Shifts in Production

Temporary shift in the production function

Imagine that, due to a weather front, goods are a lot easier to produce in general on the island. Fish, for example, become more plentiful for a time. What happens if we only consider this wealth effect? With supply increases price will decrease and quantity purchased and consumed will increase. Also, since the shock is temporary, people will tend to not change their behavior too much. They will tend to spread the benefits of the positive shock over future periods. (Imagine if you won at the lottery. You know this happens only once. Of course you do change your consumption pattern, but you will also spread the benefits over many years) Thus, people will tend to save more, driving down the interest rate. This reduction of the interest rate induces consumption to be higher since additional income is not needed as much, and people will tend to work less.

Now there is also a change in marginal productivity: not only has the weather made the level of production increase, but for every level of effort, increasing effort a bit has now a bigger incidence on production (the same net catches more fish). We saw above that this would trigger a substitution effect: people will find it more attractive to work a bit more, because each hour gets you more production. The wealth effect above, however, makes work less attractive because you already have more to consume and would prefer more leisure time. Hence, as before, we have the prediction that an increase in GDP has a positive effect on consumption and a negative effect on the interest rate, but we can't be sure about the impact on labor in the economy. However, since the wealth effect is rather small (people prefer to spread the shock), we can suspect that the substitution effect dominates, so we should have a slight increase in the total number of hours worked.

Notice that the extra consumption will tend to make the demand for money increase, and since the supply of money is fixed, the general level of prices will move slightly upwards. But apart from that, changes on the commodity market do not affect the price level. This is one side of a phenomenon usually called "Neutrality of Money," and follows the view of Monetarists like Milton Friedman.

Permanent Shift

Now, imagine that the change in the production possibilities is permanent: people have improved at what they are doing, and there are lots of plants and animals, and it is only getting better. Again, there is a wealth and a substitution effect. The first one implies an increase in consumption demand and a decrease in labor supply, while the second one implies an increase in labor supplied. So aggregate demand and aggregate supply increase. So, what is different from a temporary change? The fact it is permanent makes it neutral to savings. Think of the lottery example once more: if you know that you will win at the lottery every month from now on, you will just increase your spending. Why save, since the extra income is coming every month? It is the same for the case of the production shock on the island: the fact the shock is permanent implies no change in the interest rate. Consumption and GDP increase, since total spending increases, and so money demand will increase. These factors will again lead to an inflationary economy.