Short run fluctuations and the Keynesian Model

Short-run macroeconomics

Studies how an economy behaves over a short period of time, usually when some prices, wages or expectations have not yet fully adjust to changes in demand/supply.

Trends

Represent the long-run growth path of the economy.

Business cycles

Are short-run fluctuations over periods of 4-5 years in economic activity.

Phases of the business cycle

1. Expansion: Output rises above trend

2. Peak: Economy at or above full capacity

3. Recession: Output falls below trend

4. Trough: Lowest point before recovery

Seasonal cycles

Are very short-run fluctuations that are regular/predictable time periods within a year.

Potential output/Natural output (Y*t)

Amount of output produced when using resources at ‘normal rate’.

Actual output (Yt)

the realGDP the economy produces

Boom

Yt>Yt* producing a level of output that exceeds natural operative capacity —> can cause a problem of inflationary pressure because we are trying to squeeze way more output from a limited set of inputs

Recession

Yt<Y*t economy is operating below its natural output capacity

Output gap

The derivation between actual output Yt and potential output Y*t

• shows how far the economy is from its long-run trend

Output gap % formula

[(Yt-Y*t)/Y*t] * 100

Output gap (in levels)

Yt - Y*t

Okun’s law

Describes the inverse relationship between changes in realGDP and unemployment. Quantifies how much unemployment changes when output deviates from its potential

• when realGDP grows faster than potential output, unemployment falls (expansion)

• when realGDP grows slower (or falls), unemployment rises (recession)

Natural rate of unemployment U*t

Rate of unemployment we would expect when the economy is operating at Y*t

Formula for Ut (actual unemployment) -U*t (natural rate of unemployment)

-B[((Yt-Yt*)/Yt*) * 100]

What causes fluctuations in output over time?

When actual output (Yt) moves above/below potential output (Yt*), caused by changes in aggregate demand and aggregate supply

What causes fluctuations in potential output?

• depends on economy’s productive capacity

What causes fluctuations in output gap?

• changes in aggregate demand

• supply shocks

• monetary and fiscal policy

• external shocks

What method do we use to estimate natural output Yt* and natural unemployment Ut*

The field of business cycle theory

Business cycle theory

Refers to the recurrent fluctuations in realGDP (and other economic activity) around the long-term trend of potential output.

• provides a way to evaluate the pros and cons of various kinds of policy (monetary and fiscal policy)

What causes the business cycle? (demand-side causes)

• changes in consumer/business confidence

• monetary policy (interest rate changes)

• fiscal policy (gov. spending/taxation)

• changes in exports/global demand

What causes the business cycle? (supply-side causes)

• productivity shocks (technological break throughs or slow downs)

• energy/resource shocks (oil crisis)

• changes in input costs (wages, raw materials)

What causes the business cycle? (external causes)

• global recessions/booms

• wars, pandemics, natural disasters

• exchange rate fluctuations

Two main theoretical approaches to business cycle

• Classical Business Cycle Theory

• Keynesian Business Cycle Theory

Classical Business Cycle theory

“Supply creates its own demand”

• this means that the act of producing goods automatically generates enough income to buy those goods - so overall demand will always match overall supply

Assumptions of the classical business cycle theory

• business cycles are mainly caused by fluctuations in aggregate supply (e.g. agriculture shocks, changes in productivity)

• economy is viewed as self-correcting, markets naturally return to full employment without government help

Key policy conclusion of classical business cycle theory

• government intervention is unnecessary/even harmful

• markets adjust on their own, so demand-side policies (like gov. spending/stimulus) is counterproductive

Keynesian Business Cycle Theory

Total planned spending (demand) determines the level of output (realGDP) in the short run.

• business cycles are driven by fluctuations in aggregate demand —> changes in consumer/business confidence, investor optimism/pessimism

Key policy conclusion of Keynesian Business Cycle Theory

Government intervention can stabilise the economy.

• use fiscal policy (spending.taxation) or monetary policy (interest rates), governments can stimulate demand during recessions and cool it during booms

Keynesian model of Aggregate expenditure ‘model of short run economic output’

PAE = C + I + G

• total planned spending on final domestically produced goods and services for a given interval of time (i.e. a quarter or a year)

C

Planned consumption (household spending)

• C̄ + c(Y-T)

C̄

autonomous consumption (necessities), consumer sentiment

• ‘exogenous’ amount of consumption that occurs regardless of a persons/economy’s income level

c

Marginal propensity to consume (MPC)

• measures the proportion of an increase in income that a person/household is likely to spend on consumption rather than save

Y

Aggregate income

T

Aggregate taxes

I

Planned investment (business spending on capital goods, housing, etc)

• assume is exogenous; driven by expectations and confidence, not by level of GDP

What is the difference between MPC and ‘animal spirits’?

MPC tells us how much people spend when they get extra income. Shows the fraction of extra income that goes to consumption (spending), rather than saving. MPC is an endogenous response to income = earn more = spend more, whereas animal spirits occur independently of income

G

Government spending

• assume is exogenous

Explain what a government runs (surplus/deficit) if G < T

Government collects more money than it spends

• gov is saving money/reducing debt

• reduces aggregate demand because T withdraw income from householders, G injects spending into the economy

Explain what a government runs (surplus/deficit) if G > T

Government spending exceeds tax revenue (Gov. spending more than it earns)

• deficit must be financed by borrowing

• can be expansionary (injects spending, increase in AE —> output)

T

Taxation

Keynesian Equilibrium Condition

when PAE = AE = (Y)

If PAE < AE

Surprisingly low demand, unplanned inventory accumulation

If PAE > AE

Surprisingly high demand, unplanned inventory draw down

PAE = AE

Planned and actual expenditure consistent

Formula to find short-run equilibrium output (Y)

Y = C̄ + c(Y-T) + I + G

Government spending multiplier

1/(1-c)

• Shows the amplified impact of government spending on the economy — not just the first dollar spent, but all the extra spending it triggers

Balanced-budget multiplier

=1

The government increasing G and T by same amount, so no change in budget balance. Y still increases