Business Cycles Fall 2013

US Real GDP (Quarterly series)

Real GDP Turkey

Real GDP in Turkey

Growth rate of Real GDP in Turkey

Why? What to do about it? Alternative 1: Do nothing; it will come to back to Potential Output, (long run level of output) Alternative 2 : Do economic policy to correct the business cycles.

Why? What to do about it? ‘Schools of Thought’ Historical Perspective Classical View (until 1930s Great Depression) (Start of Macroecononomics) Keynesian View (recovery of Great Depression) Recent Perspective New Keynesians Monetarist Model The New Classical Model Real Business Cycles

Keynesian View Flow of demand for goods and services vs. Flow of supply of goods and services in GOODS AND SERVICES MARKET

Keynesian Macroeconomics Aggregate Expenditure (aggregate demand) vs. Aggregate Supply

‘Desired’ Aggregate Expenditures Buyers in the Goods Market: 1.Desired Consumption Expenditures, 2.Desired Investment Expenditures, 3.Desired Government Expenditures, 4.Desired Net Exports WHY ‘DESIRED’ EXPENDITURES?

Agents may want to purchase, plan to buy but Are there enough goods there? If not ? What happens? How does the adjustment occur? What happened at the end of 2008 in Turkey?

Equilibrium in a Macroeconomy Keynesian Model: (emphasizes the demand side) 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.

Equilibrium in a Macroeconomy 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 )

What determines the desired AE? AE d = C d + I d + G d + X d – M d Household: C d depends on Disposable Income. Firms: I d depends on cost of borrowing. External Sector: X d and M d depends on exchange rate and Income. Government: determines its own expenditure level G d (it is a policy tool).

A Model for Desired Aggregate Expenditures Desired Consumption Expenditures: C d – What is Disposable Income? YD Therefore desired consumption expenditures are an increasing function of Y.

A Model for Desired Aggregate Expenditures Desired Investment Expenditures: I d Therefore we can write as:

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 (in the simple model) Therefore we can write as:

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…

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 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.

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.).

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? ???