This unit is about
The multiplier model
- how large would the total direct and indirect impact of a rise in investment spending or governments spend
Aggregate consumption =
Autonomous consumption + consumption which depends on income
C = c0 +Yc1
Slope of the consumption function
- how much of added income will be used for consumption spending, i.e the marginal propensity to consumer
Flaw of the AC model without government and foreign trade
- even when income is 0, autonomous consumption somehow above 0
Now add in investment into the AC model
AD = c0 + Yc1 + I
Y intercept is no c0 + I
Positive AD shock impact on AD I model incomes
Increase in AD, vertically shown, so horizontal translation to 45o line of increase in income to match output at that point, continues until new AD curve meets the 45o diagram.
- smaller and smaller subsequent jumps in AD + income due to MPC
Important assumption on capacity utilisation + wages in AC I ad shift
firms can only increase output if capacity not met, also we assuming short run, so instead of increasing wages, they are hiring more wages.
Equilibrium in this model is at
When AD meets the 45o line
Negative AD shift - fall in I
So investment falls, so y intercept falls, so AD shifts down by exactly 1.5 billion, and thus firms will reduce output by 1.5 billion, to reach point C from B. Then, now incomes have fallen by 1,5 billion on the x axis, given the MPC - c1, consumption will also fall, so move from C to D, lower demand so lower output, etc all the way to point Z.
Multiplier in this simplified model
Y = (1/1-c1)(c0+I’)
Multiplier is 1/1-c1 = 1/1-MPC
Financial accelerator
change in value of collateral like houses or cars means ability/ amount borrowed will change.
Firm can spend their money on:
- dividends
- Savings
- Investment abroad
- Investment at home
Desirability of consumer to consumer now rather than later depends on
Discount rate, p
Relationship between p,r, profit rate and firm decisions
- if p is greater than r and profit rate, owners keep funds and increase consumption spending
- If r is greater than p and profit rate: the decision will be to repay debt or purchase a financial asset.
- If profit rate is greater than p and r: the owner will invest
Full multiplier model
AD = c0 + c1(1-t)Y + I + G + X -mY
1-t is taxation effect on net income
M is MPI.
Multiplier on full AD model
Y = (c0 + I + G + X)/(1-c1(1-t) + m)
Multiplier is (1-c1(1-t) + m)
3 main ways government spending and taxation can dampen fluctuation in the economy
- The size of government
- Government provides unemployment benefits
- Government can intervene via fiscal policy
Paradox of thrift
Shock to economy - save more, but if everyone does that, an aggregate attempt to increase in savings leads to a fall in aggregate income.
The paradox lies in the fact that what may be individually rational behavior can have bad effects on economy.
Fallacy of composition
Paradox of thrift is an illustration of this as when individuals make decisions based on their own circumstances, assuming what’s rational for them is optimal for society.
Private sector dampening mechanism
Consumption smoothing
Private sector amplifying mechanisms
credit constraints limiting consumption smoothing, rising value of collateral, rising capacity utilisation in a boom.
Gov dampening mechanisms
automatic stabilisers, stabilisation policy
Gov amplifying mechanisms
Policy mistakes
Crowding out
Can also occur
