Economic Fluctuations and Income Spending

GDP Growth

• Fluctuations in GDP are reflected in the year-on-year growth rate of its value.
• GDP and other national output measures are released quarterly.
• GDP growth is computed by comparing the GDP of one quarter to the GDP of the same quarter in the previous year.
• For example, the GDP of the first quarter of 2021 is compared to the GDP of the first quarter of 2020.
• Formula for GDP growth in the first quarter of 2021:
  h_{2021.1} = \frac{2021.1 - 2020.1}{2020.1} \times 100
• The GDP growth rate can be decomposed by the growth rate of its components.
• Expenditure components: GDP growth rate = \Delta \% \times hC + \Delta \% \times hI + \Delta \% \times hG + \Delta \% \times h{NX}
  • \Delta \% represents the change in percentage
  • hC, hI, hG, h{NX} represents consumption, investment, government and net exports respectively
• Example with constant 2018 prices (in million pesos):
  • Consumption (C):
    • 2019: 14,027,192
    • 2020: 12,921,444
    • Growth rate: -7.88%
    • Share in GDP in 2020: 0.74
    • Contribution to GDP Growth: -5.84
  • Investment (I):
    • 2019: 5,083,657
    • 2020: 3,265,538
    • Growth rate: -35.76%
    • Share in GDP in 2020: 0.19
    • Contribution to GDP Growth: -6.69
  • Government (G):
    • 2019: 2,410,971
    • 2020: 2,661,253
    • Growth rate: 10.38%
    • Share in GDP in 2020: 0.15
    • Contribution to GDP Growth: 1.58
  • Net Exports (X-M):
    • 2019: -2,153,307
    • 2020: -1,391,886
    • Growth rate: -35.38%
    • Share in GDP in 2020: -0.08
    • Contribution to GDP Growth: 2.82
      • Exports (X):
        • 2019: 5,650,169
        • 2020: 4,703,782
        • Growth rate: -16.75%
        • Share in GDP in 2020: 0.27
        • Contribution to GDP Growth: -4.51
      • Imports (M):
        • 2019: 7,803,476
        • 2020: 6,095,668
        • Growth rate: -21.89%
        • Share in GDP in 2020: 0.35
        • Contribution to GDP Growth: -7.64
  • GDP:
    • 2019: 19,368,513
    • 2020: 17,456,349
    • Growth rate: -9.87%
    • Share in GDP in 2020: 1.00
    • Contribution to GDP Growth: -9.87
• Lessons from the pandemic experience in 2020:
  • Consumption and investment expenditures caused the drop in GDP.
  • Despite a smaller percentage of GDP, investment had a comparable, and even larger effect to consumption.
  • The government contributed positively to GDP through stimulus programs.
  • Net exports contributed positively to GDP growth as transactions with the rest of the world dropped considerably.

Okun’s Law

• Okun’s Law: Output growth and unemployment are negatively associated.
• Reducing the unemployment rate leads to a positive GDP growth rate.
• Causality can be hypothetically reversed.
• Regression line equation (Philippine GDP growth rate and unemployment rate between 2005Q2-2019Q4):
  = 9.67 - 0.58
• Estimate: If unemployment is reduced by 1%, GDP will grow by 0.58%.

Fluctuations in Income

• Economies fluctuate between good and bad times.
• Effects are magnified in poor, agriculture-reliant economies.

How Households Cope with Fluctuations

• Agrarian economies face income swings due to:
  • Weather conditions
  • Inelastic demand and supply
  • Price changes in global commodity markets
  • Unstable infrastructure
• Shock: Unexpected event causing changes in economic variables like income and prices (can be good or bad).
  • Household shocks
  • Economy-wide shocks
• Strategies to deal with household shocks:
  • Self-insurance: Saving during high-income periods to use during negative shocks.
  • Co-insurance: Households helping others affected by negative shocks (e.g., extended families, friends, neighbors).
• Reasons for dealing with shocks:
  • Preference for a smooth pattern of consumption.
• Reasons for helping others:
  • People are not solely selfish.
  • Co-insurance is based on reciprocity, trust, and altruism.
• Economy-wide shocks:
  • Co-insurance is less effective if bad shocks affect everyone simultaneously.
  • In situations like COVID, neighbors/friends may also be experiencing income loss.
  • During events such as droughts or floods affecting an entire agrarian economy, assistance must originate elsewhere.
  • Storing agricultural produce from a bumper harvest long enough to endure until the next harvest may not be feasible.

