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Lecture 5

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McGill University
Economics (Arts)
ECON 460
William Watson

Lecture 5 ECON 460 Thursday, September 19, 2012 Chapter 10: The Marginal Propensity to Consume and the Multiplier 
“Employment can only increase pari passu with investment.” (Pari passu: Latin: “with equal step.” Side-by-side, at the same rate as.) The multiplier: R. F. Kahn, 1931.  What proportion increase in Y would you get from ….  He says MPC is 0.8 in UK, you have multiplier of 5  If poor country: investment levels are low; small government; if gov increases spending; high MPC in small government; injection gets multiplied but generating injections is problematic  Rich: lower MPC because there is more saving; economy not that responsive to injections; larger government so it doesn’t take big % increase to cause big % change in investment I
 Marginal propensity to consume: dWC/ d W Δ YW = Δ CW + Δ W = k ΔWI where 1 – (1/k) = MPC. Call k the investment multiplier. k = 1/(1 – MPC). II 
If MPC=0.9,k=? If MPC = 1, “no point of stability and prices will rise without limit.” Why prices? “If saving is the pill and consumption is the jam, the extra jam has to be proportioned to the size of the additional pill.” If MPC is high, fluctuations wide but full employment easy to restore.
If MPC is low, fluctuations less but getting to full employment requires bigger ΔI. Actual MPC: worst of both worlds: fluctuations considerable but required ΔI “too great to be easily handled.” After reaching full employment any non-zero MPC produces “true inflation.” Why true inflation? III Did Keynes understand “crowding-out”?
Will new investment discourage other investment or lower MPC? 1. Interest rate may rise with financing of new project. 2. Negative effect on “confidence.” 3. Leakage through foreign trade. 4. With big changes, MPC may decline. 5. Because of declining MPL new income may go more to entrepreneurs, who have lower MPC. 6. Re-employment may reduce negative saving (i.e., dis-saving) of the unemployed. In “typical modern community” MPC not much less than 0.8 so k = ?
Less if foreign trade is important and UI is financed by loans and pays out half of usual income. Then k as low as 2 or 3. Most are 1 to 1.5. (What are current estimates of the multiplier? Why are they so much lower?) IV How do lags affect the multiplier?  Delayed effects- multiplier will take time to cause effect  $1 spinning through economy with a given velocity V Are small countries, with high MPC’s, more subject to fluctuation than large? Do public works have a greater or lesser effect the farther a country is from full employment? Kuznets numbers: multiplier of 2.5 to 3, MPC 60-70 per cent: “quite plausible for the boom, but surprisingly, and, in my judgment, improbably low for the slump.” “Extreme financial conservatism of corporate finance in the United States, even during the slump, may account for it.” How? VI (One of Keynes’ most famous passages.) Marginal disutility of labour may now be negative. Loan-expenditure may therefore enrich the community. (What is loan-expenditure?) Wholly wasteful projects such as UI accepted while only partly wasteful projects are rejected. “...the form of digging holes in the ground known as gold-mining... the most acceptable of all solutions...” “If the Treasury were to fill old bottles with banknotes...” “...wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable...” Gold: gambling aspect means interest rate not crucial; also, its marginal utility does not decline. (Price doesn’t fall as quantity rises?) “Ancient Egypt was doubly fortunate...” General Theory: Book IV: The Inducement to Invest Chapter 11: The Marginal Efficiency of Capital I  Y= C+I; as you become richer you underconsume; the gap is investment; investment comes from marginal efficiency of capital  Investment is the production of new production capacity; you are going to need this in the future 1. Prospective yield of an asset consists of stream of after-cost return1: Q2, Q n...Q 2. Supply-price of asset (not necessarily equal to its market price) equals replacement cost Marginal efficiency of capital of that type: Discount rate that equalizes 1 and 2 Marginal efficiency of capital in general: Greatest of these MEC’s by type of asset Depends on expected yield What happens to 1 and 2 as investment proceeds?  Likely that yield goes down in 1 and opposite in 2 until investment is not profitable “Obvious” that I will be pushed to where MEC = r Where does r come from? See end of Bk IV. Not from MEC II Is the MEC equivalent to physical productivity?
Does Q depend on expectations? 1 Do all the other Qi?  He argues no because you are doing this in money and if you expect price of your production to go down then you wont make that investment  Q1 is pretty certain; probably not; Q1 is all you have? Some think yes but he says all Qs count III “Expectation of a fall in the value of money” raises schedule of MEC. (Why?)  Expected fall in r will lower MEC schedule: Today’s investment will have to compete with future investment “content with a lower return.” “Somewhat violent fluctuations” of the MEC are because of dependence on expectation. IV Two types of risk: 1. Entrepreneur’s or borrower’s risk: arising from doubts about success 2. Lender’s risk, due to moral hazard or involuntary default or a change in the val
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