MPC Formula, Cost-push Inflation, And Keynesian-Monetarist Controversy

What is MPC formula?

Question:

Describe what is meant by the marginal propensity to consume (mpc) and give its formula.

Assume that GDP rises from $550bn to $650bn.  Assume that this results in the consumption of goods and services rising from $340bn to $400bn.  What is the mpc?
Assuming that the domestic mpc remains constant, what will the level of consumption be if GDP rises to $700bn?
If Australian consumption of goods and services is $400bn, investment is $120bn, government expenditure is $150bn, exports of goods and services are $140bn and imports of goods and services are $145bn, what is the level of aggregate expenditure (E)?

1. The marginal propensity to consume of a person is the change in his or her spending with respect to the change in income received by that particular person (Carroll, Slacalek and Tokuoka 2014).

The formula of MPC = Δ C / Δ Y, where, the C= consumption and Y= income.

1. The change in GDP, i.e., [$650- $550]= $100 Billion. The change in consumption is [$400 – $340] = $60 Billion

Therefore, the MPC = Δ C / Δ Y = 60/ 100= 0.6

1. MPC= 0.6 ; Change in GDP= $700 Billion

Therefore, 0.6 = Δ C / 700 = $420 Billion

1. The level of aggregate expenditure (AE)= Consumption + Investment + Government Expenditure+ (Export – Import) = $[400 + 120 + 150 + (140-145)] Billion= $665 Billion (Case, Fair and Oster 2014)
2. If the GDP is currently $650 Billion, then the GDP has fallen by $[665 – 650] Billion= $15 billion.

1. Australian Bureau of Statistics considers those people to be unemployed who are not working more than 1 hour in the reference week and not actively searching for job in last 4 weeks but willing and able to work at the current wage rate in the reference week (gov.au 2014).

2. The problem of this criterion is that, the cut-off of 1 hour is insufficient to sustain a family or a person. However, it is an internationally set criterion, which enables the government and the policy makers to do comparison with the international level.

1. The frictional unemployment is unavoidable in an economy because, people switch their job and remain unemployed, for some period during this transition (Enderwick et al. 2015). Moreover, the fresh young workers enter the workforce, who remains jobless for some time. As a result of this, frictional unemployment is inevitable.
2. The structural unemployment is long term in nature, whereas, the cyclical unemployment varies according to the business activity of the nation. Generally, it persists for one or two years and reduced automatically. The structural change takes place due to skill gap between the available workers and the job available (Diamond 2013). It takes some government intervention to reduce this kind of unemployment.

1. 3. When price level increases due to rise in demand, as represented by rightward shift of demand curve, then it is known as demand-pull inflation (Addison and Burton 2013). In this scenario, the equilibrium quantity also increases.

When price level goes up due to fall in supply as cost of production has risen, as represented by the leftward shift of supply curve, then it is known as cost-push inflation. Here, the output of the economy falls.

1. Causes of Demand Pull Inflation: i) When government purchases increases, it raises the aggregate demand and pulls up the price level.
2. ii) Depreciation of local currency makes export cheaper. As a result of this, demand for domestic products goes up, which in turn raises the price level.

Causes of Cost Push Inflation: i) The cost of production rises when there is a rise in the wage. This induces the suppliers to cut their supply. This causes the aggregate supply to fall; thus raising the price level.

1. ii) Cost of production rises when government imposes any taxes on production. Hence, the producers reduce their production and price level goes up.

4. The monetarist economy emphasizes on controlling inflation through alteration of money supply. They believe that through money supply, interest rate can be influenced. As money supply is increased, there is no scarcity of fund and interest rate falls. This will demand more goods and services; and price level will go up due to the rise in aggregate demand.

However, the Keynes believed that through manipulating the demand for goods and services directly, the price level can be controlled. However, he did not completely disregard the role of money supply, but opined that government intervention like increasing or decreasing government expenditure can control the inflation of the economy. He also believed that money supply or monetary policy takes huge time to adjust the economic imbalances (Kindleberger 2013).

1. According to the monetarists’ economy, the aggregate supply curve is inelastic in nature in the long run; hence, the shape is vertical. The Keynes believed that aggregate supply is more elastic in nature; and it is L-shaped.

The shape of AS is important to the Keynesian-monetarist controversy; because, the policy instruments of the proponents of Keynesian or Monetarists contradicts as the affect is different on the total output of the economy (Gasper 2015). There will be no change in the output due to change in AD in case of monetarists’ view; whereas, according to Keynes the output of the economy will be affected. Therefore, the difference in the supply curve is the factor behind the controversy.

5.The capital stock is the quantity used for producing goods and services.

Destruction capital stock →  fall in  aggregate supply → price level ↑; output ↓.

1. An imposition of personal income tax reduces the disposable income of the people.

Disposable income ↓ → aggregate demand ↓ → Price level ↓; output ↓.

1. Export is a component of aggregate demand.

Export ↑ → Aggregate demand ↑→ Price level ↑; Output ↑.

1. The improvement in the marketing and selling skills of the firm manager will induces the consumers to buy more goods and services.

Marketing and selling skill↑ → Aggregate demand ↑ → Price level ↑; Output ↑.