Why is Consumption Stable?

• Consumption is a basic source of stabilization in the economy; households aim to keep their consumption of goods and services constant.
• Maintaining steady consumption requires planning to smooth income fluctuations.
• Consumption remains stable relative to its share in GDP across countries.
• Investment is more volatile than consumption.
• Much of consumption is necessary (mortgage, food expenditure, utilities).
• Investment spending is more sensitive to changes in income and consumer confidence.
• Modigliani’s Life-Cycle Hypothesis: Consumption depends on lifetime income, which varies systematically. Saving allows consumers to shift income from high-income to low-income periods.
  • Borrowing while young, accumulating while working, and dis-saving after retirement
• Friedman’s Permanent Income Hypothesis: Consumption depends on permanent income changes, not transitory changes. People smooth consumption using savings and borrowing.
  • Permanent shock: Long-run consumption level moves in the direction of the income shock.
  • Temporary shock: Long-run consumption level is not affected.
• Limits to household consumption smoothing:
  • Lack of information or confidence in future outcomes.
  • Credit constraints: Difficulty in borrowing due to lack of collateral or high-interest rates.
  • Weakness of will: Lack of self-control to prepare for adverse future circumstances.
  • Limited co-insurance: Lack of a reliable support network.

Why is Investment Volatile?

• No motivation to smooth investment spending.
• Investment can be postponed.
• Firms increase investments when expectations for future profits are high.
• Investment spending increases with favorable business confidence and expectations of high profitability.
• Firms coordinate their investments by observing other firms' behavior.
• Example: Economy with 2 firms, A and B:
  • Firm A's machinery is underutilized, and it needs to hire more employees
  • Insufficient demand to sell potential products.
  • Low capacity utilization.
  • Firm A has no incentive to invest.
  • Similar situation in Firm B leads to a vicious circle of negative expectations of future demand.
  • If firms A and B invest simultaneously, they employ more workers, increasing demand, creating positive expectations of demand.
• Coordination in investment affects aggregate demand.
• Increased aggregate spending facilitates firms' plans to adjust future capacity and stimulates investment spending.
• Investment spending is greatly affected by business confidence and expectations.
  • Virtuous circle of positive expectations of future demand

Changes in Aggregate Demand

• Firms’ investment spending depends on expectations about future post-tax profits and often occurs in clusters.
  • Adoption of new technology simultaneously
  • Similar beliefs about expected future demand
• How investment spending affects the economy:
  • Direct effect: Increased income to firms supplying new equipment
  • Indirect effects:
    1. Increased income of employees of supplying firm increases their consumption
    2. Increased spending by firm employees becomes income to other workers.
    3. The cycle continues, but at a decreasing rate over time.
• The multiplier process explains how new spending translates to a higher level of output.
  • If the total increase in GDP equals the initial increase in spending, the multiplier equals 1.
  • If the total increase in GDP is greater or less than the initial increase in spending, the multiplier is greater than or less than 1, respectively.
• This process results from the circular flow model, where one person’s expenditure is another person’s income.
• The initial new expenditure by one entity leads to increased income and total output.
  • Increase in Expenditure: Direct effect and Indirect effect.
• The cycle of spending and income decreases over time.
• People save a percentage of their income; thus, income is not solely spent.
• Example: People save 20% of their income:
  • Spending = 1 Million, Income = 1 Million, Savings = 200K
  • Spending = 800K, Income = 800K, Savings = 160K
  • Spending = 640k, Income = 640K, Savings = 128K
  • Spending = 512k
• The sum of incomes received is greater than the original increase in spending.
• A decrease in autonomous spending leads to a larger decrease in GDP.
• Example: A drought reduces incomes in the agricultural sector, decreasing demand from outside the sector.

