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

1. $100 billion in unsold goods appear

3. Income reduced by $100 billion 4. Consumption reduced by $75 billion

5. Sales fall $75 billion6. Further cutbacks in employment or wages

7. Income reduced by $75 billion more

8. Consumption reduced by $56.25 billion more

Factor markets

Product markets

Business firms

Households

9. And so on

2. Cutbacks in employment or wages

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!

Multiplier Effects$100 billion decrease in spending/MPC = .75

Real Output (in billions of dollars per year)

Pri

ce L

eve

l (a

vera

ge p

rice

)

QF = 3000

m FP0

2600 2800 AD2

C

I = $100 billionC = $300 billion

B

D

AD1

AS

AD0

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.

Concept 3: Recessionary GDP Gap

REAL OUTPUT

PR

ICE

LE

VE

L (a

vera

ge p

rice

)

QE QF

P0

PEAD0

AD2

AS

c

m a

Recessionary GDP gap

Output is reduced along with prices in a recessionary gap

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.

Demand-Pull Inflation - Inflationary GDP Gap

Real Output

Pri

ce L

eve

l (a

vera

ge p

rice

)

a

w

r

AD0

AS

QF QE

P0

P6

AD5

AD6

C = $300 billion

I = $100 billion

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 ConfidenceAn 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.conference-board.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• 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.