Lecture 5

Business Cycles (1):Aggregate Expenditure and Multiplier

1

The Business Cycle

• A recession is a period of declining real GDP, falling incomes, and rising unemployment.

• A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion.

• A depression is a severe recession

2

Business Cycle Dates in the US

– This figure shows the percentage change in real GDP over each cycle between 1928 and 2003.

3

Growth Rates of Real GDP and ConsumptionGrowth Rates of Real GDP and Consumption

4

-4

-2

0

2

4

6

8

10

1970 1975 1980 1985 1990 1995 2000 2005

Real GDP

Average growth

rate

Consumption

Annual Percentag

e

China’s Short-Run Economic Fluctuations

5

Recession

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002

Growth rates of investment, GDP and consumptionGrowth rates of investment, GDP and consumption

6

-30

-20

-10

0

10

20

30

40

1970 1975 1980 1985 1990 1995 2000 2005

Annual Percentag

e Investment

Real GDP

Consumption

Investment Spending in China

7

Recession

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002

Time horizons

• Long run: Prices are flexible, respond to changes in supply or demand

• Short run:many prices are “sticky” at some predetermined level

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The economy behaves much differently when prices are sticky.

In Classical Macroeconomic Theory,

• Output is determined by the supply side:– supplies of capital, labor– technology

• Changes in demand for goods & services (C, I, G ) only affect prices, not quantities.

• Complete price flexibility is a crucial assumption,so classical theory applies in the long run.

slide 9

When prices are sticky

…output and employment also depend on demand for goods & services,which is affected by

fiscal policy (G and T )

monetary policy (M )

other factors, like exogenous changes in C or I.

slide 10

Long Run vs. Short Run

• Long run– prices flexible– output determined by factors of production &

technology– unemployment equals its natural rate

• Short run– prices fixed– output determined by aggregate demand– unemployment is negatively related to output

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The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

12

John Maynard Keynes 1883-1946

Aggregate Expenditure

• Actual Expenditure, Planned Expenditure, and Real GDP– Actual aggregate expenditure is always equal to

real GDP.– Aggregate planned expenditure may differ from

actual aggregate expenditure because firms can have unplanned changes in inventories.

– Aggregate planned expenditure is another name of aggregate demand

13

Decompose AD/AE

• Y=C+I+G+NX

• How are the four components of GDP determined?

• What are the consequences of the changes in the four components of GDP?

14

Determinants of Consumption and Saving

• Consumption and saving are influenced by The real interest rate Disposable income Wealth Expected future income.

• Disposable income is aggregate income (GDP) minus taxes plus transfer payments. The relationship between consumption

expenditure and disposable income, other things remaining the same, is the consumption function.

15

Marginal Propensities to Consume

• The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent on consumption.

• That is: MPC = C/YD

• MPC is usually less than 1. Why?

16

Consumption and Saving Functions

• This figure illustrates the consumption function and the saving function.

17

Other Influences on Consumption

• When an influence other than disposable income changes—the real interest rate, wealth, or expected future income—the consumption function and saving function shift.

• This figure illustrates these effects.

18

Investment

• Investment decisions are affected by the following factors:– Expectations on future profitability– Tax rate, especially business tax and capital tax– Cash flow– Interest rate

• Investment decisions are not directly affected by current GDP.

19

Investment Function

• Investment function focuses on the relationship between investment and the interest rate

r = interest rate• High interest rate fewer profitable

investment projects lower investment • But investment decisions are not directly

affected by GDP!

20

( )I I r

Investment Function

21

I

r

Government

• We assume government variables are fixed at exogenous levels:

22

GG

Net Export

• In the short run, imports are positively affected by domestic real GDP

• The marginal propensity to import is the fraction of an increase in real GDP spent on imports.

• The U.S. marginal propensity to import is about 0.2.

• For simplicity, we assume imports are fixed• Exports are exogenously determined

23

Induced versus Autonomous Expenditure

– Expenditure that varies with real GDP, is induced expenditure.

– The sum of investment, government purchases, and exports, which does not vary with GDP, is autonomous expenditure.

– Consumption expenditure and imports can have an autonomous component.

24

Aggregate Expenditure Curve

25

Equilibrium Expenditure

– Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

26

Equilibrium Expenditure

• This figure illustrates equilibrium expenditure, which occurs at the point at which the aggregate expenditure curve crosses the 45° line and there are no unplanned changes in business inventories.

27

Equilibrium Expenditure

• Convergence to Equilibrium– Figure 13.6 also

illustrates the process of convergence toward equilibrium expenditure.

