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Principles of Macroecomomics - Essay Example

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On the Marginal Propensity to Consume The marginal propensity to consume or MPC is the portion of income that is spent for every additional income (Mankiw 2009, p. 373). Mankiw provided an example (2009, p. 373): if the marginal propensity to consume of a household is ?…
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Principles of Macroecomomics
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Principles of Macroecomomics

Download file to see previous pages... 295). Figure 1. Disposable income and MPC Source: Miles and Scott (2005, p. 295) It can be found in all textbooks in macroeconomics that the MPC is related with the Keynesian income multiplier. Following Mankiw (2009, p. 373-374), the Keynesian multiplier process begins when government spends. For example, let us say that government spends ?20 billion (as mentioned earlier, Mankiw’s discussion used dollars not pounds). If the MPC is ? or 0.75 then the ?20 billion spent by government is received by society as factor payments of ?15 billion wherein, in turn, 75% of the ?15 billion are spent by those who received the payments. In turn, the factors who received the payment of 75% of the ?15 billion will spend ? of their income or 75% of 75% of ?15 billion and the chain goes on continuously. According to Mankiw (2009, p. 373), the process continually repeats and goes on indefinitely resulting into a total spending illustrated by Table 1. Table 1. MPC and multiplier resulting from initial government spending of ?20 billion Source: Mankiw (2009, p. 373) Based on the above, from the Keynesian perspective, government spending multiplies or increases income received by society based on the marginal propensity to consume (Mankiw 2009, p. 373-374). Based on Mankiw (2009, p. 374), the multiplier based on the MPC can be derived as: . The foregoing is equal to the following (Mankiw 2009, p. 274): . Economists are concerned with the MPC because the MPC is intimately related with the Keynesian income multiplier. It follows from the multiplier = 1/(1-MPC) that the higher MPC or the marginal propensity to consume, the higher the multiplier is. A low MPC implies a low Keynesian multiplier. As implied by our earlier discussion, Baumol and Blinder (2009, p. 160) discussion is similar but Baumol and Blinder’s take-off point for the concept of the marginal propensity to consume is disposable income rather than plain income. Disposable income refers to that part of income left after taking out taxes and the transfers payments received are added (Baumol and Blinder 2009, p. 157). Based on Baumol and Binder (2009, p. 157), at the macro level, disposable income or DI is: DI = GDP - Taxes + Transfer payments = GDP - (Taxes – Transfer payments) = Y - T. Miles and Scott (2005, p. 298) provides an interesting illustration of the Keynesian multiplier based on the modelling of the Keynesian perspective through the consumption function. In Figure 2 below, the 45 degree line is the level where spending equals income while PEo is the initial level of spending by consumers, government, and investors. A rise in government spending leads aggregate spending to PE1 such that following the Keynesian perspective, an increase in income from Yo to Y1 results. Figure 2. Marginal propensity to consume and multiplier Source: Miles and Scott (2005, p. 298) Miles and Scott (2005, p. 298) preferred, however, to say that “the multiplier shows how much demand rises once all agents have adjusted to an event that generates a change in some component of demand.” Following, this interpretation, it is important to study the MPC because initial spending by government or an increase in spending by any one or the consumer, government, or business can increase aggregate spending “once all agents have adjusted” to the initial increase in spending by any or all of the economic agents. Miles and Scott (2005, p. 299) even pointed out that “the larger is the propensity to con ...Download file to see next pagesRead More
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