IB

Business_cycles_and_keynesian_theory

Business Cycles and the Keynesian Theory

Introduction

  • Defined by periodic expansions and contractions in an economy.

  • Present in both developed and developing countries, occurring throughout modern history.

  • Represents fluctuations in macroeconomic variables, particularly GDP.

Plan for Today

  • Discussion on:

    • Business cycles.

    • Keynesian intuition.

    • A more formal model of Keynesian theory.

Understanding Business Cycles

Definition

  • Business cycles encompass phases of economic growth and decline, characterized by:

    • Expansion: Periods of increased economic activity.

    • Recession: Periods of economic decline.

    • Depression: Extended harsh recessions.

    • Recovery: Periods where the economy rebounds.

Characteristics

  • Economic performance is inconsistent, marked by good and bad years.

  • Unpredictability across different economies.

  • GDP is a primary indicator, but other macroeconomic variables are also relevant.

Theoretical Framework

Business Cycle Model

  • Graphical representations include:

    • Peaks and troughs indicating high and low points of economic activity.

    • Changes in growth rates, such as peaks during periods of economic boom (e.g., Celtic Tiger) and declines during recessions.

Fluctuations in Unemployment

  • Unemployment rates are correlated with national income per Okun’s Law:

    • High unemployment occurs in recessions, low unemployment during economic booms.

    • Fluctuations vary significantly between countries (e.g., pronounced in Ireland).

Inflation Dynamics

Historical Overview

  • Analysis of inflation rates in Ireland from 1960 to 2023:

    • Significant peaks during the 1970s and 1980s reflecting economic instability.

  • Evidence of business cycles present in inflation patterns, as illustrated by the Phillips Curve.

Global Patterns

  • Similar inflation trends observed in other countries:

    • Notable synchronization in inflation rates across OECD countries.

Potential and Actual Output

Conceptual Understanding

  • Potential Output: The highest level of economic production achievable when all resources are employed effectively.

  • Discrepancies between actual and potential output reflect business cycles.

    • Lower output during recessions leads to increased unemployment.

    • Higher output during booms can cause inflation as demand exceeds supply.

Measurement

  • Estimations conducted by organizations such as the World Bank to gauge potential output.

  • The actual/potential output ratio fluctuates around the value of 1, indicating economic performance against capacity.

  • In Ireland, actual output remains above potential since 2014 despite measurement challenges.

Interventionist Views: Keynesian Economics

Importance of Accounting for Business Cycles

  • Keynes emphasizes the significance of short-term economic fluctuations, contending that ignoring them is impractical:

    • Keynes Quote: "In the long run, we are all dead."

Counter-Cyclical Policies

  • Keynesian economic policies advocate for:

    • Slowing down the economy during booms to control inflation.

    • Supporting economic activity during recessions to mitigate unemployment.

Aggregate Demand

  • Aggregate demand plays a crucial role in driving economic performance:

    • Short-term output can be influenced by sufficient or insufficient demand.

    • Dynamics leading to either higher or lower outputs based on consumer and firm behavior.

The Keynesian Cross Model

Expenditure Framework

  • Describes the relationship among aggregate consumption, investment, and government spending:

    • Key equation: [ E = C + I + G ] (Expenditures = Consumption + Investment + Government spending)

Analysis of Consumption

  • Consumption is a primary component of aggregate demand characterized by a linear relationship relative to disposable income:

    • Formula: [ C = a + b(Y - T) ]

    • Autonomous consumption (basic needs) and income-induced consumption (additional spending based on income).

Equilibrium Point

  • The intersection of expenditure and income lines demonstrates economic equilibrium:

    • Evaluating scenarios of potential underutilization of resources when demand falls short of full economic capability.

Policy Implications

  • Insights derived from the Keynesian cross indicate:

    • The equilibrium level of economic activity can be less than the potential output due to inadequate demand, warranting fiscal and monetary policy interventions.

Conclusion

  • Reflection on the necessity of understanding business cycles and appropriate economic interventions to enhance stability in the economy.