Outline Macroeconomic Theory and Policy Chapter 9 – Aggregate Demand and Economic Fluctuations Section 1 – Business Cycle Section 2 – Macroeconomic Modeling and Aggregate Demand Section 3 – Keynesian Model

Aggregate Demand and Economic Fluctuations Remember: macroeconomic goals of good living standards, sustainability and stabilization Now focusing on stabilization One key aspect: understanding how the amount people would like to spend overall is influenced by and influences all other macroeconomic variables. overall spending = aggregate demand Keynesian vs. classical -> need for intervention

Business Cycle Business cycle – fluctuations in the level of national production, alternating between booms and recessions. Macroeconomic policy aims to maintain stabilization to smooth out variations

Business Cycle Stylized Facts – important but not always literally true! Fact 1: During an economic downturn (recession, contraction), unemployment increases. Rule of thumb: Okun’s Law Empirical inverse relationship btw unemployment rate and real GDP growth. (e.g. 1 per cent drop in unemployment rate is associated with approx. 3 per cent boost to real GDP) Not always perfect relation! e.g. jobless recoveries

Business Cycle Fact 2: An economic recovery or expansion, if it is very strong, may lead to an increase in the inflation rate. Why? As economy “heats up”, more competition over the resources -> prices/wages increase, intensifying inflation. Remember: Philips curve Evidence: business-cycle-led variations in competition is only one cause of variations in inflation – will discuss later!

Business Cycle Stylized business cycle – based on overall growth trend in GDP. Full employment output Assumed to correspond to a case of no excessive unemployment The goal of stabilization policy is to keep the economy in this “band”, avoiding the threats of inflation and unemployment

Macroeconomic Modeling and AD Model: “thought experiment” using variables, based on certain assumptions Remember: traditional model – simplified form of economic activites taking place btw 4 sectors Further simplification: -Assume FE output does not grow. -Actors: households&businesses (only for Ch 9) -Keynesian view: recession + rising unemployment due to potentially insufficient aggregate demand

Macroeconomic Modeling and AD Y = output/income (will be used interchangeably) Incomes from production give rise to spending that stimulates producers to produce the original level of output Equilibrium->income=spending C = consumption decisions by hh II = intended investment by biz. AD = C + II

Macroeconomic Modeling and AD Y = C + I -> accounting identity with actual levels AD = C + II -> behavioural equation with intended levels, whether or not this planned level matches with what is actually achieved. Link from Y to AD - potentially weak: people with incomes do not just automatically go and spend it all! Leakages: savings!! Saving: part of income that is not spent on consumption Y= C + S => S = Y - C

Macroeconomic Modeling and AD Businesses also need funds to buy investment goods. Assume: firms must borrow from the savings put aside by hh to finance investment projects Intended investment: injection! Equilibrium: leakages = injections; S = II => Y = AD When economy is in equilibrium, this means that spending is exactly sufficient tu buy the output produced. What if hh or business changes their minds??

Macroeconomic Modeling and AD Suppose businesses decide to cut back future plans for expansion (reduce II) or households decide to consume less (increase S). Leakages exceed injections (S > II => Y > AD) Planned spending is not sufficient to support existing level of output (or vice versa) Need for adjustment! Solution??? Classical vs. Keynesian Different solutions for adjustment

Macroeconomic Modeling and AD Classical Solution to Leakages Q: how does an economy (assumed to run in FE) keep leakages into saving exactly equal to the injections coming from intended investment? Flexible markets! Which market?? Market for loanable funds: supply comes from households (S), demand comes from firms (II); price = interest rate Equilibrium = FE balance

Macroeconomic Modeling and AD Classical Solution to Leakages Imbalance: suppose firms decide to cut back II, demand for loanable funds decrease, excess supply of funds at the equilibrium rate, price falls, households choose to save less and consume more until new demand equates supply. AD still equal to FE level, S = II Less II balanced by more C Self-sustaining economy at FE level thanks to price adjustment

leakage injection Production generates income Spending stimulates firms to produce Saving (S ) Equilibrium in the market for loanable funds Intended Investment (II ) is equal to S Output (Y* ) Consumption (C ) Income (Y* ) Spending sufficient to sustain full employment AD = Y* Aggregate Demand and Economic Fluctuations Remember: Classical view on macroeconomic equilibrium

Keynesian Model of AD Assume: simple closed economy, no government Consumption: households are able to spend on consumption when income is generated Consumption function – autonomous part and a part that depends on the level of aggregate income C = C 0 + mpc. Y C 0 : autonomous consumption, not related to income minimum level of consumption that people feel required to spend for survival mpc: marginal propensity to consume, the amount of additional consumption people make for each additional income they receive

Keynesian Model of AD Logically 0 <mpc < 1 Remember: saving is the part of income not spent on consumption by households. S = Y – C = Y – (C 0 + mpc. Y) = - C 0 + (1-mpc) Y mps: marginal propensity to save = 1 – mpc Additional saving when income increases Plot consumption = income line (45 degree line) Consumption function – increasing in income Distance between C and 45 degree line is savings

45 Consumption (C ) (= + mpc Y) Income (Y ) Consumption (C ) Consumption = Income Line 400 Saving (S) = Slope = mpc Keynesian Model of AD

Consumption function may shift due to -wealth: if feel wealthier, may tend to spend more -consumer confidence: if less confident about future (e.g. political instability, war etc.), tend to spend less -attitudes: if many people decide to spend less due to health or environmental concerns, overall consumption may slow down -government policies: any policy to raise savings (as a source of capital) may lower C -income distribution: poorer may tend to spend more ; a more egalitarian distribution of income raises C

Keynesian Model of AD Investment : cost of borrowing is only factor in amount of investment, but an important determinant of level of investment “animal spirits” – optimism / pessimism of investors about future intended investment is autonomous: II = II 0 Aggregate Demand AD = C + II Any increase in consumer and investor desired spending increases AD

Consumption (C ) Income (Y ) Consumption, Investment, and Aggregate Demand 400 Aggregate Demand (AD ) = C + II Intended Investment (II ) C +II = Keynesian Model of AD

Unintended investment? Occurs when AD is insufficient; in other words when the inventories build up unexpectedly Actual investment: I I = II + excess inventory accumulation or depletion Plot output = income line (45 degree line) Difference between 45 degree line and AD is unintended investment Keynesian Model of AD

45 Income (Y ) Aggregate Demand and Output Output = Income Line Aggregate Demand (AD ) 800 E unintended investment (build up of inventories) Keynesian Model of AD

Movement to equilibrium – will cut back production until excess inventories are used up When economy arrives at equilibrium, balance between S & I has been restored – due to changes in income!! Persistent unemployment? Keynesian view: there is no automatic mechanism that settles the economy Great Depression: stock market crash, cut back investment spending, contraction, low income high unemployment equilibrium – need for stimulus Keynesian Model of AD

Output (Y* ) Income (Y* ) Insufficient Spending AD < Y* Production generates income Income goes to households If leakages are larger than injections… Lower Income Lower Spending AD = lower Y Lower Output Keynesian Model of AD