Saturday, February 28, 2009

Economics at Play - Why "dubah-ya" wanted us to Spend

You often hear on the news that because of the economy:

- People are taking less vacations
- Buying less cars
- Buying less technology

Intuitively, this makes sense to all of us, but in looking at the economy as a whole, we can see that there are larger implications. I think that this is very important to discuss, especially when it comes to stimulus plans in the US and the multiplier effect. There are many different ideas at play and it is important to acknowledge their respective effects on the economy.

Marginal Propensity to Consume (MPC) - This is a measure of overall spending habits. It is usually phrased as such: "If I was to give you an extra dollar, how much of it would you spend?". MPC is a measure of individual spending, but also, more importantly money flow. This eventually leads to the powerful idea of a GDP multiplier (why George W. Bush asked us to all go out and spend). When you spend a dollar, the GDP will go up by an amount greater than the dollar. Why? Because if you spend that dollar, the person who receives it will save a portion of it (marginal propensity to save, MPS = 100% - MPC) and spend the rest (MPC). This amount that is spent recursively goes through the same process over and over again. The result is a converging geometric series whose aggregate solution is the multiplier (the multiplier is calculated by 1/MPS, so if we all spend half of the $1 we get, the GDP eventually goes up $2). Hint: The US has a generally higher MPC than Japan (who has a higher MPS). But it also lends itself to volatility (when times are good, a high MPC allows the GDP to grow really quickly, but when times are bad, all the extra GDP growth from strong money flow drys up just as fast).

Income Demand Elasticity - Income Demand Elasticity is essentially a fancy way of saying, if I gave you more money, would you buy more of a particular item. It is a good way of anticipating consumer behaviour for different classes of goods. For instance, if you suddenly made 10x more money, you'd probably not buy any more orange juice than you already do, but you might be tempted to buy that sports car. Conversely, if you got laid off and had to live off of savings for a while (a situation many people are now finding themselves), you might not give up OJ as quickly as the new car. This lends itself to the idea of "defensive" class stocks such as Walmart and McDonalds. These types of companies don't suffer as much (and often thrive) in hard times because peoples spending in these areas don't change.

Whether on an aggregate (GDP) or microeconomic (one particular company) scale, government spending would manifest as a right shift in the demand curve (more demand) which implies (cateris paribus) that both quantity supplied and prices would go up (demand pull).

Based on this, you can see why Democrats and more Keynesian style economists would like to stimulate the economy through spending. However, Republicans and conservatives would usually prefer tax cuts as a method of rewarding working business models and getting government out of the way (another interesting analysis for a future post).

Despite all this analysis, however, it seems like a bit of a moot point in our current environment. The stimulus package won't single handedly solve the problem (as almost everyone has acknowledged that more help will be needed) and it seems that the most important issue that needs to be address is that something needs to be done expediently and there will certainly be a need to reassess the next steps in the near future.

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