Friday, September 23, 2005

More on stimulating aggregate demand

A reader asks the following question:

Consider for example an employer that, instead of giving the household helper a raise, keeps the money under the mattress, or another situation where the household helper is given a raise but instead of spending also keeps the money in the wallet. But what good to the economy is that money or purchasing power? It is in the exercise of purchasing power where the magic of Hyperwage Theory begins. If the employer is an entrepreneur, he may use the savings (purchasing power) to expand or conduct a new business, employing more people in the process. By the labor of these additional employees and use of other economic resources, more goods and services are produced or rendered. Additional profit or savings is made and the purchasing power is further increased. If the employer is just a saver and does not conduct any business, he may transfer the purchasing power or deposit the money in a bank that will in turn loan it to an entrepreneur, employing more economic resources and increasing further the purchasing power.

So we see that purchasing power is increased by additional labor and other economic resources that are employed through the exercise of initial purchasing power. Otherwise, these economic resources would remain idle and be wasted by mere passage of time. This is why if the economy is stagnant or sluggish, investors are encouraged in business and the government is urged by economists to spend in order to stimulate the economy. Now, here is a question: "Who should be in a better position to exercise the initial purchasing power for the economy, the employer or the household helper?" Let's discuss your answer next time.

Pol Espanola
Saudi Arabia

I'll break up my answer into two parts (see my hyperwage posts for a background):

First, when there is unemployment, then increasing demand will stimulate output momentarily. Maybe hyperwage theory entails a transfer of income from a sector with low propensity to consume to a sector with high propensity to consume. I'll grant this for the sake of argument. (Hyperwage is not actually a transfer unless government also enforces a no lay-off policy.) We can represent this by an income transfer from "employer-households" (direct purchasers of labor, and owners of business firms) to "employee-households" (those who obtain income mostly from selling labor). I'll use simple maths in the following, so bear with me.

I need to introduce the concept of "marginal propensity to consume", or MPC. This is the amount of extra spending that a household will undertake given an extra dollar of income. This is a fractional number. Suppose employer-households have a low MPC, say 0.5. Employee-households have a high MPC, say 0.9. Let there be a fifty-fifty split of total income Y between these two household-types. For simplicity, suppose consumption is the only form of spending in the economy. Consumption unrelated to income ("autonomous consumption") is symbolized by A. Then equality of aggregate income and aggregate demand requires:

Y = A + 0.5(0.5Y) + 0.9(0.5Y)
Y = A + 0.7Y

Y = A/0.3 = 3.33A. So if A = 100, equilibrium national income is 333.33.

Okay, let's transfer 50% of income from employer-households to employee households. Then the income share of the former is down to 25%, tne latter up to 75%. We get:

Y = A + 0.5(0.25Y) + 0.9(0.75Y)
Y = A + 0.8Y
Y = A/0.2 = 5A. So A = 100 implies national income of 500.

If full employment is 500, that's it; even more transfers of income from employer-households to employee-households will not increase output any further.

Which brings me to the second point: failure of an economy to grow in the long term is not due to lack of demand. Think of the maximal output that a country can produce given its available resources. That is the full employment output. There is no aggregate demand "magic" that will push the economy beyond this frontier.

The full employment output of a developing country cannot reach the per capita output of developed countries. The per capita income of the Philippines is about US$ 1,000; this is less than 1/30th that of the US. Eliminating unemployment (even though it stands now at about 11%) cannot close this gap. The above cartoon example gives a good indication of the orders of magnitude involved: from 333.33 to 500 may look like a big jump, but this is nowhere near the twenty or thirty-fold increase we are looking for to reach developed country standards.

For that, we need to look beyond the demand side, to the supply side: the amount of resources available, and the aggregate level of productivity. I have an earlier post about it here.

Hope this helps.


Anonymous said...

As an economist myself, this is a bad example of using mathematics. The sharing of 50%-50% is the INITIAL CONDITION, and not the FINAL condition. the IC is the starting point. the consumers spend their money and it generates more income for biz and so on and so forth. the FC will not the be amounts that you plugged inthe formula. your mistake is in plugging in the IC into the formula. The iteration will have to be done first.

Econblogger said...


(Sorry, for the delayed reply!)

The derivation is correct as long as income shares are unchanged after the multiplier process. Unless you have a convincing basis for reallocating the demand-induced output increase differentially across the household sectors, I stand by the derivation.