İKTİSADA GİRİŞ II - Deneme Sınavı - 9

Leakages are used to denote reductions in autonomous components of aggregate expenditures. It is possible to mention three types of leakages from the income-expenditure flow: savings, taxes, and imports for an open economy. Let’s shortly review these concepts. Leakages are the factors that cause autonomous components of aggregate expenditures to reduce.  Because saving is defined as an unspent part of income, households will spend less to increase their savings. Another leakage arising from the income-expenditure flow is taxes. Taxes lead to compulsory reductions in consumption expenditures.  The savings realized by the households are the source of funds that can be borrowed by the financial system and used for financing investment expenditures of firms.

Injections are additions to income-expenditure flow.

Saving Paradox is the reduction in the consumption expenditures and, therefore, income because of rising savings.

The multiplier is a coefficient that can give us to the opportunity to calculate how much income will change when there is a shift in aggregate expenditures, stemming from the change in autonomous expenditures. The multiplier value is always greater than 1. The reason for this is that the change in autonomous expenditure leads to an additional change in consumption expenditures

Full Employment Level of Income is the level of income that will be attained in the economy if all the factors of production participate most effectively in production.

Deflationary gap is the expenditure gap when the economy is in equilibrium below the full employment level of income.

The inflationary gap is the excess of expenditures when the economy is in equilibrium above the full employment level of income.

Equilibrium in Classical Model

In the equilibrium approach of the Classical model, thanks to the smooth operation of the market mechanism, the economy is in constant balance, that is, at full employment. The classical model explains the continuous realization of employment in the economy, based on Say’s Law, which states that “every supply creates its own demand”. According to this law, a certain amount of income is generated as a result of the production of goods and services. This income is used again to buy goods and services. Firms purchase or lease the resources required in the production process. They pay their owners in the form of fees, interest, rents, and profits. The amount that the producers pay to the owners of the production factors has to be equal to the value of the goods and services produced. Here, the production factor consumes all the income that the owners have gained and everything produced is sold. Thus, according to Say’s Law, every supply creates its own demand. It is not the case that the aggregate expenditures are insufficient in terms of full employment level. In some economies, when there is supply surplus or excess demand in some markets, the price mechanism is engaged and the market returns to the equilibrium level again. Therefore, the economy is in constant equilibrium.

Equilibrium in Classical Model

When households decide to save a portion of their income, how will the necessary expenditure to be made ensure the complete purchase of the economy’s production? The Classics’ answer to this question is that savings of the production factors are invested by the firms. Such a reduction in expenditure resulting from savings will be offset by investments. What is important here is how the savings will be equal to investments. According to Classical economists, interest rate is the key variable to provide this equality. This interest rate, which is determined on the loanable funds market, will change so as to ensure that the funds provided as a result of savings are equal to the funds requested for investments. End of this process, equilibrium interest rate rises in the market and the amount invested will be equal to the amount saved.

Equilibrium in Keynesian Model

The views of the classical model which guarantee full employment equilibrium were began to be questioned as a result of the long-term economic stagnation and the associated high unemployment during Great Depression that occurred in the 1930s. In order to solve this problem, British economist John Maynard Keynes argued that the economic equilibrium, as put forward by Classical economists, does not mean that the level of full employment income is provided at the same time. According to Keynes, equilibrium income can be achieved at the level of underemployment or overemployment. What is important here is the level of aggregate demand. Since it is difficult to change the production capacity that determines aggregate supply in the short term, the level of income depends on aggregate demand or aggregate expenditures. In other words, firms give their production decisions according to the expected aggregate expenditure or aggregate demand level. If the economic units plan to spend more, the sales expectations of the companies will increase and they will make more production. As it is seen, Keynes links the deviations from full employment to the inadequacy of aggregate expenditures in the economy. Accordingly, full employment in the economy can be achieved by an adequate level of aggregate expenditure. Then, Keynesian theory criticizes the views expressed by Classics on investment as a function of the interest rate and on wage-price elasticity. The Keynesian theory argue that the economy is not always be at full employment equilibrium because flexible prices and wages are not always valid. According to this opinion, there are many factors that prevent wages and prices from being flexible. For this reason, markets are moving away from fully competitive structure. In some sectors the existence of firms that do not want to reduce prices may be the case. Prices in these sectors can remain at the same level for a long time instead of falling when there is a fall in demand or expenditure. Because of the existence of strong labor unions and long-term wage contracts, the same is also true in labor markets. According to Keynesian model, one reason why equilibrium income is not always at full employment level is that investment and saving equality cannot always be provided as Classics argue. The reason for this is that the economic units that save and invest in the economy are generally different from each other. These economic units give savings and investment decisions for different reasons. For example, when savings for households occur as accumulation for future days, firms’ investment decisions are directed at expanding facilities or purchasing new capital goods to increase their profitability. In this case, it may not happen that savings at an income level that close to full employment equal investments. Savings can also lead to an increase in the amount of money held, rather than being used for financing investments. In this case, savings-investment equality will not be provided again.

