to analyse the factors that
can cause changes in C, I, G, and X.
Keynesian theory of consumption and
savings
 Definition : Y = C + S + T
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T = Tax revenues of the government
T = t Y, 0< t <1
t = Income tax rate
S= private savings
C=Private consumption
Yd=Disposable income
Yd= Y- T + Tr
Tr = Transfers received from government, such as
pensions, unemployment benefits and subsidies.
Ignoring Tr
 But in this class, for the sake of simplicity we
will assume that Tr=0, so that;
 Yd=Y – T
 Yd= C + S
 So disposable income of households is the
part of their income that can be allocated for
consumption and savings.
Keynesian consumption and savings
functions.
1)
C = a + bYd,
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0<b<1
a= autonomous part of consumption which depends
on factors other than disposable income.
b= marginal propensity to consume (m.p.c.)
S=Yd – C
S= Yd – (a + bYd)
S= -a + (1 – b)Yd
2)
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1-b= marginal propensity to save (mps)
Substituting for Yd into equation 1 and 2, we get
C= a + b(1 – t)Y
S= -a +(1 – b)(1 - t)Y
Note that Yd = Y- T = (1 – t) Y
3)
4)
 According to Keynesian theory, the most important
factor that affects C and S levels of households is
their disposable income which is positively affected
by their income level (Y) and negatively affected by
the prevailing income tax rate (t). In other words,
higher Y leads an increase in Yd, whereas higher t
leads to a decrease in Yd through an increase in T
(total tax payment of households to government).
 But there are other factors that can affect C and S.
So first we list all the factors and explain how each
one of the other factors affects C and S decisions of
households and then present the C and S functions
graphically.
Factors affecting consumption and
saving decisions of households
1.
2.
3.
4.
5.
Disposable income (Yd)
Real interest rate (r)
Wealth (W)
Expected future disposable income
Rate of time preference for present vs.
future consumption
(1) Disposable income (Yd)
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An increase in Yd (either due to an increase
in Y or due to decrease in t which lowers T)
affect both C and S positively
(2) Real interest rate (r)
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r= i - ∏e
∏e= expected inflation rate
i=nominal interest rate
There are two opposite effects of a given increase in r
on C and S:
a-) Substitution effect (S.E)
b-) Income (or wealth) Effect (I.E)
The net effect is given by the sum of these two effects.
SE: Increase in r  increase in opportunity cost of
present consumptions in terms of foregone future
consumption
 Decrease in present consumption and increase in
present savings in order to be able to consume more in the
future.
(2) Real interest rate (r) (cont’d)
I.E: Increase in r  increase in expected future income
streams from a given financial wealth ( or given savings)
increases the “perceived” wealth of the household
 Decrease in present savings and equivalent increase in
present consumption
 Most empirical studies suggests that there is a slight negative
relationship between r and C for most countries. In other
words as r increases C decreases, and S increases slightly
indicating that S.E dominates I.E so that the net effect of a
given increase in r on C is slightly negative and its net effect
on S slightly positive.
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(3) Wealth (W)
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An increase in wealth is expected to
increase C positively and S negatively. In
other words, households will start
consuming bigger share of their disposable
income and save smaller fraction of it in
response to a given increase in their wealth.
Example: changes in stocks market prices
can change the financial wealth of
households affecting C and S.
(4) Expected future disposable income
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An increase in expected future income or a
decrease in expected future taxes will
increase the value of expected future
disposable income leading to a decrease in
private savings and an increase in private
consumption in the economy.
(5) Rate of time preference for present
vs. future consumption
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An increase in the time preference of
households for present consumption and
against future consumption will lead them to
decrease their present savings and
increase their present consumption. This
parameter largely depends on cultural
factors as well as the nature of the social
security system.