PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 8 (LECTURES 20-21)
Oct. 18-22, 1999

[In these lectures we finish up the Phillips Curve, thus finishing up our unit on unemployment and inflation, look briefly at the Great Depression as the dawn of macroeconomics, and start on aggregate demand and the multiplier model. (Note that while we've now covered Chapters 1-9 and part of Chapter 10 of McConnell's book, the Phillips Curve does not appear in the book until Chapter 16. So if you do not completely understand your class notes on the Phillips Curve, you may want to read pages 336-39 of the book.)
-- Note: there were no classes on Mon., Oct. 18 (fall break).
-- These notes were last revised on Sun., Oct. 24, at 7:20 pm.]
 

LECTURE 20
Wed., Oct. 20, 1999

Today:
I.    The Phillips Curve (finish)
II.   The Great Depression and the birth of macroeconomics
III.  Aggregate demand (begin)
 

I.   THE PHILLIPS CURVE (finish)

[I drew a Phillips Curve on the board, much like the ones in McConnell's Figure 16-7. I also showed an overhead of a modified Phillips Curve, that graphed the unemployment rate against the change in the inflation rate and yielded a good fit for every year from 1972 to 1992. I will scan that picture onto the Internet someday; until then, if you're dying to see that diagram again, you can find it on page 33 of the 1997 edition of Paul Krugman's book The Age of Diminished Expectations, which is at Penfield Library.]

Q: Why is there a tradeoff between inflation and unemployment? (Or, equivalently, why is there a tradeoff between low prices and real GDP growth? Or, why does the Phillips Curve slope downward?)

A: Two main reasons:

(1) It's easier for firms to raise prices when incomes (and hence product demand) are high. Sometimes they're just following supply and demand -- if demand increases and the firm faces diminishing returns to expanding production in the short run, then the new supply price of the firm's good will have to be higher than the old price. Firms in noncompetitive industries -- i.e., firms that have some price-setting ability will often take advantage of high product demand to raise their prices, because they know they can do that without losing a lot of customers.

(2) When firms want to expand production, workers tend to get paid higher wages. This is because expanding firms will require more labor, which often requires paying a higher wage to (a) attract more workers and/or (b) induce their existing workers to work overtime. Also, with tight labor markets, workers are harder to replace and thus are in a better position to demand higher wages. The higher wages are then passed onto consumers in the form of higher product prices.

Q: Why does the Phillips Curve "curve" (i.e., why does it get flatter as you follow it from left to right?)

A: The economy has an "inflationary bias" -- it's much easier for prices and wages to go up than to go down. Companies are reluctant to cut the prices of their products, even in periods of slack demand; and workers fiercely resist any attempts to cut their nominal wages. So periods of rapid economic growth and low unemployment will generate many price and wage increases, and hence be very inflationary; by contrast, even a severe economic recession, while it will reduce the rate of growth of prices, will probably be unable to wipe out inflation altogether. A certain amount of "inertial inflation" is simply built into the system.

In the 1970s, inflation and unemployment frequently increased at the same time, something that had never really happened before. There was no obvious tradeoff between inflation and unemployment, which led many people to charge that the whole concept of the Phillips Curve was pure bunk.
--> Defenders of the Phillips Curve countered that the Phillips Curve was shifting and shifted up at least twice during the 1970s. (It also seems to have shifted down in the mid-1980s and again in the 1990s.)
---- Economist Arthur Okun said it best: "The Phillips curve has become an unidentified flying object."

Today, the Phillips Curve is somewhat controversial -- it is not popular (which may be why your textbook doesn't introduce it until Chapter 16), but most economists do agree that there is some tradeoff between unemployment and inflation. Recessions cause firms to moderate their price increases and workers to moderate their wage demands. The Fed's Board of Governors seem to operate under the assumption that their policies will affect both unemployment and inflation. It is almost universally accepted that the Fed's tight-money policies in 1979-82 were responsible both for lowering inflation and for producing the 1981-82 recession. To quote one textbook:
-- "There is a tradeoff between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves much more than simply choosing a point along a nice, smooth [Phillips] curve."

