Output, growth and business cycles Econ 102

How does GDP change over time? GDP/cap in countries: The average growth rates of countries are different. Two components to growth: – Long-run trend growth – Short-run fluctuations

Average Growth Rates of GDP/cap The average growth rates of countries are different.

Potential GDP/cap grows over long-run Trend GDP/cap, (With normal rate of utilization of factors), Countries with: – High savings rate have higher GDP/ cap. – High population growth rates have low GDP/ cap.

GDP, per capita GDP and savings rate

How to analyze the GDP/cap over time? Long-run trend growth – The LR changes in potential GDP/cap Short-run fluctuations: Business cycles

Output grows over time:

Which output level is produced: Demand and Supply Aggregate Demand and Aggregate Supply

SR and LR Aggregate Supply There are constraints on Price changes and Output changes. Very long run: capacity is growing, shifts in the LRAS curve. Long run AS: capacity of production is constant, an increase in demand increases prices but not quantity. Short run AS : price pressures are less, there are unemployed resources and if demand increases output increase without price increase.

Very long run Aggregate Supply

SR and LR Aggregate Supply LR Aggregate SupplySR Aggregate Supply

Business Cycles Expansionary Period: – Production, employment and income increase. – Pressure in factor markets and on wages. – Prices and rate of change in prices increase. – Interest rates are increasing/ Boom: at the peak, – over utilization of resources, lowest rate of unemployment. Contractionary period: – Demand, production, employment and income decrease, – Price pressures are less and wage demands are smaller or none. Trough: (Depression or Recession) – at the bottom, highest unemployment rate.

Why do we have business cycles?

Economic Models: representation of reality – Abstract from details not seen as relevant, – Use Assumptions to create an environment to examine, – Using the Model ask the questions that you are interested in, – Compare the results with the reality, – If they are correct, continue to examine, – If wrong, define a new model.

Why do we have business cycles? Economic Model Aggregate Demand Aggregate Production Aggregate Demand determines Aggregate Production

Equilibrium output (income) Keynesian Model: John Maynard Keynes “General Theory of Employment, Interest and Money” (1936) Years of Great Depression (or 1945)

Great Depression Output fell by more than 50% in US

Output decline during Great Depression

Equilibrium output (income) Keynes’ Principle diagnosis of the situation was that there was not enough expenditures Basic principles of the equilibrium: Aggregate Expenditure= Output

Keynesian Model Aggregate Expenditures 45 o Aggregate Output (Income)

Keynesian Model Aggregate Expenditures 45 o Aggregate Output (Income)

Aggregate Demand or Aggregate Expenditures Total of desired aggregate expenditures Which type expenditures? – Desired Consumption Expenditures: – Desired Investment Expenditures: – Government Expenditures: – Net Exports: WHY ‘DESIRED’ EXPENDITURES?

‘Desired’ Aggregate Expenditures Buyers in the Goods and Services Market: Desired Consumption Expenditures + Desired Investment Expenditures + Desired Government Expenditures + Desired Net Exports ___________________________________________________ Desired Aggregate Expenditures (AE d )

WHY ‘DESIRED’ EXPENDITURES? Agents may want to purchase, may plan to buy but Are there enough goods there? If not ? What happens? What type adjustment occur will happen?

Equilibrium in a Macroeconomy (Keynesian Model) Graphical Presentation and Equilibrium:

Disequilibrium adjustment If the economy starts at a point where AE ≠ Y; what happens? The forces in the economy will bring the economy to the equilibrium output level. (Stable equilibrium) If for example AE<Y… then inventories will pile up, the firms will cancel orders, firms will cut back production, fire workers, employment and production will decline until AE=Y. (Reverse is also true for AE>Y )

When will there be an equilibrium? When aggregate desired expenditures are equal to total output produced AE d = Y (Equilibrium) If Aggregate Expenditure is less than output AE d < Y, stocks of unsold good will pile up. If Aggregate Expenditure is more than output AE d > Y stocks of unsold good will decline.

