Essentials of Economics

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Essentials of Economics

• Business 502

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What Determines Output and Unemployment?

• It seems that there is some involuntary
  unemployment in our market economy, at least
  sometimes.
• What determines how much?
• Expenditure? Income?

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Aggregate Demand

• Since Malthus -- but especially since John
  Maynard Keynes -- some economists have argued
  that unemployment results from deficient
  aggregate demand.
• In the same way, inflation is connected to
  excessive aggregate demand.

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J. M. Keynes
A. C. Pigou
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Expenditure

• Consumption expenditure.
• Investment expenditure.
• Government expenditure.
• Net Exports.

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Consumption 1
Marginal Propensity to Consume -- abbreviation
MPC From one additional dollar of income (after
taxes), the Marginal Propensity to Consume is the
fraction of the dollar that is spent on
consumption. (The rest is saved).
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Consumption 2
Autonomous Consumption Autonomous consumption is
the portion of consumption expenditure that does
not depend on income.
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Consumption Function
1. C a bY where C is the consumption
expenditure, (in billions of 1992 dollars, for
example), Y the national income (in the same
units) and a and b are constants. The constant b
is the Marginal Propensity to Consume. The
constant a is autonomous consumption.
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Consumption Function
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Some Real Numbers
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More of the Model

• Y C I G NX
• Y is total income or RGDP
• C is consumption expenditure
• I is investment expenditure
• G is government purchases of goods and services
• NX is net export expenditures
• For simplicity, assume G, NX zero and I given.

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Putting it Together
1. Y C I G NX 2. C a bY For an
illustrative example, make that 2. C 2500
0.6Y And assume I1500, GNX0
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Multiplier
Here a drop in planned consumption results in a
decrease of production about 3 times as large --
a multiplier of 3. A big issue in February 2009
was which policy changes have bigger
multipliers?
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Remember,

• Consumption has two components
• autonomous consumption
• the part that doesn't depend on income
• induced consumption
• the part that does depend on income

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Currently,

• There are many indications that consumer spending
  is falling, both because consumers cannot get
  loans, and because consumers are growing much
  more pessimistic about their incomes over the
  near to middle future.

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Paradox of Thrift

• Now suppose
• people try to increase their saving
• this leads to a decline in equilibrium income
• their saving is no more than before
• The reduction in income offsets the increase in
  intended saving. How do the two changes balance
  out? In this simple model, they cancel out
  exactly -- although people have tried to increase
  their saving, the result is a drop in equilibrium
  income and no change in saving. This is called
  The Paradox of Thrift.

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Booms

• We should point out that an increase in
  consumption would also have a multiplier effect.
  In our numerical example, an increase in
  autonomous consumption by 100 billion dollars
  would increase equilibrium production by
  100333.33 333.33 billion dollars. The
  multiplier works in both directions.

US saving rate
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Investment 1

• A change in investment will also cause a change
  in production in the same direction, with a
  multiplier.

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A few years ago

• One of the most prominent causes of the recession
  of 01 was a drop in investment spending.
• The Japanese decline began in a similar way,
  after a period of great investment growth in the
  1980s.

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Investment 2

• For example, house construction is an important
  part of investment.

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Investment 3

• Here is the longer view

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Investment 4

• The decline in investment played a key part in
  the Great Depression.

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Taking Stock (Pun Intended)
Just what sort of "equilibrium" is this?
Inventories are a key to the answer. Inventorie
s are stocks of goods held in businesses to
bridge the gap between unpredictable sales and
scheduled deliveries.
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Plan-Fulfillment Equilibrium
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Keynes Other Model 1
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Keynes Other Model 2
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Inventory-Sales Ratio
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Inventories

• Note the key role of inventories in both graphs.
• Inventories are considered a key factor in the
  business cycle. (But why?)
• However, the ratio of inventories to sales has
  shown a downward trend recently. (Why?)
• Although below their recent average, inventories
  are now much above trend. (So What?)

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How Big is the MPC?

• It all depends

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Time

• If we look at a longer time period, people can
  adjust more completely to changes.
• Also, some of the short-term changes average out.

