Cost of Production, Crowding Out, Multiplier Effect, and Monetary Policy Limits

Cost of Production and Aggregate Supply

  • If the price of energy (PE) rises:
    • Businesses pay workers more.
    • Input costs increase (e.g., lumber for baseball bats).
    • It becomes more expensive to produce goods.
    • At every price level, businesses are willing to produce less.
    • Short-run aggregate supply (AS) shifts left.
  • If the price of energy (PE) falls:
    • Businesses' costs decrease.
    • Short-run aggregate supply (AS) shifts right.
  • Large changes in the expected price level can significantly impact the short-run AS.
    • Example: The 1970s OPEC oil crisis, where reduced oil supply increased costs, shifting short-run AS left and leading to economic challenges.
    • Long-run AS shifts based on the production function, but these shifts are longer-term.

Crowding Out

  • Scenario: An economy with only crowding out and no multiplier effect.
  • Government spending is expected to fall by 80,000,000,00080,000,000,000. Would the effect on GDP be smaller or larger than the initial 80,000,000,00080,000,000,000 shift?
  • Multiplier effects amplify changes (positive or negative).
  • Crowding out shrinks the size of any change in aggregate demand (AD) due to changes in government spending (G) or taxes (T).
  • Process:
    • Initially, AD shifts left by 80,000,000,00080,000,000,000.
    • This causes GDP and real income to fall.
    • Fall in real income leads to a fall in money demand.
    • Money demand falls, and interest rates fall.
    • Lower interest rates cause consumption and investment to rise, shifting AD back to the right.
    • The total effect on GDP will be smaller than 80,000,000,00080,000,000,000 (e.g., negative 60,000,000,00060,000,000,000 or negative 40,000,000,00040,000,000,000).

MPC and the Multiplier Effect

  • Scenario:
    • When income is 45,00045,000, consumption is 35,00035,000.
    • When income is 75,00075,000, consumption is 55,00055,000.
  • Calculate MPC (Marginal Propensity to Consume):
    • MPC=ChangeinConsumptionChangeinIncome=55,000−35,00075,000−45,000=20,00030,000≈0.67MPC = \frac{Change in Consumption}{Change in Income} = \frac{55,000 - 35,000}{75,000 - 45,000} = \frac{20,000}{30,000} \approx 0.67
  • The multiplier effect happens in stages:
    • Initially, there is a rise in AD of 8,5008,500.
    • AD shifts further right due to MPC: 8,500×0.67≈5,6958,500 \times 0.67 \approx 5,695 (additional shift).
    • The 5,6955,695 rightward shift creates an additional shift of 5,695×0.67≈3,816.655,695 \times 0.67 \approx 3,816.65, and so on.
  • Fiscal Policy Multiplier simplifies this process to a single equation:
    • Multiplier=11−MPCMultiplier = \frac{1}{1 - MPC}
  • The multiplier effect works for any component of aggregate demand:
    • Change in government spending.
    • Change in consumption.
    • Change in investment (investment accelerator).
    • Change in net exports.
  • Formula for the multiplier effect with a change in consumption:
    • ChangeinY=11−MPC×ChangeinCChange in Y = \frac{1}{1 - MPC} \times Change in C
  • Example Calculation:
    • ChangeinY=11−0.67×8,500=10.33×8,500≈3.03×8,500≈25,755Change in Y = \frac{1}{1 - 0.67} \times 8,500 = \frac{1}{0.33} \times 8,500 \approx 3.03 \times 8,500 \approx 25,755

Limit on the Effectiveness of Monetary Policy

  • When interest rates are near zero, expansionary monetary policy may be ineffective.
  • Expansionary monetary policy relies on cutting interest rates.
  • Negative interest rates are uncommon.
  • If interest rates cannot be lowered further (already at zero), it limits the ability to expand the economy during a recession.
  • The Federal Reserve (The Fed) can target other interest rates (e.g., long-term bonds) to influence the economy.
    • Quantitative easing during the 2008 crisis involved the Fed targeting long-term bonds to lower mortgage interest rates.
    • It can help bypass the inability to lower short-term interest rates and address specific issues (e.g., mortgage rates).