Closer look at the components of desired AE? AE d = C d + I d + G d + X d – M d Household: C d depends on Disposable Income, after tax income. Firms: I d depends on cost of borrowing; interest rate. External Sector: X d and M d depends on exchange rate and Income of domestic and foreign income. Government: determines its own expenditure level G d (it is a policy tool).

Equilibrium in a Macroeconomy Keynesian Model: (emphasizes the demand side, assumes constant prices and unemployed resources) If AE d > Y, then there is unplanned decline in the inventory levels of the firms, firms start to increase production. If AE d = Y, then there is no unplanned change in inventory levels, no change in production (Equilibrium). If AE d < Y, then there is unplanned increase in the inventory levels of the firms, firms start to decrease production.

More of a closer look at the components of Aggregate Expenditures Desired Consumption Expenditures: C d – What is Disposable Income? DI – Therefore desired consumption expenditures are increasing function of DI and hence Y.

A Model for Desired Aggregate Expenditures Desired Investment Expenditures: I d The model assumes interest rates to be constant, hence we can write: –

A Model for Desired Aggregate Expenditures Desired Government Expenditures: G d – Therefore we can write as:

A Model for Desired Aggregate Expenditures Desired Net Exports: NX d I n the simple model the exchange rate and foreign income are held constant, hence we can write:

Mathematical Example Steps to find the Equilibrium Income (Output): 1.Find Desired Aggregate Expenditure Function as a function of Y. 2.Use equilibrium condition: AE d = Y 3.Solve for Y, which will be the level of output which is equal to the level of AE d. Example…

Economic Models Economic models are the use of simple (often mathematical) relationships in order to represent the complex of economic processes. We make assumptions and use the necessary variables we are interested in. We do not explicitly mention the other factors that might have relatively less important effect on the outcome. Example: Consumption Function and

Why does the Equilibrium Income change? If any of the autonomous spending increase then equilibrium income will increase from Y E to Y E NEW. Possible causes of autonomous income increase are: (Graphically all of these are vertical (upward) shift of the AE function)

How does the Equilibrium Income change? Example: If Investment increases from to (where ) Then

How does Eq. Income respond to a change in AE d ? What is the change in equilibrium income if I d increases? Multiplier: Numeric example…

Why is there a ‘multiplier effect’? Initial increase in autonomous spending sets off a series of increase in AE and in real GDP. First increases, which means firms want to purchase more new machines, the AE in the economy increases, the factories which makes these machines will hire workers. This will increase their salary payments, the workers will increase their desired consumption and hence the economy will move to a higher Y level along the new AE function.

How does the multiplier work?

Multiplier For one unit increase in the autonomous desired expenditures the equilibrium income increases by a multiple amount. The formula for the multiplier: The steeper the slope of AE function, the larger will be the multiplier.

Why do we need the multiplier information? If Desired Government Expenditure increase by 1 billion TL, we can tell what will be the change in the equilibrium income. (Multiplier x 1 billion TL) Hence we will be able to tell how much increase in desired government expenditure is necessary to bring the economy to Potential Real GDP level.

Output Gap = Y – Y Graphically Output Gap

Necessary change in G to close the Output Gap ∆Y= multiplier*∆G Hence you may compute the necessary change in change in G from the above equation, as ∆G= ∆Y/ multiplier

What if the government increases taxes by 1 Billion TL Is the effect on Real GDP ( Equilibrium income) expansionary or contractionary? ??? How much will be the change in Real GDP? ???

Potential Output Ideal level of income What is an ideal level of Real GDP? POTENTIAL INCOME (Full employment level of income) The income level that corresponds to the output that will be produced if all resources are employed at a ‘normal’ rate. Here, the output level at the Natural Rate of Unemployment, (U% is equal to only frictional + structural U% rate, and cyclical U% is zero.).