Marginal propensity to consume (MPC), Expenditure multiplier

Marginal propensity to consume (MPC)

MPC = Proportion of each additional dollar of income spent on personal consumption
= Marginal increase in consumption / Marginal increase in income.

Expenditure multiplier = 1/ (1 - MPC).

Keynesian or aggregate expenditure (AE) model:

Keynesian macroequilibrium:
Actual output (income) = the planned output given by the AE model (i.e demand or expenditure in next period)

Real GDP = C + I + G + NX

Planned consumption (C)

• Determined by disposable income, less than one to one basis

Planned investment (I) and Government Spending (G)

• Fixed constant, unrelated to income

Planed net exports (NX)

• Decreases as income increase

If the actual expenditure is lower, inventories will build up. If higher, inventories will be depleted.

SRAS is horizontal out to the full employment where it becomes vertical.
If below full employment, increase expenditures =>increase output, change in AE = change in output
If at full employment, increase expenditure=> increase prices

Self-correcting mechanisms that dampen the economic cycle:

Consumer demand* {tends to lag changes in income, relatively stable over business cycle}
Real interest rates {rise during boom and fall in depression}
Resource prices {rise during boom and fall in depression}

*Permanent income hypothesis:

• Consumption depend on expected long-run income; people spread temporary increase in income over several future periods =>smoothing

In expansion,
Output exceed potential capacity, higher interest rate à decrease AD ; higher resources prices => decrease supply.

In contraction,
Reverse.
If fast process- don’t need monetary and fiscal policy;
If slow process- need monetary and piscal policy

Impact of unanticipated change in aggregate demand and supply

Impact of unanticipated decrease in AD :
In short run,

• Unanticipated decrease in aggregate demand => excess supply of resources => decline in resource prices & increase unemployment => decline in price and output

In long run,

• Lower resources costs => shift aggregate supply to the right => produce at the level of output consistent with full employment but at a lower price level

Impact of unanticipated increase in AD
In short run,

• Unanticipated increase in AD => output level greater than that with full employment => less unemployment than the "natural rate" of unemployment => upward pressure on resource prices and interest rates (modified contract)

In long run,

• Higher resources prices and interest rate => shift AS => output decline to what is consistent with full employment.=> decrease in aggregate demand => no change in output but increase in price.

A new market equilibrium will occur at a higher price level. So in the long-run, inflation (higher prices) will be the major effect of the increase in aggregate demand .

Impact of unanticipated Dncrease in AS:
In the short-run,

• Unanticipated decrease in AS => lower the availability of resources => increase in resource prices => shift the aggregate supply curve of goods and services to left => reduce level of output and higher prices.

In long-run,

• For temporary shock, no change in price and output.
• For permanent shock, shift the LRAS to the left, the economy would produce a lower level output at higher prices.

Impact of unanticipated increase in AS
In short-run,

• Unanitipated increase in AS => shifit SAS to the right => increase output and price => increase employment => increase income => increase savings if the income increse is temporary => increase supply of loanable funds => decrease real interest rate.

In Long-run

• For temporary shock - LR-all return to pre-shock levels
• For permanent shock - LR – all remain at post-shock levels

Aggregate Demand Demand Curve and Supply Curve

Aggregate demand (AD) curve:
Quantity demanded on y-axis. Price on x-axis.

It is the relation between the price level and the real quantity of goods and services demanded, 4 components of which are consumption, investment, government spending, net exports (exports minus imports)

Aggregate supply (AS) curve:
Quantity supplied on the y-axis. Price on the x-axis.

Note:

• Shortrun AS (SRAS) is a different curve from long-run AS (LRAS).

Factors that shift aggregate supply (AS)
Factors that shift SRAS curve to the right:

• All three factors that shift LRAS plus:
• Temporary increase in the supply of resources.
• Favorable supply shocks.
• Changes in expectations for inflation - If suppliers expect goods to sell at much higher prices in the future, their willingness to sell in the current time period will be reduced and the SAS will shift to the left.

Factors that shift LRAS curve to the right:

• Improvements in productivity.
• Permanent increase in supply of resources e.g. labour and capital
• Increase in efficiency of resource utilization.

Shortrun aggregate supply (SRAS) is a different curve from long-run aggregate supply (LRAS)

Factors that shift aggregate demand
Factors that shift AD curve to the right:

• Increase in real wealth.
• Decrease in real rate of interest {saving becomes less attractive}.
• Positive business expectations/sentiment.
• Expectation of future inflation.
• Increase in income of other countries.
• Fall in the value of the domestic currency.
  
  The reverse of these factors would push AD curve to the left.
  As it is believed long-run productive capacity will improve when time passes, price falls (assume demand no change)