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Example Joan Doe Has

• Income of 70,000 per year (after taxes)
• Lease with rent bill of 24,000 per year
• Her consumption is 240000.5Y 35,00024,000
  59,000
• She saves 11,000
• Her lease will not expire until the end of the
  third quarter

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In the Second Quarter

• Joan Does income drops to 50,000 and remains at
  that level.
• At 240000.5Y, Joan consumes 24,000 25,000
  49,000
• She saves 1000
• Joan might like to cut back on her rental cost,
  but her lease will not expire until the end of
  the third quarter.

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For a Single Quarter,

• Joans autonomous consumption is 24000
• Her MPC is 0.5

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Longer Term

• On October 1, she moves into a downsized
  apartment at a monthly rent of 1400, for rental
  expenditure of 16,800 on an annualized basis.
• Her consumption for other goods and services
  continues at the rate of 25,000
• In the fourth and subsequent quarters her
  consumption is 41,800 and her saving is 8,200.

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Autonomous Consumption, Income, and MPC for One
to Eight Quarter Periods
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Implication
When we observe data averaged over a longer
period, on the whole, we would suppose that the
adjustment will be more complete, so that the MPC
will be greater and the autonomous component
less. On the whole, that is what we observe.
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Permanent Income Hypothesis

• This example reflects the permanent income
  hypothesis -- that consumption depends on (what
  people perceive as) their permanent income.
• This hypothesis is due to Milton Friedman
  (1912-2006).

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Expectations and Uncertainty

• Principle the Surprise Principle
• Economic agents respond differently to the same
  changes in their opportunities and other economic
  circumstances depending on whether the changes
  are anticipate or come as a surprise.
• In particular, the marginal propensity to consume
  and the autonomous consumption will depend on
  whether the change in income is anticipated or
  comes as a surprise. (Lower MPC, usually.)

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Interim Summary

• MPC and autonomous consumption depend on
• Whether a change in income or economic
  circumstances comes as a surprise or is
  anticipated,
• Expectations of future economic circumstances,
• Uncertainty about future economic circumstances,
• The length of the time period over which the data
  are averaged

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How Long a Time Period is Right?
According to Franco Modigliani (1918-2003),
antifascist resistor and Nobel Laureate macro-
economist, the life cycle is the right period
for many purposes.
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According to Modigliani,

• a rational person would (as nearly as possible)
  base saving and consumption decisions on lifetime
  income. Also these decisions will differ over the
  life cycle
• Young students often dissave
• Ditto elderly retired people
• Younger families may save little
• People in the prime earning years need to save a
  lot

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But Many People Dont Come Close --

• For example, from Modiglianis viewpoint, most
  students dont borrow enough
• One thing the theory overlooks is that what one
  can borrow tends to be limited by ones assets.
  The lender will often want some collateral
  against the loan. Then the borrower is Liquidity
  Constrained.
• Without assets, you may not be able to borrow at
  all, or pay penalty interest rates.

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Another Complication
A persons MPC will depend on whether or not she
is liquidity constrained, and if so, the MPC may
be quite large since additional income can be a
source of increased collateral to borrow!
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Another Interim Summary

• The life cycle perspective helps us to understand
  saving behavior.
• On the one hand, adjustments (and the MPC) can be
  higher if we average over a longer period.
• Lifetime income is the first consideration in
  deciding consumption and saving.
• However, liquidity constraint (like short time
  limits) can limit the persons ability to adjust
  to lifetime income considerations.

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Unemployment Two Views

• The "Keynesian" view of Unemployment
• Unemployment is an excess supply of labor
  resulting from a failure of coordination in the
  market economy.
• The "Classical" view of Unemployment
• Unemployment is job search -- people engaged in
  the productive work of looking for a better match
  between worker and employer.

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Definitions

• unemployed
• A person is said to be "unemployed" if he or she
  is looking for work, is willing to work at the
  prevailing wage, but is unable to find a job.
• unemployment
• Unemployment refers to the condition of being
  unemployed, or to the number or proportion of
  people in the working population who are
  unemployed.

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Excess Supply

• Some economists, especially in the Keynesian
  tradition, think of unemployment as an excess
  supply of labor.
• However, there are some problems with this view.

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Controversy -- of course

• Many "conservative" economists just do not accept
  the idea that unemployment, as we usually think
  of it, is an excess supply of labor.
• Many "liberal" economists would say that the
  supply-and-demand interpretation points in the
  wrong direction. Looking at the diagram, we would
  say that wages are "too high" and that the
  solution of the problem is to decrease wages. But
  that seems a hasty conclusion.
• The excess-supply model suggests that real wages
  would be higher in recessions than in booms, but
  the opposite is true.

