The Income-Expenditure Framework: Consumption and the Multiplier
To understand business cycles we require a model that doesn’t guarantee always-full employment and in which real GDP doesn’t always equal potential output. Business cycles after all aren’t fluctuations in potential output but fluctuations of actual production around potential output. Therefore the full-employment model is of no help because its supposition that prices are flexible guarantees full employment. The flexible-price assumption permitted us to start our analysis by noting the labor market would clear with the supply of workers equal to the demand for labor that as a result firms would fully employ the labor force and therefore real GDP and household income would be equal to potential output.
From this point forward nevertheless we necessitate to break this flexible-price assumption in order to build a more useful model of the business cycle. From this end forward prices will be ‘sticky’ they will not move freely and immediately in response to changes in demand and supply. Instead prices will stay fixed at predetermined levels as businesses expand or else contract production in response to changes in demand and costs. As you will observe such ‘sticky prices’ make a big difference in economic analysis they will drive a wedge among real GDP and potential output and between the supply of workers and the demand for labor. We will then they can use this sticky-price model to account for business-cycle fluctuations.
Why prices sticky? You might inquire. Why do not they adjust quickly as well as smoothly to maintain full employment? Why do businesses react to fluctuations in demand first by hiring or firing workers in addition to accelerating or shutting down their production lines? Why do not they respond first by lifts or lowering their prices.
Economists have recognized any number of reasons that prices could be ‘sticky’ however they are uncertain which are most significant. Some possible explanations are that:
a) Managers as well as workers find that changing prices or renegotiating wages is costly, consequently best delayed as long as possible.
b) Managers as well as workers lack information and therefore confuse changes in total economy-wide spending with changes in demand for their specific products.
c) The level of prices is as greatly a sociological and an economic variable--determined as much by what values people think is ‘fair’ as by the balance of supply and demand. Workers take a cut in their wages as a sign that their employer doesn’t value them—hence managers avoid wage cuts for the reason that they fear the consequences for worker morale.
d) Managers as well as workers suffer from simple ‘money illusion’ they overlook the effect of price-level changes when assessing the shock of changes in wages or prices on their real incomes or sales.
Income and Expenditure:
If prices are sticky higher cumulative demand boosts production which boosts incomes. Higher incomes give an additional boost to consumption which in turn boosts aggregate demand some more. Therefore any shift in a component of aggregate demand upward or downward leads to an amplified shift in total production for the reason that of the induced shift in consumption. The before twentieth century British economist John Maynard Keynes was one of the first to stress the significance of this multiplier process.
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