ECO 2013-Chapter 11: The Business Cycle

Business Cycle

The irregular periods of recession and expansion through which the economy passes

Expansion

A period where GDP grows at a faster rate than normal

Recession

A significant decline in economic activity lasting for two or more quarters

Characteristics During a Recession

GDP falls below its potential/average level (often turning negative), unemployment rises above its natural/average rate, investment spending falls, and the inflation rate falls (price level increases more slowly)

Full Employment/Potential Output (Y1)

The value of GDP when there is no cyclical unemployment, meaning labor and capital resources are fully utilized and the inflation rate is stable

Recessionary Gap

Occurs when the equilibrium level of GDP (Y₃) is below full employment output (Y₁) because Planned Aggregate Expenditure (PAE) is "too low"

Inflationary Gap

Occurs when the equilibrium level of GDP (Y₂) is above full employment output (Y₁) because Planned Aggregate Expenditure (PAE) is "too high”

Aggregate Expenditure (AE)

The total spending in the economy, calculated as C + I + G + NX (Consumption + Investment + Government Spending + Net Exports)

Consumption Spending (C)

Spending by individuals (or households) on new final goods and services

Disposable Income

Income minus taxes, which is split between Consumption (C) and Saving (S_p)

Marginal Propensity to Consume (MPC or b)

The amount that consumption increases when disposable income increases by one dollar. It is the percentage of disposable income an individual chooses to spend. If MPC = 0.80, a household spends 80 cents of every dollar earned

Factors Affecting Consumption (C)

Current income, wealth (assets - debts), expected future income, the interest rate (lower rates increase borrowing/spending), consumer confidence, and taxes (higher taxes reduce disposable income)

Investment Spending (I)

Purchases of new physical capital by firms (to replace or expand capacity)

Factors Affecting Investment (I)

Expected profitability, confidence in the state of the economy, the interest rate, and business taxes

Government Spending (G)

Spending on new goods and services, such as military, roads, national parks, and the justice system

Net Exports (NX)

The value of Exports minus Imports

Factors Affecting Net Exports (NX)

Domestic income (more income → more imports), foreign income (more foreign income → more exports), exchange rates (stronger dollar → fewer exports), preferences for foreign goods, and trade policy

Planned Aggregate Expenditure (PAE)

The sum of the four planned expenditure categories: PAE = C + I + G + NX

PAE vs. Actual AE

PAE may differ from "actual" aggregate expenditure due to unplanned inventory changes

Inventory Investment

Keeps track of goods produced but not sold; unplanned inventory investment occurs if sales are not as expected

Consumption Function (Simplified Model)

C = a + bY, where a is autonomous spending (fixed spending like rent) and bY is spending that depends on income (like meals out); b is the MPC, and Y is income (GDP)

Simplified PAE Equation

PAE = A + bY, where A (Autonomous Expenditure) is a + I + G + NX, and b is the MPC

Keynesian Equilibrium

Occurs when the economy is in balance: GDP = PAE. Firms choose production (output, or GDP) to match spending (PAE)

Adjustment to Equilibrium (GDP = PAE)

If GDP > PAE, there is a positive unplanned inventory change, and firms will decrease production (output moves toward equilibrium). If GDP < PAE, there is a negative unplanned inventory change, and firms will increase production. Equilibrium is at GDP=21 in the example table where unplanned inventory change is 0

The Spending Multiplier

An increase in consumer spending caused by an increase in autonomous investment (or any autonomous spending). It means any given change in autonomous spending results in a larger change in GDP

Fiscal Policy

Changes in government spending (G), income taxes (affects C), business taxes (affects I), tariffs (affects NX), or transfer payments (affects C) used to change PAE and, consequently, equilibrium GDP

Sticky Prices

The phenomenon that many prices adjust slowly over time due to factors like customer satisfaction, firms taking time to gather information, and wages/input prices being fixed by contract