Equilibrium in Keynesian Model

The Keynesian theory argue that the economy is not always be at full employment equilibrium because flexible prices and wages are not always valid. According to this opinion, there are many factors that prevent wages and prices from being flexible. For this reason, markets are moving away from fully competitive structure. In some sectors the existence of firms that do not want to reduce prices may be the case. Prices in these sectors can remain at the same level for a long time instead of falling when there is a fall in demand or expenditure. Because of the existence of strong labor unions and long-term wage contracts, the same is also true in labor markets.

Equilibrium in Keynesian Model

According to Keynesian model, one reason why equilibrium income is not always at full employment level is that investment and saving equality cannot always be provided as Classics argue. The reason for this is that the economic units that save and invest in the economy are generally different from each other. These economic units give savings and investment decisions for different reasons. For example, when savings for households occur as accumulation for future days, firms’ investment decisions are directed at expanding facilities or purchasing new capital goods to increase their profitability. In this case, it may not happen that savings at an income level that close to full employment equal investments. Savings can also lead to an increase in the amount of money held, rather than being used for financing investments. In this case, savings-investment equality will not be provided again.

Leakages and Injections- Leakages

Leakages are used to denote reductions in autonomous components of aggregate expenditures. It is possible to mention three types of leakages from the income-expenditure flow: savings, taxes and imports for an open economy.

Saving Paradox

When the households decide to increase their savings without a change in income level, interesting contradiction called as saving paradox will arise. To understand this situation, we need to answer the question “What if households want to save more today in order to prepare for the difficult days in the future?” For instance, if planned savings of households increase, let’s say 400 TL at every level of income, the total leakages curve (S1 + T + IM) in Figure 3.4 shifts upward to S2 + T + IM position. Planning to increase savings also means planning less consumption at the same time. As a result of the decrease in consumption, aggregate expenditure, i.e., aggregate demand, will decrease. In this case, the decrease in aggregate expenditures leads to an increase in stocks. This increase in stocks will lead to production level of firms and income level to decrease.

Before the increase in savings, the level of equilibrium income was 5,000 TL, expressed by the point D1 where injections line intersects leakages line. Increase in savings shifted equilibrium point to D2 and the new level of equilibrium income is 4,000 TL. As you see, 400 TL increase in savings regarding their beginning values has resulted in a decrease of 1,000 TL in equilibrium income level. When Table 3.2 is considered, the original level of savings was 1,200 TL when equilibrium level of income was 5,000 TL. In the new equilibrium level of income at 4,000 TL, households again save the same amount (1,200 TL) with the beginning value. According to this result, households planning to save more and consume less now, but save the same amount. This is a paradox indicating that increasing saving reduces consumption and, therefore, income; however, at this new income level savings are at the same level. When you consider the fact that savings are used to finance investments in the country, this result contradicts the widespread belief that savings are beneficial for the economy.

Saving Paradox is the reduction in the consumption expenditures and, therefore, income because of rising savings.