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Concepts

• the labor force
• The labor force consists of all those persons who
  are willing to work at a market equilibrium wage,
  and who either have jobs or are seeking work.
• unemployment rate
• The unemployment rate is a ratio, obtained by
  dividing the number of unemployed persons by the
  number of persons in the labor force.

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Says Law
Say reasoned that there could never be
unemployment because consumption could never be
deficient. The only reason to produce, he
reasoned, is to be able to consume, either to
consume ones own production or to sell it in
order to consume the production of others.
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Time!

• Savers and investors are different groups in
  society.
• Savers are people who produce today in order to
  consume in the future.
• Investors are people who consume today in order
  to produce in the future.
• Thus, at any particular moment in time, there
  could be more production today in order to
  consume in the future than there is consumption
  today in order to produce in the future that is,
  more (planned) production than consumption.
• (Thanks to John Stuart Mill for that argument.)

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Coordination Failure

• If
• Consumers plan to save more or less than
  investors plan to invest,
• Then
• We have a failure of coordination between
  consumers and investors.

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Coordination Failure
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A Counterargument
Markets will take care of it.
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Why Dont Wages Drop?Efficiency Wage
In some circumstances a decrease in wages below a
certain level causes the employees to cut back on
their effort, so that productivity drops off at
the lower wage. If productivity drops enough, the
cut in wages actually reduces profits. So
businessmen may be maximizing their profits by
keeping the wage above the market equilibrium.
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Reasons

• Effort and productivity will be greater when
  workers have something to lose by being let go.
• Labor turnover is costly, and keeping wages above
  the market minimum reduces costly turnover.
• In a learning economy, lower turnover gives
  employees more opportunity and incentive to learn
  the job, leading to still higher productivity in
  the longer run.
• Workers may be motivated by reciprocity, so that,
  when they feel their wages are less than they
  deserve, they take revenge by withdrawing
  effort.

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Interpret with Caution

• Some things left out of that simple view include
• The influence of interest and money.
• The crucial role of expectations.
• The position of the consumer in the life cycle.

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Interest and Investment 1

• Until now we have been treating investment as
  given. Thats over simple -- so what might
  influence investment?
• One important variable that would influence
  investment is the rate of interest, because
  interest is a key cost of investment.

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Interest and Investment 2

• If the investor must borrow to invest, clearly he
  or she must make enough to pay the "note," i. e.
  to repay the loan with interest.
• Even if the investor takes the money from his or
  her bank account, the investor must give up the
  interest she would otherwise get -- and that's an
  "opportunity cost."

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Discounting

• Potential investments can be evaluated in terms
  of their discounted present value.
• The higher the interest rate, the higher the
  discount rate and so (in general) the less
  attractive long-term investments will be.
• Internal Rate of Return
• The rate of interest at which an investment will
  just break even is called the "internal rate of
  return" for that investment.

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The Marginal Efficiency of Investment

• Marginal Efficiency of Investment
• The Marginal Efficiency of Investment is a
  relationship between interest and investment that
  tells us, for each respective interest rate, the
  amount of investment that can be undertaken
  profitably, ceteris paribus.
• Abbreviation MEI

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What Determines Interest?
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Aggregate Demand

• So far we have said little or nothing about the
  price level.
• We should think of this as a model of the
  determination of aggregate demand with a given
  price level.
• But probably the aggregate demand will change
  when the price level changes.

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Real Money Supply

• For now we will treat the money supply, in
  nominal units (dollars) as given.
• However, the demand for money is a demand for
  real purchasing power -- so we have to adjust the
  money supply for inflation, treating the money
  supply as real balances.
• If the price level goes up, real balances
  decline, and if the price level goes down, real
  balances rise. (Thank you, A. C. Pigou).
• Thus a rise in the price level will cause
  interest rates to rise, investment and production
  to decline, with a given nominal money supply.

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Aggregate Demand and the Price Level
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Summary for this Section

• The income-expenditure model seems to be a
  powerful diagnostic tool for
• Unemployment
• Inventories
• Impacts of investment and consumption changes

• Problem can it be consistent with microeconomic
  rationality?