Keynesian Multiplier Equilibrium Keynesian Spending Multiplier Keynesian spending

Keynesian Multiplier & Equilibrium

Keynesian Spending Multiplier �Keynesian spending multiplier: tells us the amount by which a particular injection of government spending, investment, or export spending will increase the nation’s total GDP �Spending by one person represents income to another, so an injection leads to a more than proportional increase in GDP �The spending multiplier (k) is a function of the marginal propensity to consume and is determined from the formula, o k = 1 ÷ (1 – MPC) �The ultimate change in GDP resulting from an initial change in expenditures (E) is, o ∆GDP = k × ∆E

Example; Keynesian Multiplier �Assume for example, the governments of two countries are considering a fiscal policy involving an increase in government spending by $10 billion. �In country A, 50% of a change in income goes towards consumption of domestic goods and services o Country A’s MPC is 0. 5 o k. A = 1 ÷ (1 – 0. 5) = 2 �In country B, 80% of any increase in income goes towards consumption o Country B’s MPC is 0. 8

�In country A, $10 billion new income will result in an increase in GDP of $20 billion o ∆GDP = k × ∆E = 2 × $10 billion = $20 billion �In country B, $10 billion new income will result in an increase in GDP of $50 billion o ∆GDP = k × ∆E = 5 × $10 billion = $50 billion �Key idea: the larger the marginal propensity to consume (MPC), the greater impact a change in government spending, investment or exports will have on the level of national income in the country

Aggregate Supply �Aggregate supply (AS): is the total amount of goods and services that all firms in all the industries in a country will produce at every price level in a given period of time o The AS curve illustrates the relationship between the price level in a nation and the total output of the nation’s producers o The AS curve is upward-sloping because higher prices encourage firms to produce more while at lower prices firms are forced to reduce output o The AS curve becomes steep above potential output because a relatively large increase in the price level is required if the firms increase output in this range

�There are two competing theories on the response of a nation’s producers to changes in the price level that are often combined, �Short-run aggregate supply (SRAS): also called the Keynesian aggregate supply curve o Assumes aggregate supply (AS) is relatively elastic when the nation is producing at a relatively low level of output �Long-run aggregate supply curve (LRAS): also called the neo-classical AS curve o Assumes that regardless of the price level in a nation, the nation’s producers will always produce at the level of output at which the nation’s resources are fully employed

o Aggregate supply (AS) is perfectly inelastic at the nation’s full employment level of output Short-run Aggregate Supply (SRAS) Long-run Aggregate Supply (SRAS

Short-run Equilibrium �The SRAS curve is upward sloping and has the following properties, o SRAS curve is horizontal (relatively elastic) at levels of output below full employment o SRAS curve is vertical (relatively inelastic) at levels of output beyond full employment �In the short-run, firms are very responsive to a decrease in the demand for national output o A fall in aggregate demand (AD) will lead to a small decrease in the price level, but a relatively large decrease in total output

SRAS: Fall in aggregate demand (AD) �Equilibrium national output is determined by the intersection of the nation’s AD and AS. �YFE is the full-employment level of output o At YFE the nation experiences very low unemployment, stable prices (low inflation), and the nation’s resources are being used efficiently and near their full capacity

�The decline in the short-run equilibrium output and employment resulting from a fall in AD is explained by the fact that in the short-run, wages and prices are downwardly inflexible �Sticky Price Model: when AD falls in the short-run, firms must lay off workers to reduce costs because firms find it difficult to cut workers’ wages, hence output and employment falls �Labor market rigidities that make wages inflexible in the short-run include, o Work contracts: legally binding agreements make it difficult for firms to cut wages in the face of falling demand for their products o Minimum wage laws: make it difficult to reduce costs without laying off workers when demand falls o Government regulations: regulation mandating fair