1. “Banks do not create money because this is the Central Bank’s responsibility”—this statement cannot be agreed. The central bank controls the supply of money to control other economic activities. The central bank increases money supply through several tools. However, the commercial bank also plays an important role in creating money in the economy. When people deposits money in their respective bank account, the banks use that money to offer loans to the investors or the borrowers with an interest rate. This money is circulated in the economy. When the borrowers are returning that money, the banks are getting the actual value they lent plus the interest earnings. Hence, through multiplier effect, the money is increasing through the commercial banks (McLeay,  Radia and Thomas 2014).
2. While depositing pay cheque drawn on one bank into another bank account, does not have any multiplier effect. It is just the transferring of monetary value from one bank to another. Therefore, there will be no change in the overall money supply of an economy.
3. When the reserve ratio is 10%, then Westpack Bank will keep 10% of $1000 to the RBA.

10% of $1000 = 10/100 × 1000 = $100.

Therefore, the bank can lend maximum of $(1000 – 100) = $900 from this deposit.

1. Monetary base of an economy is the total money circulated in the hands of people and bank deposits held by the central bank. This includes the liquid currencies. When the RBA purchases the government securities, it injects cash money into the economy. Therefore, the monetary base of the economy will increase.
2. Since, the central bank has bought government securities, the money deposit and reserve of the commercial bank will also increase. They will be able to supply more fund, as monetary base has increased. The cost of borrowing will be lowered. This will pull down the short-term interest rate in the money market.

• Long-terms loans are made through bond instruments. Therefore, when the interest rate falls due to purchasing of government securities, the bond price will rise (Toma and Toma 2012). The prce of bond fluctuates in the long term. Therefore, higher interest rate is charged in case of long-term maturity interest rate; even if the money supply has increased.

1. Since, the money supply has been increased through purchasing of government securities; people have more money to purchase goods and services. Therefore, there will be a rise in consumption. Moreover, since interest rate is reduced, investors will invest more. As a result of this, the consumption and investment components of the aggregate demand will rise that will shift the aggregate demand curve upward. The rise in aggregate demand will increase the price level. In addition to this, the total output, i.e., the GDP will rise, the economy is expected to face growth. However, in the long run, due to speculation about asset price goes up in the economy. This often leads to recession. Therefore, economic activity will be negatively affected.

1. When the government securities are sold to the banks, the banks are paying for it. Therefore, money is withdrawn from the economy. This indicates the money supply will be reduced and there will be no growth in supply of money.
2. When interest rate falls, the cost of borrowing becomes cheaper. As a result of this the people will borrow more. The more money is borrowed, the more return they have to pay to the banks at the cost of interest rate. The bank will further lend the same money plus the interest earnings and will get back additional amount. As a result of this, more money will be created through multiplier effect. Hence, fall in interest rate will increase the supply of money; there will be growth in the money supply.
3. When the government borrows from banking sector, it will return that money with rate of interest after completion of the tenure. Moreover, government spending will generate value to the economy. Hence, there will be growth in the money supply of the economy.
4. When central bank purchases government securities from the banking sector, it pays money to the banks. The lending capacity of banks will rise. The more money will be circulated in the economy; there will be growth in the money supply.
5. To reduce target inflation rate the central bank will increase the interest rate. Rise is interest rate will lower the tendency of borrowing, which will reduce the money supply. There will be no growth in the money supply.

Categories	Elements of Balance of Payment
a	i
b	xii
c	vi
d	x
e	xi
f	xiv
g	xiii
h	vi
i	viii
j	ii

References

Abs.gov.au. 2014. 6105.0 – Australian Labour Market Statistics, July 2014. [online] Available at: https://www.abs.gov.au/AUSSTATS/[email protected]/0/FBE517ECA9B07F63CA257D0E001AC7D4?OpenDocument [Accessed 7 Jun. 2016].

Addison, J.T. and Burton, J., 2013. The demise of “demand-pull” and “costpush” in inflation theory. PSL Quarterly Review, 33(133).

Carroll, C.D., Slacalek, J. and Tokuoka, K., 2014. The distribution of wealth and the marginal propensity to consume.

Case, K.E., Fair, R.C. and Oster, S., 2014. Principles of economics. Pearson Higher Ed.

Chipman, J.S., 2014. Balance of payments theory. Economic Analysis in Historical Perspective: Butterworths Advanced Economics Texts, p.186.

Diamond, P.A., 2013. Structural unemployment. FRB of Boston Public Policy Brief, (13-6).

Enderwick, P., Manzetti, L., Mavrotas, G., Shorrocks, A. and Motamen-Samadian, S., 2015. Employment and Unemployment. Booms and Busts: An Encyclopedia of Economic History from the First Stock Market Crash of 1792 to the Current Global Economic Crisis, p.230.

Gaspar, J., 2015. A dynamic aggregate supply and aggregate demand model with Matlab (No. 559). Universidade do Porto, Faculdade de Economia do Porto.

Kindleberger, C.P., 2013. Keynesianism vs. monetarism: and other essays in financial history. Routledge.

McLeay, M., Radia, A. and Thomas, R., 2014. Money creation in the modern economy. Bank of England Quarterly Bulletin, p.Q1.