Macroeconomics

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Macroeconomics

• Unit 10
• Self-Adjustment or Instability?

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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?

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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.

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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.

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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.

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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.

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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.

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Concept 2 The Multiplier Process
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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)

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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

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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.

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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!

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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.

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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!

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Multiplier Effects100 billion decrease in
spending/MPC .75
AS
m
D
F
P0
B
AD0
C
AD1
AD2
QF 3000
2600
2800
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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.

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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.

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Concept 3 Recessionary GDP Gap
Output is reduced along with prices in a
recessionary gap
AS
AD2
m
a
P0
c
PE
AD0
Recessionary GDP gap
QE
QF
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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.

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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.

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Demand-Pull Inflation - Inflationary GDP Gap
AS
?C 300 billion
?I 100 billion
w
P6
r
P0
a
AD6
AD5
AD0
QF
QE
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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.

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Instability

• According to Keynes, the economy is vulnerable to
  abrupt changes in spending behavior and wont
  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.

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Concept 5 Consumer Confidence

• An 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/

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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.

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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.