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.