Aggregate Demand - Aggregate Supply Chapter One: MPS, MPC, Spending Multiplier, SRAS, LRAS, Segmented and Extended Models
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 - ImportsSimplifying 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 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)
The 45 degree represents equal spending and saving
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 ExampleSo with a .75 MPC…I $50BI spending becomes another’s Y
New Y = $50BSave $12.5BSpend $37.5BNew spending becomes another’s Y
New Y = $37.5BSave $9.4BSpend $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 $3.9All 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
m x initial in spending =
GDP
4 x $50B = $200 in GDP
Luke Skywalker says,“All this investment gets stuck back in the circular flow and keeps making flowing around.”
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 SupplyIn 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 Supply3 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 Supply2. 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
PL SRAS
11.9
8.9
$636 $836 RGDP(Billions of 2000 dollars)
1933
1929
In the Great Depression,from 1929 to 1933:when deflation occurredand the aggregate PLfell from 11.9 in 1929to 8.9 in 1933, firmsresponded by reducingthe quantity of aggregateoutput supplied from$865 billion to $636 billionmeasured in 2000 dollars.
Shifts in the SRAS1. 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 SRAS2. 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
1. Keynesian
2. Intermediate
3. Classical
PL AS
(3)
(2)(1)
RGDP
Long Run Aggregate Supply
Imagine:
If ALL prices drop by 50% (retail, input, wages, etc.), what will happen to production?
Nothing
LR Aggregate SupplyThe 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 Supplyo Even nominal wages
adjust proportionately
o LRAS’s position on the horizontal axis represents the speed limit or potential (non-inflationary) level of output (i.e. full employment)
LR Aggregate SupplyActual 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:
in labor force
in physical capital
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
• 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
PLLRAS SRAS’
SRAS
Pop Quiz“Along” or “of” SRAS?
1. CPI leads to increased outputAlong 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)