The Macro Saga of Bubba and Bubbalonia

When Bubbagets a raise of $20

per week, he spends an extra $15 on fishing gear and other stuff.

When Bubba gets laid-off, he still spends$60 or so---by drawing down past savings.

Can you write the linear equationsthat describe Bubba’s

consumption and saving behavior?

Can you calculate Bubba’s marginal propensity to consume.

Bubba’s MPCis simply ΔC/ΔY:

ΔC/ΔY = 15/20 = 0.75

C = a + bY, where a is Bubba’s zero-income spending,

and b is Bubba’s MPC. C = 60 + 0.75Y

It’s the slope of the consumption equation,the rise over the run.

$60 is the C that corresponds to a Y of zero.It’s the vertical intercept, the C-intercept.

The general form of theconsumption equation is C = a + bY

Bubba’s consumption equation isC = 60 + 0.75Y

The general form of thesaving equation is S = - a + (1 – b)Y

Bubba’s saving equation isS = - 60 + 0.25Y

Noticewhat happens when

we add Bubba’s consumption equation and saving equation:

C = 60 + 0.75Y S = - 60 + 0.25Y

We get: C + S = Y — which is to say that the part of Bubba’s income that he spends plus the part of his income that he doesn’t spend is equal to all of his income.

In the wholly privateEconomy of Bubbalonia,

total income (Y) stands at $8,000.

Consumption behavior (for the whole economy) is given by C = 600 + 0.75Y.

Investment spending is $1,400.

Is Bubbalonia in a Keynesian equilibrium?

Is the Bubblalonian labor force fully employed?

Springinto action!! Run the numbers!

C = 600 + 0.75YY = 8,000

C = 600 + 0.75(8,000)C = 600 + 6,000

C = 6,600I = 1,400

C + I = 6,600 + 1,400E = 8,000

Y = E Bubbalonia is in a Keynesian equilibrium.

However, the labor force may not be fully employed.

Again, this is a Keynesian equilibrium(but the labor force may not be

fully employed).

C = 600 + 0.75YS = -600 + 0.25Y

S = -600 + 0.25(8,000)S = -600 + 2,000

S = 1,400

I = 1,400S = IAlte

rnatively

:

With increasedoptimism, investment

spending rises and Bubbalonia achievesa full-employment equilibrium (without inflation) at an income level of $9,200.

Bubbalonia is still a wholly private economy; consumer spending is still C = 600 + 0.75Y. Just how much is the optimistic business

sector spending on investment goods?And what can you say about the

unemployment rate inBubbalonia?

Y = E Y = C + I

C = 600 + 0.75Y C = 600 + 0.75(9,200)

C = 600 + 6,900 C = 7,500

Y = C + I 9,200 = 7,500 + I

I = 1,700

. The unemployment rate in Bubbalonia is the “natural

rate,” i.e., 5% - 6%.

C = 600 + 0.75YS = -600 + 0.25Y

S = -600 + 0.25(9,200)S = -600 + 2,300

S = 1,700S = I

I = 1,700Alternativ

ely:

Again, the unemployment rate in Bubbalonia is the “natural rate,” i.e., 5% - 6%,Which means that Bubbalonia is

experiencing no cyclicalunemployment.

NOTE:In the pre-optimism equilibrium:

I = 1,400; Y = 8,000.

In the post-optimism equilibrium: I = 1,700; Y = 9,200.

When I rose by 300, Y rose by 1,200.That is, ΔI = 300 implies ΔY = 1,200.

There’s some leverage here,a multiplier of some sort.

Then, investors lost their nerve, got cold feet, and cut back on investment spending by 500.

At what level of income didthe spiraling cease?

Still a wholly private economy with consumer spending given by C = 600 + 0.75Y,

Bubbalonia went into a downward spiral.

Bubbalonia wasenjoying full-employment

(without inflation) while bothincome and expenditures were $9,200.

Investors cut back on investment spending by 500.

ΔI = - 500The investment multiplier is in play here.