Aggregate Demand and Output

• In goods market equilibrium, aggregate demand equals the economy’s output. Assuming two sectors: households and firms:
  Y = AD = C + I
• Unplanned inventory investment or disinvestment: IU = Y - AD
  • IU > 0, Y > AD
  • IU < 0, Y < AD
• Firms adjust excesses or shortages by cutting back on production or drawing down inventories.

The Consumption Function

• 2 parts of aggregate consumption spending:
  • Autonomous consumption (fixed amount) – spending independent of income.
  • A variable amount – depends on income. C = c0 + c1Y
    • c0 > 0; 0 < c1 < 1
  • For every increase in income by 1 peso, consumption spending increases by c_1 cents.
• c_1 is called the marginal propensity to consume (mpc).
• The steeper the consumption line, the larger the consumption response to a change in income (larger mpc).

Consumption and Saving

• The rest of the income, not spent on consumption, is saved.
• Savings take the fraction (1-c_1) of any increase in income.
• Any income unspent is saved:
  S = Y - C
• Relating savings to income:
  S = Y - C = Y - c0 - c1Y = -c0 + (1-c1)Y
• The marginal propensity to save is (1 - c1). An additional peso income results in an additional (1 - c1) cents in saving.

Goods Market Equilibrium (2-Sector Economy)

• AD = C + I = c0 + c1Y + I
• Function of aggregate demand includes autonomous investment expenditure.
• At equilibrium, aggregate demand must equal output (Y).
• Deviations of the actual output from aggregate spending are represented by unplanned changes in the level of inventories firms keep due to uncertainties in sales.
• Because of unplanned changes to the level of inventory investment, we can also say that at equilibrium is when actual expenditure is equal to planned expenditure.
• Actual expenditure represents actual output and the economy and planned expenditure is the expenditure level that represents the output that sectors in the economy needs in the short-run.
  Y = AD = PE

Keynesian Cross Diagram

• The 45-degree line plots points where aggregate demand equals total output.
• Disequilibrium means output is bigger or smaller than aggregate demand.
• A positive difference in unplanned inventories (IU) means total output is greater than aggregate demand.
• A negative difference means the opposite.
• In equilibrium, this level of unplanned inventories should be zero, meaning there are no unplanned additions to the inventories of firms.
• This occurs at the intersection of the 45-degree line and the AD curve, where actual expenditures equal planned expenditures.

The Multiplier Process

• The multiplier refers to the increase (decrease) in final income arising from any injection (leakage) of spending.
• Consumption function: C = 40 + 0.8Y
• Numerical value of the multiplier:
  Y = c0 + c1Y + I
• The multiplier Formula:
  \frac{1}{1-c_1}
• The formula above tells us that the multiplier determines how much Y will change given changes in autonomous spending (c_0 + I).
• With the earlier consumption function, the multiplier equals 5.
  \frac{1}{1-0.8} = \frac{1}{0.2} = 5
• An increase in investment spending by 10 million pesos increases aggregate demand directly by 10 million pesos.
• Firms increase production and employment.
• With output and employment higher, income increases by 10 Million pesos.
• Households increase consumption. Aggregate consumption will increase by 0.8 times the increase in aggregate demand.
• Incomes will rise equal to the amount in the second round of spending.
• An additional 8 million pesos will come out as income to some people in the economy.
• The cycle continues until any additional increases in spending and income become zero.
• An increase in investment by 10 million pesos will result in an increase in GDP by 50 million pesos (multiplier of 5).
  \Delta Y = \frac{1}{1-c_1} [\Delta I]
• The multiplier suggests output changes when autonomous spending (including investment) changes, and the change in output can be larger than the change in autonomous spending.
• The multiplier magnifies the effects of shocks, whether positive or negative.
• Three Takeaways:
  • An increase in autonomous spending raises the equilibrium level of income.
  • The increase in income is a multiple of the increase in autonomous spending.
  • The larger the marginal propensity to consume (c_1), the larger the multiplier arising from the relation between consumption and income.

Goods Market Equilibrium (3-Sector Economy)

• Including the government introduces taxes (T), transfers (TR), and government spending (G).