�The SRAS curve is highly inelastic beyond the full employment level of output SRAS: Increase in aggregate demand (AD)- Beyond full employment �According to the SRAS model, it is possible, in the short- run, for a nation to produce beyond its full-employment level of output

�When AD rises, increases in output are proportionately smaller than the rise in the price level due to the rising demand for workers o Workers wages are fixed and have yet to increase in response to higher demand for output o As output grows, the number of workers available to hire begins to decrease and firms must compete for the limited supply of labor �The Keynesian SRAS curve reflect the stickiness and inflexibility of wage in the short-run o A fall in AD leads to recession, high unemployment and deflation o An increase in AD can lead to economic growth, reductions in unemployment and inflation

Long-run Equilibrium �The long-run aggregate supply (LRAS) assumes that wages and prices are perfectly flexible o They adjust to the level of demand to ensure that output always remains at its full-employment level o LRAS is perfectly inelastic at the full employment level of output

�When AD falls from AD 1 to AD 2, in the short-run, unemployment would rise and output would fall, with a slight decrease in the price level o In the long-run, as unemployment rises and demand remains weak, workers begin to accept lower wages offered by firms o Consequently, employment and output return to the full -employment level while price adjust downwards �Recessions, are only likely if wages and prices are inflexible, in the short-run o Assuming wages are flexible over time, then in the long run, the economy is able to self-correct from a recession

Increases in Aggregate Supply �There are several factors that can lead to an increase in SRAS, o Lower wages or a reduction in the minimum wages o Lower resource costs (e. g. oil, minerals and other raw materials) o Improvement in the productivity of land or capital o Government subsidies to producers o Investment tax credits (e. g. encouraging firms to invest in capital) o Reduction in trade union power

o Better educated or more skilled workforce (e. g. productivity) o Stronger currency (e. g. makes imported resources cheaper) �If an economy is already producing at it full-employment level and any of the above determinants of SRAS improve then, o Both the nation’s SRAS and LRAS curves shift to the right, increasing the nation’s full-employment level of output

�If an economy is producing below its full-employment level, as a result of a reduction in AD (movement along the SRAS curve), and any of the above determinants of SRAS improve then, o In the long-run SRAS will shift to the right and the output will be restored at the full-employment level and at a lower price level

Decreases in Aggregate Supply �Factors that can reduce SRAS in a nation include, o Increase in the minimum wage o Increase in resource costs (e. g. oil shocks, higher food prices) o Increase in trade union power o Higher business taxes o Weaker currency (e. g. Imported raw materials more expensive) �If any of the above occur, a nation’s SRAS curve shifts to the left, causing an increase in the price level and a fall in

�If the economy if producing at full-employment and any of the above factors change o It will result in both a recession (a fall in national output) and inflation (caused by higher production costs of production for firms)

�If an economy is producing above its full-employment level, as a result of a increase in AD (movement along the SRAS curve), and any of the above determinants of SRAS change then, o In the long-run, wages adjust upwards and the SRAS curve shift to the left, restoring output at its fullemployment with more inflation in the economy

Summary: Shifts in AS Aggregate supply increases and the AS curve shifts to the right, with the following: Aggregate supply decreases and the AS curve shifts to the left, with the following: Increase in the supply of economic resources from: Decrease in the supply of economic resources from • Increase in labor supply • Increase in capital stock • Increase in land • Increase in entrepreneurship • Decrease in labor supply • Decrease in capital stock • Decrease in land • Decrease in entrepreneurship Increase in productivity due to technological progress Decrease in productivity due to technological decline Change in government policies, • Lower taxes • Higher taxes

Study Questions � 1 a. of an Use an AD/AS diagram to analyze the likely effects increase in interest rates. � 1 b. To what extent is the level of interest rates in an economy the primary factor businesses consider when make investment decisions? � 2 a. Identify the components of aggregate demand briefly explain two factors which might determine each of these components � 2 b. Evaluate the likely impact on an economy of a substantial rise in the level of savings among the nation’s households