--> Costs of disinflation: These tend to be high, because the only sure way to reduce inflation is by creating a recession.
---- By one reasonable estimate, the U.S. "war on inflation" of the early 1980s cost us $1 trillion in lost output, the equivalent of 20% of a year's GDP.
---- Economists speak of the "sacrifice ratio" -- the reduction in the output ratio (Q/Q*) that would be necessary to reduce inflation by one percentage point.
------ It is estimated that to reduce inflation by 1 percentage point, we would have to reduce the output ratio (Q/Q*) by 4 percentage points, a high price.
-- Officially the Fed has said it wants to reduce the inflation rate (currently about 2%) to 0 within five years-- economist Paul Krugman says this is "pure hypocrisy," since it would require a substantial increase in the unemployment rate for several years, and the nation and the Fed are not willing to tolerate such high unemployment for long.
 

II. THE GREAT DEPRESSION

Worldwide, but most severe in the U.S. Real GDP fell 40% from 1929 to 1933, and the unemployment rate peaked at 25% in 1933. The unemployment rate stayed over 10% for the entire decade of the 1930s, and it took a World War, starting in 1941, to get us out of the Depression.
-- The Great Depression is often linked with the stock-market crash of October 1929, but the Crash really was not the cause of the Depression. In hindsight, most economists would agree that the Depression was caused by severe declines in consumption and investment spending.
-- Government and Federal Reserve policymakers in the 1930s were fairly clueless as to how to end the Depression. Again in hindsight, most economists would agree that the government and the Federal Reserve should have taken a more active approach (see below).
-- John Maynard Keynes published his landmark book The General Theory (1936) largely as a response to the Depression. He said the Depression resulted from a severe drop in effective demand in the private sector, most notably big drops in physical capital investment (by firms) and consumption (by households).
-- Keynes's proposed solution to the Depression: The government should intervene to boost effective demand by spending more money (especially on public-works programs like new roads, bridges, etc.) financed by running deficits (expansionary fiscal policy -- when the government increases spending and/or cuts taxes in order to stimulate the economy). Keynes also thought the Federal Reserve should intervene to create more bank reserves and enlarge the money supply (the total amount of cash in circulation plus bank deposits; expansionary monetary policy-- when the central bank expands the money supply and lower interest rates in order to stimulate the economy.)
-- Today those are the standard remedies for an economic recession or depression.

***

PRINCIPLES OF MACROECONOMICS
WEEK 8, LECTURE 21
Fri., Oct. 22, 1999

Today:
I.   Aggregate demand
II.  The multiplier model (begin)

I. AGGREGATE DEMAND

Where we left off: The Great Depression, explained by Keynes as having been caused by a severe shortfall of effective demand or aggregate demand.

Aggregate demand (AD) = The total quantity of goods and services demanded (i.e., purchased).

= C + Iplanned + G + Xn
              |
Planned investment does not include "unintended inventory accumulation". If firms produce goods (say, Edsels) but can't sell them, those goods are counted in GDP, as (unintended) inventory investment (I), but they are not part of aggregate demand, because, plainly, nobody was demanding those goods.

-- Note that this is very similar to the equation for GDP using the product/expenditure approach:

GDP = C + Itotal + G + Xnet

-- The difference between AD and GDP is the difference between planned investment and total investment. In a word, that difference is inventories. Unintended inventory accumulation counts total gross investment (I) but not toward planned investment. Unintended inventory investment can also be negative (we would call it unintended inventory decumulation), if AD exceeds output and firms meet the excess demand by selling off goods that they'd been planning to keep as inventories for the future.
-- AD is often referred to as effective demand, notably by Keynes.

