MGMT 510Lecture 2

Presented By:

Prof. Dr. Serhan Çiftçioğlu

Types of Contracts

Some economists believe that the presence of contracts

a) Explicit contracts

b) Implicit contracts

Between suppliers (producers) and their customers create price stickiness, meaning price rigidity in goods and services market.

Due to these factors, producers do not change prices easily in the short run even when the demand for the products change. And they wait until the end of their explicit contracts to announce new prices.

Another factor for producers not changing prices immediately in response to changing conditions of demand is the fact that they cannot easily know whether a given change in demand is permanent or transitory. That’s why they may prefer to wait and then make a price adjustment.

Price/Wage rigidity

Similarly presence of wage contracts between firms and labour unions which usually fixes wage rate over the duration of wage contract creates an important reason for the wage rigidity. In other words, even when demand for their output falls and firms lower their output, they may not be able to reduce wages or even fire labour force due to the presence of wage contracts.

Therefore the assumptions of short run price and wage rigidity in Keynesian model seem to be realistic.

Price/Wage rigidity (Cont’d)

However we note that even in Keynesian theory firms can change prices if there is an increase in their unit cost of production. For example, if the price of energy, raw materials, wage rate ( or other input prices) unexpectedly increases even in the short run firms can increase prices.

Therefore short run price rigidity is particularly valid in relation to changing conditions of demand.

How about the assumption that the economy operates below full employment or potential output?

This is important in the sense that simple Keynesian model particularly attempts to explain the short run behaviour of the national income (GDP), unemployment rate, interest rates, trade balance, private consumption and savings, price level investment, budget balance of government and other variables particularly for economies which are facing unemployment above the natural rate of unemployment and their output level is below their potential or full employment level. Therefore in such economies there are idle resources such as labour and capital. This is an important assumption of the model which helps us to remember the characteristics of economies for which Keynesian model can be particularly used to analyse.

(cont’d)

As a corollary of the first three assumptions, Keynesian model finally assumes that: in the short run output (National income or GDP) is only determined by the level of aggregate demand (total expenditure or spending) for domestic output. This is our starting point in developing mathematical, graphical, and economic aspects of simple Keynesian model.

Aggregate Demand

We note that: AD = Aggregate demand on domestic

output or total expenditures or total spending on domestic output

AD = C + I + G + E – M E – M = X Net exports or trade balance AD = C + I + G + X

Keynesian model says:

In the short run (during which prices and wages are fixed in responses to changes in aggregate demand) :

Y = AD Output (GDP) is given by the level of the AD. But this means: ∆ AD ∆Y in the short run Therefore to understand the factors responsible for

short run fluctuations in economies, according to Keynesian model we need to understand the factors responsible for fluctuations in AD:

Since AD = C + I + G + X in the short run any change in Y must be due to changes in C, I, G, and X. In other words:

∆C∆I ∆ Y – (In the short run)∆G∆X Therefore in developing simple Keynesian

model, we have to analyse the factors that can cause changes in C, I, G, and X.

Keynesian theory of consumption and savings

Definition : Y = C + S + T

T = Tax revenues of the government T = t Y, 0< t <1 t = Income tax rate S= private savings C=Private consumption Yd=Disposable income Yd= Y- T + Tr Tr = Transfers received from government, such as

pensions, unemployment benefits and subsidies.

Ignoring Tr

But in this class, for the sake of simplicity we will assume that Tr=0, so that;

Yd=Y – T Yd= C + S So disposable income of households is the

part of their income that can be allocated for consumption and savings.

Keynesian consumption and savings functions.1) C = a + bYd, 0<b<1

a= autonomous part of consumption which depends on factors other than disposable income.

b= marginal propensity to consume (m.p.c.) S=Yd – C S= Yd – (a + bYd)

2) S= -a + (1 – b)Yd 1-b= marginal propensity to save (mps) Substituting for Yd into equation 1 and 2, we get

3) C= a + b(1 – t)Y4) S= -a +(1 – b)(1 - t)Y Note that Yd = Y- T = (1 – t) Y

According to Keynesian theory, the most important factor that affects C and S levels of households is their disposable income which is positively affected by their income level (Y) and negatively affected by the prevailing income tax rate (t). In other words, higher Y leads an increase in Yd, whereas higher t leads to a decrease in Yd through an increase in T (total tax payment of households to government).

But there are other factors that can affect C and S. So first we list all the factors and explain how each one of the other factors affects C and S decisions of households and then present the C and S functions graphically.

Factors affecting consumption and saving decisions of households

1. Disposable income (Yd)

2. Real interest rate (r)

3. Wealth (W)

4. Expected future disposable income

5. Rate of time preference for present vs. future consumption

(1) Disposable income (Yd)

An increase in Yd (either due to an increase in Y or due to decrease in t which lowers T) affect both C and S positively

(2) Real interest rate (r) r= i - ∏e ∏e= expected inflation rate i=nominal interest rate There are two opposite effects of a given increase

in r on C and S: a-) Substitution effect (S.E) b-) Income (or wealth) Effect (I.E) The net effect is given by the sum of these two

effects. SE: Increase in r increase in opportunity cost of

present consumptions in terms of foregone future consumption

Decrease in present consumption and increase in present savings in order to be able to consume more in the future.

(2) Real interest rate (r) (cont’d) I.E: Increase in r increase in expected future

income streams from a given financial wealth ( or given savings) increases the “perceived” wealth of the household

Decrease in present savings and equivalent increase in present consumption

Most empirical studies suggests that there is a slight negative relationship between r and C for most countries. In other words as r increases C decreases, and S increases slightly indicating that S.E dominates I.E so that the net effect of a given increase in r on C is slightly negative and its net effect on S slightly positive.

(3) Wealth (W)

An increase in wealth is expected to increase C positively and S negatively. In other words, households will start consuming bigger share of their disposable income and save smaller fraction of it in response to a given increase in their wealth.

Example: changes in stocks market prices can change the financial wealth of households affecting C and S.

(4) Expected future disposable income

An increase in expected future income or a decrease in expected future taxes will increase the value of expected future disposable income leading to a decrease in private savings and an increase in private consumption in the economy.

(5) Rate of time preference for present vs. future consumption An increase in the time preference of

households for present consumption and against future consumption will lead them to decrease their present savings and increase their present consumption. This parameter largely depends on cultural factors as well as the nature of the social security system.