28

Equilibrium Expenditure

• If aggregate planned expenditure is greater than real GDP (the AE curve is above the 45° line), an unplanned decrease in inventories induces firms to hire workers and increase production, so real GDP increases.

29

Equilibrium Expenditure

• If aggregate planned expenditure is less than real GDP (the AE curve is below the 45° line), an unplanned increase in inventories induces firms to fire workers and decrease production, so real GDP decreases.

30

Equilibrium Expenditure

• If aggregate planned expenditure equals real GDP (the AE curve intersects the 45° line), no unplanned changes in inventories occur, so firms maintain their current production and real GDP remains constant.

31

The Multiplier

– The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.

32

The Basic Idea of the Multiplier

– An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and real GDP and the increase in real GDP leads to an increase in induced expenditure.

– The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP.

– So real GDP increases by more than the initial increase in autonomous expenditure.

33

Year C I NX Real GDP Unemployment

1929 $661 billion $91.3 billion -$9.4illion $865 billion 3.2%

1933 541 billion 17.0 billion -$10.2 billion 636 billion 24.9%

Great Depression and the Multiplier

34

The Multiplier

• This figure illustrates the multiplier.

• The Multiplier Effect• The amplified change in real

GDP that follows an increase in autonomous expenditure is the multiplier effect.

35

The Multiplier

• When autonomous expenditure increases, inventories make an unplanned decrease, so firms increase production and real GDP increases to a new equilibrium.

36

The Multiplier

• Why Is the Multiplier Greater than 1?– The multiplier is greater than 1 because an

increase in autonomous expenditure induces further increases in expenditure.

• The Size of the Multiplier– The size of the multiplier is the change in

equilibrium expenditure divided by the change in autonomous expenditure.

37

The Multiplier

• This figure shows the relation between the multiplier and the slope of the AE curve.

• In part (a) the slope of the AE curve is 0.75 and the multiplier is 4.

38

The Multiplier

• In part (b) the slope of the AE curve is 0.5 and the multiplier is 2.

39

Math

40

1. Consumption function

2. Investment function

3.Government spending function

4. Net export function

5. Equilibrium condition

)(MPC

)(MPC

TYC

TYCC

II

GG

XNNX

NXGICAEY

Math

41

MPC ( )

Y AE

C I G NX

C Y T I G NX

(1 MPC)

1 MPC

Y C MPC T I G NX

C MPC T I G NXY

Math

42

1 MPC

C MPC T I G NXY

Lump-sum Tax Multiplier:

Investment multiplier, government expenditure multiplier and foreign export multiplier:

1 MPC

MPC

1

1 MPC

Solving for Y

slide 43

Y C I G

Y C I G

MPC Y G

C G

(1 MPC) Y G

11 MPC

Y G

equilibrium conditionin changes

because I exogenousbecause C = MPC Y

Collect terms with Y on the left side of the equals sign:

Finally, solve for Y :

The government purchases multiplierExample: MPC = 0.8

slide 44

11 MPC

1 15

1 0 8 0 2. .

Y G

G G G

The increase in G causes income to increase by 5 times as much!

The government purchases multiplierDefinition: the increase in income resulting from a $1 increase in G.In this model, the G multiplier equals

slide 45

In the example with MPC = 0.8,

11 MPC

YG

15

1 0.8YG

Why the multiplier is greater than 1

• Initially, the increase in G causes an equal increase in Y: Y = G.

• But Y C further Y further C further Y

• So the final impact on income is much bigger than the initial G.

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An increase in taxes

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Y

E

E =Y

E =C2 +I +G

E2 = Y2

E =C1 +I +G

E1 = Y1

Y

At Y1, there is now

an unplanned inventory buildup……so firms

reduce output, and income falls toward a new equilibrium

C = MPC T

Initially, the tax increase reduces consumption, and therefore E:

Solving for Y

slide 48

Y C I G

MPC Y T

C

(1 MPC) MPCY T

eq’m condition in changes

I and G exogenous

Solving for Y :

MPC1 MPC

Y T

Final result:

The Tax Multiplierdef: the change in income resulting from a $1 increase in T :

slide 49

MPC1 MPC

YT

0 8 0 84

1 0 8 0 2. .. .

YT

If MPC = 0.8, then the tax multiplier equals

The Tax Multiplier…is negative: A tax hike reduces consumer spending, which reduces income.

…is greater than one (in absolute value): A change in taxes has a multiplier effect on income.

…is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

slide 50

The Tax Multiplier…is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income.…is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

slide 51