• Equilibrium condition:
  Y = AD = c0 + c1(Y + TR - T) + I + G

• Rearranging:
  Y = \frac{1}{1-c1} [c0 + c1TR -c1T + I + G]

• Combining all autonomous expenditures:
  Y = \frac{1}{1-c_1} [A]

• An increase in government spending shifts the aggregate demand curve upward, increasing the equilibrium level of output.

• The increase in output equals the increase in government spending multiplied by the government spending multiplier (same as the investment multiplier).

• Assuming no changes in other spending items:
  \Delta Y = \frac{1}{1-c_1} [\Delta G] = [\Delta G]

• If government spending increases by 5 million pesos, the equilibrium level of output increases by 25 million pesos (multiplier = 5).
  \Delta Y = \frac{1}{1-0.8} [5] = 5[5] = 25

• If the level of transfer payments increases, we expect aggregate demand to shift upwards as consumption expenditure increases. This causes equilibrium level of output to increase as well.

• The increase in output will be equal to the increase in the level of transfer payments multiplied by the transfers multiplier:
  \Delta Y = \frac{c1}{1-c1} [\Delta TR] = [\Delta TR]

• If transfer payments by the government increases by 5 million pesos, equilibrium level of output increases by 20 million pesos, assuming the same mpc = 0.8.
  \Delta Y = \frac{0.8}{1-0.8} [5] = 4[5]

• If the level of autonomous taxation increases, we expect aggregate demand to shift downwards as consumption expenditure decreases. This causes equilibrium level of output to decrease as well.

• The decrease in output will be equal to the increase in the level of taxation multiplied by the tax multiplier:
  \Delta Y = \frac{-c1}{1-c1} [\Delta T] = [\Delta T]

• If government taxation increases by 5 million pesos, equilibrium level of output decreases by 20 million pesos, assuming the same mpc = 0.8.
  \Delta Y = \frac{-0.8}{1-0.8} [5] = -4[5]

• We can also model taxation as proportional to income:
  T = tY

  • where t is the income tax rate.

• Going back to the equlibrium equation, we will have:
  Y = c0 + c1(Y + TR - T) + I + G
  Y = c0 + c1(Y + TR -T) + I + G

• New autonomous spending multiplier:
  =\frac{1}{1-c1(1-t)} [c0 + c_1TR + I + G]

• The multiplier decreases in size; any effects to income caused by changes in the autonomous spending components are dampened, or lessened.

• Any increase in the income tax rate will flatten the aggregate demand curve.

• The multiplier decreases in size; any effects to income caused by changes in the autonomous spending components are dampened, or lessened.

• Any increase in the income tax rate will flatten the aggregate demand curve.

• Example: c_1; t = 0.25

• With an increase in government spending:
  \Delta Y = \frac{1}{1-c_1(1-t)} [\Delta G]

• With example earlier, income will increase by 12.5M from an increase of 5M in government spending using the new multiplier\Delta Y = 2.5[5]

Goods Market Equilibrium (4-Sector Economy)

• Home economy sells goods and services abroad (exports).

• We also demand goods and services from other countries (imports).

• The amount of imports depends on domestic incomes.

• Marginal propensity to import (m): The fraction of each additional unit of income spent on imports.
  IM = mY

  • where 0 < m < 1

• Putting together all components of aggregate demand:
  AD = c0 + c1(Y + TR - T) + I + G + X - IM

• Both taxes and imports decrease the multiplier (leakages).

• Spending that could have been used for domestic consumption ends up as taxation and importation of foreign commodities.

• New autonomous spending multiplier:
  =\frac{1}{1-c1(1-t) + m} [c0 + c_1TR + I + G + X]

Exercise

1. Find the level of equilibrium output given: C = 50 + 0.8Y
2. Suppose, G becomes 250, by how much will output change?
3. Suppose t increases to 0.3 in order to accommodate the increase in government spending, what is the new equilibrium level of output including the effect of the increase in government spending?
4. If a budget surplus means that T > G + TR, calculate if we have a budget surplus or a budget deficit, given the new policy changes.