Expenditure Multiplier

The multiplier is a coefficient that can give us to opportunity to calculate how much income will change when there is a shift in aggregate expenditures, stemming from the change in autonomous expenditures. The multiplier value is always greater than 1. The reason for this is that the change in autonomous expenditure leads to an additional change in consumption expenditures. Here, the determinant of the size of the Equilibrium in the Economy effect is marginal propensity to consume. As you remember, the marginal propensity to consume gives us how consumption rises when income rises. For example, the primary effect of 1 unit increase in autonomous expenditure would be to increase production and income by 1 unit. If the marginal propensity to consume is large, this increase in income leads to a large increase in consumption. In this case the multiplier effect will also be large. If the marginal propensity to consume is small, this increase will lead to a low change in consumption. In this case, the multiplier effect will be small. Based on this value, we find that 100 TL increase in the initial expenditure level leads to an increase of 2.5 times in GDP, that is, an increase of 250 TL (2.5 x 100). If you remember our discussions on leakages and injections above, the rest of the income increase after separating leakages is devoted to domestically produced goods and services, and the ratio of this amount to income increases is measured by marginal propensity to consume (MPC). Therefore, we can also calculate the multiplier by writing the same formula in terms of MPC as:

Here we also get the same multiplier value when we write 0.60 instead of MPC:

Regarding the multiplier, whichever formula above we use, we reach the following conclusion: The larger the leakages (in other terms, the lower the marginal propensity to consume), the smaller the value of the multiplier will be. The smaller value of multiplier means that the income generating effect of the same amount initial expenditure increase will also be small. For example, when the marginal propensity to save (MPS) is 0.35 and the marginal propensity to import (MPI) is 0.15, the multiplier will be 2:

In this case, the expanding effect of the increase in spending on the economy will be smaller because a smaller portion of the income generated at each stage will be spent. If the multiplier is 2, the income increase effect on the economy will be 200 TL (2 x 100).

Expenditure Multiplier

The multiplier is a coefficient that can give us to opportunity to calculate how much income will change when there is a shift in aggregate expenditures, stemming from the change in autonomous expenditures. The multiplier value is always greater than 1. The reason for this is that the change in autonomous expenditure leads to an additional change in consumption expenditures. Here, the determinant of the size of the Equilibrium in the Economy effect is marginal propensity to consume. As you remember, the marginal propensity to consume gives us how consumption rises when income rises. For example, the primary effect of 1 unit increase in autonomous expenditure would be to increase production and income by 1 unit. If the marginal propensity to consume is large, this increase in income leads to a large increase in consumption. In this case the multiplier effect will also be large. If the marginal propensity to consume is small, this increase will lead to a low change in consumption. In this case, the multiplier effect will be small. Based on this value, we find that 100 TL increase in the initial expenditure level leads to an increase of 2.5 times in GDP, that is, an increase of 250 TL (2.5 x 100). If you remember our discussions on leakages and injections above, the rest of the income increase after separating leakages is devoted to domestically produced goods and services, and the ratio of this amount to income increases is measured by marginal propensity to consume (MPC). Therefore, we can also calculate the multiplier by writing the same formula in terms of MPC as:

Here we also get the same multiplier value when we write 0.60 instead of MPC:

Regarding the multiplier, whichever formula above we use, we reach the following conclusion: The larger the leakages (in other terms, the lower the marginal propensity to consume), the smaller the value of the multiplier will be. The smaller value of multiplier means that the income generating effect of the same amount initial expenditure increase will also be small. For example, when the marginal propensity to save (MPS) is 0.35 and the marginal propensity to import (MPI) is 0.15, the multiplier will be 2:

In this case, the expanding effect of the increase in spending on the economy will be smaller because a smaller portion of the income generated at each stage will be spent. If the multiplier is 2, the income increase effect on the economy will be 200 TL (2 x 100).

Savings compensate for investment.

According to Keynes, the level of production in the economy is determined by aggregate demand.

The Keynesian theory argues that the economy is not always at full employment equilibrium because flexible prices and wages are not always valid.

A decrease in export is not an injection into income-expenditure flow in an open economy.