Aggregate expenditures model: a model in which GDP is ultimately determined by aggregate demand, and equilibrium GDP is the level of GDP where aggregate expenditures (AD) equal aggregate production (output).
-- also known as the multiplier model
 

II. THE MULTIPLIER MODEL

The term multiplier refers to the way that an initial increase in aggregate expenditures (C, I, G,net X) causes a ripple effect that leads to more and more spending and raises GDP by a multiple of that initial increase in spending. The main reason why this happens is because when you spend money, the person who receives that money from you as payment will turn around and spend some of it. And the same thing will happen when that person spends his money -- the person he paid the money to will turn around and spend some it, too. The chain of spending continues until there's nothing left to spend.

Key concept: the marginal propensity to consume (MPC) -- the fraction of an extra dollar of a person's disposable income that the person will spend on consumer goods.

How does this multiplier work? A hypothetical example:
-- First off, suppose everyone has the same MPC, 0.75
-- I withdraw $100 from my savings acct and buy a leather jacket
-- Biff, the leather jacket salesman, since he has MPC = 0.75, spends $75 (on a hat)
-- Cheryl, the hat salesperson, spends 0.75*$75 $56 (on a puppy)
-- Ralph, the dog breeder, spends (0.75)2*$75 $42 (on a haircut)
-- Olga, the hairstylist, spends (0.75)3*$75 $32 ...
-- and so on. Note that each subsequent amount spent is 75% of the previous amount. After many more iterations the amount spent will be so tiny (75% of a fractional cent) that we can forget about it. But by then the total increase in spending will have been quite large.

Note: the multiplier model is a Keynesian economic model -- that is, it was first proposed by John Maynard Keynes, in The General Theory. (The book devotes three whole chapters to the marginal propensity to consume and the multiplier.) The multiplier model is a model of output determination -- it tells you what the level of output (GDP) will be, based on the behavior of consumption, planned investment, and the other components of aggregate demand.

Consumption accounts for about two-thirds of both GDP and aggregate demand, so let's start by examining the behavior of consumption. First, some notation:
Q = GDP
C = consumption
S = saving
DI = disposable income (i.e., after-tax income)

All of a person's disposable income goes toward consumption and saving, i.e.,
DI = C + S

For now, we will assume there are no taxes, so Q = DI and
C = Q - S

Although in the real world there are several factors that determine a household's or a society's consumption, this model focuses on just two -- (1) everyone's basic subsistence needs (food, clothing, shelter, etc.), which each of us would somehow provide for even if we had no income, by borrowing or living off our past savings; and (2) income (people consume more when they have more income to spend). We break those two types of consumption down into (1) autonomous consumption and (2) induced consumption.

Thus we divide people's consumption into two parts:
Consumption = autonomous consumption + induced consumption
                                        |                                            |
                                  a constant;                         rises as income rises
                                  unaffected by
                                  changes in income
or symbolically:
C = a + bQ
              |
              b = marginal propensity to consume (MPC)
              b = slope of the consumption function when we graph it
[drawn in class, with a slope of b and intersecting the vertical axis at a; Figure 9-2, 9-3, or 9-4 of McConnell's book is close to, though a bit less precise than, what I drew]

(a is autonomous consumption; bQ is induced consumption.)

We assume that:
a > 0 (people's autonomous consumption is some positive number)
0 < b < 1 (the MPC is positive but less than 100% of people's income)

The above equation is a consumption function -- a simple linear (straight-line) equation that depicts consumption as a function of disposable income. Since we're assuming no taxes for now, the consumption function shows consumption as a function of total income, or GDP (Q).

Equivalently, we can use the two above equations (QC+S and C=a+bQ) to derive a saving function:

S = Q - C
   = Q - (a+bQ)
   = -a + (1-b)Q
        |          |
        |        MPS; also the slope of the saving function
        |
  autonomous saving (negative)

Note: MPS + MPC = 1
-- (just as saving + consumption = income. There is a mathematical connection between the two equations.)
-- Verify: b + (1 - b) = b + 1 - b = 1
[I also drew the saving function on the board, with a slope of 1-b and intersecting the vertical axis at -a. It too appears in McConnell's Figures 9-2, 9-3, and 9-4.]

(Just why we bother to derive a saving function will become clearer in the next lecture.)