ECON 101B Chapter Notes - Chapter 9: Consumption Function, Money Illusion, Automatic Stabilizer
Chapter 9 The Income-Expenditure Framework: Consumption and the Multiplier
9.1 Sticky Prices
● Business Cycles
○ Prices will be sticky: they will not move freely and instantaneously in response to
changes in demand and supply instead the prices will will remain fixed at
predetermined levels as businesses expand or contract production in response to
changes in demand and costs
● The Consequences of Sticky Prices
○ Flexible Price Logic
■ Labor market equilibrium
● No matter what the flow of aggregate demand flexible wages and
prices mean that employment remains at full employment and the
level of real GDP produced remains at potential output
■ The effect on saving of a fall in consumption spending in the flexible price
model
● A fall in consumption means a rise in private saving and an
increase in the supply flow of saving through financial markets
thus the real interest rate falls and the more investment projects are
undertaken. The fall in the real interest rate also raises the value of
the exchange rate and boosts net exports
■ As households and businesses try to divert some of their spending to build
up their stocks of liquid money, their actions put downward pressure on
prices, restoring equilibrium in the money market
■ There are the flexible-price-model consequences of a fall in consumer's’
desired baseline spending
● Consumption falls
● Savings rise
● The real interest rate falls
● Investment rises
● The value of the exchange rate rises
● The price level declines
○ Sticky Price Logic
■ Consequences of a fall in consumption spending under the sticky price
assumption
● Consumption falls
● Production and employment decline
● National income declines
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■ What does wrong with the flexible price logic according to which a fall in
consumption spending generates an increase in saving that then boost both
investment spending and net exports?
● As firms cut back production and employment, total income fals
● A fall in total income reduces savings if income is held constant
● Under the sticky price assumption that effects on savings of the fall
in consumption and the fall in income cancel eachother out there is
no change in the flow of savings
● Thus there is no rightward shift in the position of the saving supply
curve on the flow of funds diagram
● There is no fall in interest rates to trigger higher investment and a
higher value of the e exchange rate and expanded net exports
● There is nothing to offset the fall in consumption spending and
keep GDP from falling below potential output
○ Expectations and Price Stickiness
■ Price stickiness causes problems only in the short run
■ A change can be considered long run if enough people see it coming far
enough in advance and have had time to adjust to it - to renegotiate their
contracts and change their standard operating procedures accordingly
■ The length of the long run and thus how many of us will be bead before it
comes depends in turn on the degrees of price stickiness and the process
by which people form their expectations
● Why are Prices Sticky?
○ Economists have ID-ed any number of reasons that prices could be stick but they
are uncertain which are most important
■ Managers and workers find that change prices or negotiating wages is
costing and hence best delayed as long as possible
■ Managers and workers lack info and so confuse changes in total economy
wide spending with changes in demand for their specific products
■ The level of prices is as much a sociological as an economic variable -
determined as much by what values people think are “fair” as by the
balance of supply and demand workers take a cut in their wages as an
indication that their employer does not value them- hence manager avoid
wage cuts bc they fear the consequences for worker morale
■ Managers and workers suffer from simple “money illusion” they overlook
the effect of price level changes when assessing the impact of changes in
wages or prices on their real incomes or sales
● Recap:
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Chapter 9 the income-expenditure framework: consumption and the multiplier. No matter what the flow of aggregate demand flexible wages and prices mean that employment remains at full employment and the level of real gdp produced remains at potential output. The effect on saving of a fall in consumption spending in the flexible price model. A fall in consumption means a rise in private saving and an increase in the supply flow of saving through financial markets thus the real interest rate falls and the more investment projects are undertaken. The fall in the real interest rate also raises the value of the exchange rate and boosts net exports. As households and businesses try to divert some of their spending to build up their stocks of liquid money, their actions put downward pressure on prices, restoring equilibrium in the money market. There are the flexible-price-model consequences of a fall in consumer"s" desired baseline spending. The value of the exchange rate rises.
