L6._Business_cycle_terminology_and_aggregate_spending

Economic Fluctuations and Unemployment

Introduction to Business Cycles

• Definition of Business Cycles:

  • Periodic fluctuations in economic activity measured by employment, prices, and production levels.

  • First use of the term was in 1919; industrial cycles noted from the mid-19th century.

Historical Perspective

• First Industrial Cycles (UK 1800-1860):

  • Total of 14 cycles, averaging 4.3 years.

• Subsequent Cycles (1860-1914):

  • 7 cycles with an average length of about 7.5 years.

  • Noted industrial depression post-1873 until WWI.

Phases of Business Cycles

1. Peak:

   • Maximum productive capacity utilization, shortages may arise.

2. Recession:

   • Defined as two successive quarters of declining real GDP, leading to reduced incomes, employment, and profits.

   • Deep, prolonged recessions termed as depressions.

3. Trough:

   • High unemployment and low demand, low business confidence.

4. Recovery:

   • Rise in incomes, employment, optimism in business; new investments begin.

Great Depression

• Historical Context:

  • Unemployment peaked at 22% in 1932, with specific industries suffering more.

• Notable unemployment rates:

  • Coal miners: 34.5%

  • Steelworkers: 47.9%

  • Shipbuilders: 62%

Theoretical Perspectives

• Marx (1850s): Recognized negative impacts of recessions.

• J.A. Hobson (1896): Cited 'over-production' as a cause linked to income inequality.

• Government involvement in economic issues was not seriously considered until the 1930s.

Economists’ Reactions to the Great Depression

• Economists like Robbins and Schumpeter believed the economy was fundamentally sound and resisted intervention.

• **Keynes’ Contributions:

  • Argued for the necessity of government intervention to address unemployment.

  • Developed the General Theory of Employment that emphasized effective demand for full employment.**

Keynes’ Short-Run Macroeconomic Framework

• Defined the short-run in economics as a period characterized by a negative output gap (actual < potential).

• Focus on maintaining minimal gaps between actual and potential GDP.

Aggregate Expenditure (AE) and Consumption

• Keynes’s framework: Evaluated what determines aggregate expenditure

• Components of Aggregate Expenditure:

  • Consumption (C) – households' expenditure.

  • Investment (I) – business spending.

Consumption Function and Behavior

• Key Concept: Level of aggregate consumption depends on aggregate income.

• Keynes states:

  • Consumption is positively correlated with disposable income but does not rise in proportion to income increases.

• Marginal Propensity to Consume (MPC):

  • Definition: MPC = ∆C/∆Y, indicating that consumption changes less than income changes.

  • Progressively smaller MPC at higher income levels suggests a non-linear consumption function.

Savings Function

• Saving is defined by the relationship between consumption and income:

  • S = Y - C

• Average Propensity to Save (APS) and Marginal Propensity to Save (MPS):

  • APS = S/Yd; MPS = ∆S/∆Yd

  • Relationship: APS + MPC = 1; MPS + MPC = 1.

Investment Spending

• Investment is the most volatile GDP component and is typically influenced by business expectations rather than alone by interest rates.

• Types of Investment:

  1. Inventories – changes in stocks of goods.

  2. Residential housing construction.

  3. Business fixed capital – durable investments in operations.

Aggregate Spending Function

• Overall Equation:

  • Aggregate Expenditure (AE) = C + I

  • Marginal Propensity to Spend (c) measures the change in aggregate spending relative to changes in income (∆AE/∆Y).

Conclusion

• The emergence of trade cycles is an inherent feature in capitalism.

• Marx connected economic cycles to fluctuations in unemployment.

• Keynes contended against classical views, arguing for a demand-driven economic model instead of a supply-driven one, highlighting the demand-side necessity for economic functioning.