Chapter 12 Economic Fluctuations

Equilibrium Inventory changes.  Unintended changes in inventories cause price levels and real outputs to reach equilibrium.  Two possibilities: the results of an inventory increase and of an inventory decrease.

An Economy in Equilibrium

Positive Unplanned Investment: an unintended increase in inventories; a surplus Results of an Inventory Increase Results of an Inventory Decrease Negative Unplanned Investment: an unintended decrease in inventories; a shortage

 Unplanned investment plays a central role in stabilizing the economy, whether there is an inventory increase or decrease. The Role of Unplanned Investment  Unplanned investment is positive when the price level is above its equilibrium value and negative when the price level is below its equilibrium value, and in each case unplanned investment is identical to the discrepancy between aggregate demand and aggregate supply.

Injections and Withdrawals Injections: additions to an economy’s income-spending stream i.Investment (I) ii.Government purchases (G) iii.Exports (X) Withdrawals: deductions from an economy’s income- spending stream. i.Saving (S) ii.Taxes (T) iii.Imports (M)

Investment and Saving There are 3 reasons the amount saved and the amount invested in an economy is not equal: 1)companies keep a portion of their profits to reinvest 2)governments also borrow money 3)foreign funds

Government Purchases and Taxes If government purchases exceed taxes:  governments will borrow funds in financial markets If taxes exceed government purchases:  governments can use their excess revenues to pay off some of their outstanding debt.

Exports and Imports  imports were greater than exports from 1989 to 1993  that means Canadians are spending more on foreign goods than they receive revenue from selling products to foreigners.

Total Injections and Withdrawals  comparing these two provides a way of explaining macroeconomic equilibrium that complements the approach using aggregate demand and aggregate supply.  total injections = ( I + G + T )  total withdrawals = ( S + T + M ) Expanding economy: total injections > total withdrawals  flows into the income-spending stream falls are less than output

 the income-spending stream falls and slows down Contracting economy: total withdrawals > total injections  flows into the income-spending stream are less than outflows  the income-spending stream falls and slows down Equilibrium: total injections = total withdrawals  inward and outward flows match, the income- spending stream circulates at a steady rate, so that real output and spending in the economy stay constant

Equilibrium With Injections and Withdrawals

An Economy at Its Potential Output

Equilibrium Vs. Potential Output  it is possible for equilibrium to occur at the economy’s potential output. In this case, actual unemployment equals the natural unemployment rate Recessionary Gaps  an economy’s real output rarely equals its potential output.  if equilibrium output is below its potential level, unemployment is above the natural unemployment rate.  recessionary gap: the difference between equilibrium output and potential output

Inflationary Gaps  if equilibrium output is above its potential output, unemployment is temporarily below the natural unemployment rate.  inflation will accelerate if this situation persists.  Inflationary Gap: when equilibrium output exceeds potential output

Recessionary and Inflationary Gaps

John Maynard Keynes and the Transformation of Macroeconomics John Maynard Keynes ( ) His father was an economist and his mother was a city politician. Studied mathematics at Cambridge University Published The General Theory of Employment, Interest, and Money. During the Depression, Keynes and his followers were able to convince most politicians and economists that government intervention with a coherent theory, which stressed the role-played by aggregate demand in determing output in the macroeconomic,. Keynesian ideas dominated macroeconomics from after WWII to the end of 1970’s.

Neoclassical Theory Prior to Keynes, most economists believe that economic slowdowns are self-correcting, this is referred to as the neoclassical theory. Two major assumptions: flexible labour markets and Say’s Law.

Flexible Labour Markets  The demand and supply of labour depend on the real wage rate, or wages expressed in constant basted-year dollars, rather than the nominal wage rate, which is valued in current dollars.  Both workers and employers adjust their behavior only when the purchasing power of wages changes.  Employers demand less labour at higher real wage rates, while workers choose to supply more.

Voluntary unemployment: when workers decide that real wages are not high enough to make work worthwhile. Involuntary unemployment: when someone wants to work at the current real wage rate but cannot find a job. Involuntary unemployment occurs when market demand and supply create a surplus, and as long as labour markets are flexible, the market forces of demand and supply eradicate the surplus.

A Flexible Labour Market

Say’s Law  First outlined by a French economist Jean-Baptiste Say.  Using the circular flow of money in the economy, Say argued that supply automatically creates its own demand.

Keynesian Theory Keynes challenged both of the assumptions of neoclassical economics. A theory that explained how involuntary unemployment and under spending had become chronic problems during the Depression

Challenge to Flexible Labour Markets  Keynes believed workers were influenced by money illusion.  Workers would respond to changes in nominal wages, rather than real wages and purchasing power.

Challenge to Say’s Law Keynes proved Say’s Law is only valid if all income in an economy is spent. According to the law, reduced spending is only temporary; total expenditures and production soon balance each other out. This occurs since total withdrawals and injections can be equal at any output. Interest rates charged in financial markets will vary until withdrawals leaving the circular flow are matched by injections. However, Keynes proved that output levels, not interest rates, adjust to bring about a balance between total injections and withdrawals. Say’s Law is only true when injections are less than withdrawals, output falls until a new equilibrium level is reached, and it is only at this equilibrium that this law is true.

An Inflexible Labour Market