Lecture 5 Business Cycles (1): Aggregate Expenditure and Multiplier 1

The Business Cycle A recession is a period of declining real GDP, falling incomes, and rising unemployment. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. A depression is a severe recession 2

Business Cycle Dates in the US – This figure shows the percentage change in real GDP over each cycle between 1928 and

Growth Rates of Real GDP and Consumption Real GDP Average growth rate Consumption Annual Percentage

China’s Short-Run Economic Fluctuations 5 Recession

Growth rates of investment, GDP and consumption Annual Percentage Investment Real GDP Consumption

Investment Spending in China 7 Recession

Time horizons Long run: Prices are flexible, respond to changes in supply or demand Short run: many prices are “sticky” at some predetermined level slide 8 The economy behaves much differently when prices are sticky.

In Classical Macroeconomic Theory, Output is determined by the supply side: – supplies of capital, labor – technology Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Complete price flexibility is a crucial assumption, so classical theory applies in the long run. slide 9

When prices are sticky …output and employment also depend on demand for goods & services, which is affected by  fiscal policy (G and T )  monetary policy (M )  other factors, like exogenous changes in C or I. slide 10

Long Run vs. Short Run Long run – prices flexible – output determined by factors of production & technology – unemployment equals its natural rate Short run – prices fixed – output determined by aggregate demand – unemployment is negatively related to output slide 11

The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat. 12 John Maynard Keynes

Aggregate Expenditure Actual Expenditure, Planned Expenditure, and Real GDP – Actual aggregate expenditure is always equal to real GDP. – Aggregate planned expenditure may differ from actual aggregate expenditure because firms can have unplanned changes in inventories. – Aggregate planned expenditure is another name of aggregate demand 13

Decompose AD/AE Y=C+I+G+NX How are the four components of GDP determined? What are the consequences of the changes in the four components of GDP? 14

Determinants of Consumption and Saving Consumption and saving are influenced by  The real interest rate  Disposable income  Wealth  Expected future income. Disposable income is aggregate income (GDP) minus taxes plus transfer payments.  The relationship between consumption expenditure and disposable income, other things remaining the same, is the consumption function. 15

Marginal Propensities to Consume The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent on consumption. That is: MPC =  C/  YD MPC is usually less than 1. Why? 16

Consumption and Saving Functions This figure illustrates the consumption function and the saving function. 17

Other Influences on Consumption When an influence other than disposable income changes—the real interest rate, wealth, or expected future income—the consumption function and saving function shift. This figure illustrates these effects. 18

Investment Investment decisions are affected by the following factors: – Expectations on future profitability – Tax rate, especially business tax and capital tax – Cash flow – Interest rate Investment decisions are not directly affected by current GDP. 19

Investment Function Investment function focuses on the relationship between investment and the interest rate r = interest rate High interest rate  fewer profitable investment projects  lower investment But investment decisions are not directly affected by GDP! 20

Investment Function 21 I r

Government We assume government variables are fixed at exogenous levels: 22

Net Export In the short run, imports are positively affected by domestic real GDP The marginal propensity to import is the fraction of an increase in real GDP spent on imports. The U.S. marginal propensity to import is about 0.2. For simplicity, we assume imports are fixed Exports are exogenously determined 23

Induced versus Autonomous Expenditure – Expenditure that varies with real GDP, is induced expenditure. – The sum of investment, government purchases, and exports, which does not vary with GDP, is autonomous expenditure. – Consumption expenditure and imports can have an autonomous component. 24

Aggregate Expenditure Curve 25

Equilibrium Expenditure – Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. 26

Equilibrium Expenditure This figure illustrates equilibrium expenditure, which occurs at the point at which the aggregate expenditure curve crosses the 45° line and there are no unplanned changes in business inventories. 27

Equilibrium Expenditure Convergence to Equilibrium – Figure 13.6 also illustrates the process of convergence toward equilibrium expenditure. 28

Equilibrium Expenditure If aggregate planned expenditure is greater than real GDP (the AE curve is above the 45° line), an unplanned decrease in inventories induces firms to hire workers and increase production, so real GDP increases. 29

Equilibrium Expenditure If aggregate planned expenditure is less than real GDP (the AE curve is below the 45° line), an unplanned increase in inventories induces firms to fire workers and decrease production, so real GDP decreases. 30

Equilibrium Expenditure If aggregate planned expenditure equals real GDP (the AE curve intersects the 45° line), no unplanned changes in inventories occur, so firms maintain their current production and real GDP remains constant. 31

The Multiplier – The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. 32

The Basic Idea of the Multiplier – An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and real GDP and the increase in real GDP leads to an increase in induced expenditure. – The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. – So real GDP increases by more than the initial increase in autonomous expenditure. 33

YearCINXReal GDPUnemployment 1929$661 billion$91.3 billion - $9.4illion$865 billion3.2% billion17.0 billion-$10.2 billion636 billion24.9% Great Depression and the Multiplier 34

The Multiplier This figure illustrates the multiplier. The Multiplier Effect The amplified change in real GDP that follows an increase in autonomous expenditure is the multiplier effect. 35

The Multiplier When autonomous expenditure increases, inventories make an unplanned decrease, so firms increase production and real GDP increases to a new equilibrium. 36

The Multiplier Why Is the Multiplier Greater than 1? – The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in expenditure. The Size of the Multiplier – The size of the multiplier is the change in equilibrium expenditure divided by the change in autonomous expenditure. 37

The Multiplier This figure shows the relation between the multiplier and the slope of the AE curve. In part (a) the slope of the AE curve is 0.75 and the multiplier is 4. 38

The Multiplier In part (b) the slope of the AE curve is 0.5 and the multiplier is 2. 39

Math Consumption function 2. Investment function 3.Government spending function 4. Net export function 5. Equilibrium condition

Math 41

Math 42 Lump-sum Tax Multiplier: Investment multiplier, government expenditure multiplier and foreign export multiplier:

Solving for  Y slide 43 equilibrium condition in changes because I exogenous because  C = MPC  Y Collect terms with  Y on the left side of the equals sign: Finally, solve for  Y :

The government purchases multiplier Example: MPC = 0.8 slide 44 The increase in G causes income to increase by 5 times as much!

The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the G multiplier equals slide 45 In the example with MPC = 0.8,

Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y:  Y =  G. But  Y   C  further  Y  further  C  further  Y So the final impact on income is much bigger than the initial  G. slide 46

An increase in taxes slide 47 Y E E =Y E =C 2 +I +G E 2 = Y 2 E =C 1 +I +G E 1 = Y 1 YY At Y 1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium  C =  MPC  T Initially, the tax increase reduces consumption, and therefore E:

Solving for  Y slide 48 eq’m condition in changes I and G exogenous Solving for  Y : Final result:

The Tax Multiplier def: the change in income resulting from a $1 increase in T : slide 49 If MPC = 0.8, then the tax multiplier equals

The Tax Multiplier …is negative: A tax hike reduces consumer spending, which reduces income. …is greater than one (in absolute value) : A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. slide 50

The Tax Multiplier …is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income. …is greater than one (in absolute value) : A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. slide 51