ΔY = [1/ (1- b)] ΔI1/ (1-b) = 1/(1 – 0.75) = 1/0.25 = 4ΔY = 4ΔI = 4(- 500) = - 2,000

The downward spiral ceased whenincome fell from $9,200

to $7,200.

A further loss of confidence in Bubbalonia’s

investment sector turnedrecession into depression. The economy

finally found its macro-equilibrium at $5,600.

In desperation, the government hired Bubba himself as its chief economist. Bubba’s staff

told him that C = 600 + 0.75Y and that full-employment income would be $9,200.

Bubba thinks that the governmentshould do some spending.

But how much?

The difference between full-employment income ($9,200) and the current (equilibrium) income ($5,600) is the needed ΔY, i.e., $3,600.

The government-spendingmultiplier is in play.

So, we write: ΔY = [1/(1- b)] ΔG, realizing that 1/(1-b) = 1/(1 – 0.75) = 4.

ΔY = 4ΔG; $3,600 = 4ΔG

That’s how much spendingBubba recommends.

ΔG = $900.

Senator Susan (Bubba) Collins (R-Maine)supported the 2008 Stimulus Package of

$800,000,000,000.She claimed that it would “help to create

three-to-four million jobs.”

$800,000,000,0004,000,000

$200,000 per job=

SENATOR SUSAN COLLINS(R-MAINE)

What happened to the wage rate when the level of income rose from $5,600 to $9,200?

Did it rise, fall, or stay the same?

What would have happened if the Bubba had recommended $1,000 in new government

spending (instead of $900)?

But judged in the context of full employment, the wage rate is stuck just right.

Judged in the context of the depression, the wage rate is stuck too high.

The wage rate remained unchanged

—because wage rates (and prices) are “sticky downwards.”

Spending $1,000 would put upward pressure on W x N with N at fullemployment. Hence, the wage

rate would rise.

Bubbalonia has now matured into a

full-fledged mixed economy.The government taxes, spends, and

manipulates. Equilibrium income is $22,760,but full-employment income is estimated to

be $23,000. Knowing that people save 25 cents out of each additional dollar of income,

Bubba suggests two alternative policies:

. Springinto action!! Run the numbers!

Increase G by _____.OR:Decrease T by _____.

Increase G by _____.OR:Decrease T by _____.

.

ΔY = Yfe – Yeq ΔY = 23,000 – 22,760

So, the needed ΔG is 60.

ΔY = 240Gov’t spending multiplier = 1/ (1- b)

Tax multiplier = -b/ (1- b)

So, the needed ΔT is -80.6080

1/ (0.25) = 4

-0.75/ (0.25) = -3

.

Increase G by _____and increase T by _____.

240240

Suppose that people are concerned about government

budget deficits (because of the uncertainty that they always entail).

What combination of fiscal actions (changes in both G and T) will keep the budget in

balance while driving Bubbalonia from its current equilibrium income of $22,760, to its

full-employment income of $23,000.

.

Frustrated with stimulus packagesand mushrooming government debt,

and with the general fiscal irresponsibilityof Keynesian policymakers,

Bubba retires tothe Isle of St. Canes.

CODA:

a

100

70

C = a + bY

C = 50 + 0.70Y

S = – a + (1 – b)Y

S = – 50 + 0.30Y

When the Isle of St. Canes is functioning at full employment, the Islanders earn $400 billion and spend $330 billion.

During the last recession, when earnings fell to $300 billion, the Islanders spent only $260 billion.

What is the Marginal Propensity to consume on the Isle of St. Canes?

400

330

300

260

Y

C

If total earnings on the Isle of St. Canes falls to zero, how much will the Islanders spend?

MPC = b = 70/100 = 0.70

C = a + 0.70Y

C = a + bY

330 = a + 0.70 (400)

330 = a + 280

a = 330 – 280

a = 50

260 = a + 0.70 (300)

260 = a + 210

a = 260 – 210

a = 50

Can you write the equations that describe the Islanders’ consumption behavior and their saving behavior?