KW5_Ch11 - short

Understanding Business Cycles

• What drives business cycles?

  • Fluctuations in real GDP

  • Two contrasting theories:

    • Pre-Keynesian View (Classical):

      • Economy is self-regulating

      • Automatic tendency towards full employment

    • Keynesian View:

      • Economy is not self-regulating

      • Fluctuations in spending (aggregate demand) drive business cycles

      • Lack of spending can lead to recession

      • Necessity of government policies (monetary and fiscal) to stabilize business fluctuations

Income-Expenditure Model

• Goal:

  • Offer a Keynesian model of business cycles

  • Determine factors that influence real GDP

  • Conclusion:

    • Fluctuations in GDP are influenced by spending levels

Income-Expenditure Model: Assumptions

• GDP Formula: GDP = C + I + G + X - IM

• In a closed economy (no international trade):

  • X = 0, IM = 0

• No government present:

  • G = 0, TR = 0, T = 0

• Simplified GDP equation: GDP = C + I

Consumer Spending (C)

• Household consumption depends largely on income.

Current Disposable Income and Consumer Spending

• Current Disposable Income:

  • Income after taxes and received government transfers

• Example 2015 Data:

  • Average Household Disposable Income: $46,807

  • Average Household Consumer Spending: $45,912

The Consumption Function

• Definition: An equation showing the relationship between household consumer spending and disposable income

• Formula: c = a + MPC × yd

  • c = household’s consumer spending

  • yd = household disposable income

  • MPC = marginal propensity to consume

  • a = autonomous consumer spending (spent even at zero income)

The MPC

• Concept: Slope of the consumption function

• Calculation: If spending increases by $6 with a $10 rise in income, then MPC = $6/$10 = 0.6

• Savings: Anything not spent is saved

  • MPS: Marginal propensity to save, calculated as MPS = 1 - MPC

Fit of the Data to Theory

• Current conditions in 2015:

  • Autonomous spending: $16,070

  • MPC: 0.67

Aggregate Consumption Function

• Definition: Relationship between aggregate disposable income and aggregate consumer spending

• Formula: C = A + MPC × YD

  • Same structure as the consumption function but at an aggregate level

• Influences on Autonomous Consumption (A):

1. Consumer expectations (confidence)

2. Wealth (assets like stocks and housing)

• Impact of Higher Autonomous Consumption:

  • Shift in consumption function upward

Shifts in the Aggregate Consumption Function

• If consumers expect higher income or wealth:

  • Consumption increases at all income levels

  • Opposite occurs for lower expectations

Investment Spending (I)

• Definition: Sum of planned and unplanned inventory investment

  • I = Iplanned + IUnplanned

Determinants of Planned Investment Spending

• Factors:

  1. Interest rate

  2. Expected future real GDP (accelerator principle)

     • Higher GDP growth leads to higher planned investments

  3. Current production capacity

     • Higher capacity leads to less desire for new purchases

Inventories and Unplanned Investment Spending

• Inventories: Stocks held for future sales

  • Example: Change in inventory from 200 to 230 computers shows a positive inventory investment of 30 computers

• Unplanned Changes in Inventories:

  • Positive when actual sales are less than expected (IUnplanned > 0)

    • Firms produce less

  • Negative when sales exceed expectations (IUnplanned < 0)

    • Firms produce more

  • Zero when actual sales meet expected levels (IUnplanned = 0)

Income-Expenditure Model

• Look at spending changes and firm responses.

• Importance of Inventories:

  • Key for understanding economic directions

• Model Goal:

  • Explain real GDP determinants and business cycle influences

• Simplified Equations:

  • GDP = C + I

  • Planned aggregate spending (AEPlanned) = C + IPlanned

Income-Expenditure Equilibrium

• Equilibrium Condition:

  • GDP = C + IPlanned + IUnplanned

• When real GDP exceeds planned spending, unplanned inventory investment is positive.

  • When real GDP is less than planned spending, unplanned inventory investment is negative.

• Equilibrium Level:

  • Economy balances when real GDP equals planned aggregate spending (IUnplanned = 0)

Multiplier Process

• Concept:

  • GDP changes by more than the initial change in spending

  • Multiplier effect escalates changes in spending and GDP

• Example:

  • Increase of $100 billion in construction spending leads to further GDP increments.

• Formula:

  • Total increase in GDP = (1 + MPC + MPC² + MPC³ + ...) × $100 billion

• Multiplier Calculation:

  • Demonstrates the chain reaction from initial spending changes.