Chapter Nine: Aggregate Demand and Economic Fluctuations

The Business Cycle

Figure 9.1: U.S. Real GDP and Recessions Source: BEA quarterly data 1985–2012, and NBER

Figure 9.2: U.S. Unemployment Rate and Recessions

Figure 9.3: U.S. Inflation Rate and Recessions Source: “Economic Report of the President” 1985–2005; rate is calculated as a three-month moving average of the CPI; NBER.

Year Trough ContractionExpansion GDP Y* Peak Figure 9.4: A Stylized Business Cycle

(a)Real Standard and Poor’s Stock Index (b)Unemployment rate (official) 3.2%24.9% (c)Price level (CPI) (d) Real gross domestic product865.2 billion635.5 billion (e) Real personal consumption expenditures661.4 billion541.0 billion (f) Real gross private domestic investment91.3 billion17 billion (g)Real private debt 88.9 billion102.0 billion (h)Bankruptcy cases 56,86767,031 (i)Non-farm real estate foreclosures 134,900252,400 (j)Food energy per capita per day (calories) Table 9.1: The Early Years of the Great Depression in the United States Sources: (a) from Historical Statistics of the United States, p. 1004, series X495.; (b)-(c) from Dornbusch, Fischer, & Startz (2001);( d)-(f) from (g) from Historical Statistics of the United States, p. 989, series X399.; (h) from Bradley Hansen and Mary Eschenbach Hansen, The Transformation of Bankruptcy in the United States ( ); (i) from Historical Statistics of the United States, p. 651, series N301; (j) from Ibid., p. 328, series 851; (d) and (e) are inflation-corrected using (b)

Macroeconomic Modeling and Aggregate Demand

Output (Y ) Income (Y ) Spending (Aggregate Demand or AD ) Spending stimulates firms to produce Production generates incomes Incomes give actors the ability to spend Figure 9.5: The Output-Income-Spending Flow of an Economy in Equilibrium

Production generates income to households Saving (S ) leakage Intended Investment ( I I ) injection firms decide how much to invest households decide how much to consume and save Output (Y ) Spending (AD ) Income (Y ) Consumption (C ) ? Sufficient to sustain output at a steady level Figure 9.6: The Output-Income-Spending Flow with Leakages and Injections

Quantity of funds borrowed and lent Interest rate 140 5% Supply of Loanable Funds Demand for Loanable Funds E1E1 Figure 9.7: The Classical Model of the Market for Loanable Funds

Quantity of funds borrowed and lent Interest rate 140 5% Supply of Loanable Funds Original Demand E1E1 New Demand 60 3% E0E0 Figure 9.8: Adjustment to a Reduction in Intended Investment in the Classical Model

leakage injection Production generates income Spending stimulates firms to produce Saving (S ) Equilibrium in the market for loanable funds Intended Investment (I I ) is equal to S Output (Y* ) Consumption (C ) Income (Y* ) Spending sufficient to sustain full employment AD = Y* Figure 9.9: Macroeconomic Equilibrium at Full Employment in the Classical Model

The Keynesian Model

(1) Income (Y) (3) The part of consumption that depends on income, with mpc = 0.8 =0.8  column(1) (4) Consumption C = Y = column(2) + column(3) (5) Saving S = Y–C = column(1) –column(4) Table 9.2: The Consumption Schedule (and Saving)

45 Consumption (C ) (= + mpc Y) Income (Y ) Consumption (C ) Consumption = Income Line 400 Saving (S) = Slope = mpc Figure 9.10: The Keynesian Consumption Function

Income (Y ) Intended Investment (= I I ) Intended Investment (I I ) (= I I ) I I = 60 Figure 9.11: The Keynesian Investment Function

Consumption (C ) Income (Y ) Consumption, Investment, and Aggregate Demand 400 Aggregate Demand (AD ) = C + I I Intended Investment (I I ) C +I I = Figure 9.12: Aggregate Demand

Table 9.3: Deriving Aggregate Demand from the Consumption Function and Investment (1) Income (Y) (2) Consumption (C) (3) Intended Investment (II) (4) Aggregate Demand AD = C + II = column (2) + column (3)

Table 9.4: Aggregate Demand with Higher Intended Investment (1) Income (Y) (2) Consumption (C) (3) Intended Investment (II) (4) Aggregate Demand (AD)

Income (Y ) Aggregate Demand AD (I I = 140) 800 AD (I I = 60) Figure 9.13: Aggregate Demand with a Higher Level of Intended Investment = =

(1) Income (Y) (2) Aggregate Demand (AD) (3) Excess Inventory Accumulation (+) or Depletion (-) = column(1)- column(2) (4) Intended Investment (I I ) (5) Investment (I) = column(3) + column(4) (6) Check that the macroeconomic identity still holds: Y = C+I Table 9.5: The Possibility of Excess Inventory Accumulation or Depletion

45 Income (Y ) Aggregate Demand and Output Output = Income Line Aggregate Demand (AD ) 800 E unintended investment (build up of inventories) Figure 9.14: Unintended Investment in the Keynesian Model

45 Income (Y ) Aggregate Demand and Output AD 0 (I I = 140) 800 E0E0 Full Employment Y* 160 Figure 9.15: Full Employment Equilibrium with High Intended Investment

45 Income (Y ) Aggregate Demand and Output AD 0 (I I = 140) 800 E1E1 E0E0 Full Employment AD 1 (I I = 60) Persistent unemployment equilibrium Y* Figure 9.16: A Keynesian Unemployment Equilibrium

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 Output (Y* ) Figure 9.17: Movement to an Unemployment Equilibrium

(1) Change in Intended Investment (2) Change in Aggregate Demand (as C or I I change) and in Output and Income (as firms respond to changes in AD) (3) Change in Consumption ΔC = mpc Δ Y =.8  Column (2) 1. Investors lose confidence. Δ I I =  Reduced investment spending leads directly to Δ AD =  80. Producers respond to reduced demand for their goods by cutting back on production. Δ Y =  Less production means less income. With income reduced by 80, households cut consumption by mpc Δ Y =.8   80 ΔC =  Lowered consumption spending means lowered AD Δ AD =  64 Producers respond. Δ Y =  Households cut consumption by mpc Δ Y =.8   4 ΔC =  Δ Y =  mpc Δ Y =.8   51.2 ΔC =  Δ Y =  ΔC =  Δ Y =  ΔC =  etc. Sum of changes in Y =  80 +  64 +    =  400 Table 9.6: The Multiplier at Work