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 - Imports Simplifying 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 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 Example So with a.75 MPC… I  $50B I spending becomes another’s Y New Y = $50B Save $12.5B Spend $37.5B New spending becomes another’s Y New Y = $37.5B Save $9.4B Spend $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$3.9 All 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 Supply In 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 In 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 Supply 3 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  3 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 Supply 2. 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 $636 $836 RGDP (Billions of 2000 dollars) In the Great Depression, from 1929 to 1933: when deflation occurred and the aggregate PL fell from 11.9 in 1929 to 8.9 in 1933, firms responded by reducing the quantity of aggregate output supplied from $865 billion to $636 billion measured in 2000 dollars.

Shifts in the SRAS 1.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 SRAS 2. 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 Imagine: If ALL prices drop by 50% (retail, input, wages, etc.), what will happen to production? Nothing

LR Aggregate Supply The 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 The 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 Supply oEven nominal wages adjust proportionately oLRAS’s position on the horizontal axis represents the speed limit or potential (non- inflationary) level of output (i.e. full employment)

LR Aggregate Supply  Actual 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  Actual 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  in human capital  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 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 PL LRAS SRAS’ SRAS

Pop Quiz “Along” or “of” SRAS? 1. CPI  leads to increased output Along 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)