Changes in Macroeconomic Activity

The Business Cycle The phases of the business cycle are: Recovery or Expansion, Peak or Boom (shaded green) Recession or Contraction trough or Depression (blue shaded areas). Time Real GDP Business peak Depression or trough Recession Recovery Business peak Depression or trough Trend line

Ups and downs characterize business activity. There has been an upward trend in real GDP in the United States and other industrial nations. The Business Cycle Cycles are irregular Source: Economic Report of the President, various issues. Annual growth rate of real GDP Long-run growth rate (approx. 3%) 2009

Changes in Total (Aggregate) Spending in the Economy, cause changes in total (aggregate) production and employment

1. Households 2. Businesses 3. The Government 4. Foreigners

HouseholdsBusinesses Goods and Services Markets Resource Markets Resources Payments $$ Simple Case: all output is purchased by the household Nothing left for businesses, government or foreigners

1. Spend their earned income 2. Biggest spenders (7.1 of 10.2 trillion) 3. Expansion a.Increased spending b.larger output c.increased employment d.more income 4. Contraction a.Decreased spending b.smaller output c.decreased employment d.less income

Next Case: households save some of their income, output is left over Businesses purchase left over output, government or foreigners still get none

Another Circular Flow

1. Investment spending 2. Borrow to buy capital replace old and new machinery 3. Reasons to buy or invest a.expected profits b.economic activity c.lower interest rates

Next Case: not all output is purchased by the household or businesses something left for government or foreigners

1. Second largest spender 2. Purchases goods and services 3. provides transfers No goods or services received

Another Circular Flow

Final Case: all output is not purchased domestically Something left for foreigners

1. Exports Foreign purchases of US goods and services 2. Imports US purchases of Foreign goods and services

Another Circular Flow

From the Circular Flow: 1. Savings – consumers not spending 2. Taxes - money not able to spend 3. Imports - money sent abroad

From the Circular Flow: 1. Investments –spending from Business 2. Government transfers - money not earned by Households 3. Exports - money from abroad

The Multiplier The Multiplier: A change in an injection (e.g. investment) leads to an even larger change in output and employment. An injection comes from outside of the circular flow. (non-household) Once it enters, the dollars are spent over and over. The multiplier is the number by which the change in spending is multiplied to obtain the total increase. The size of the multiplier depends on how much is spent of each increase. The greater this %, the greater the effect

The Multiplier Remember: injections will increase the size of the multiplier; leakages will decrease the size of the multiplier,

effectively, $4 million is spent in the economy. Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until … Expenditure stage Additional income (dollars) Marginal propensity to consume Additional consumption (dollars) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000, , , , , , , , , , , ,914 Round 1 Round 2 Round 3 Round 4 Round 5 Total 4,000,0003,000,000 All others 3/4 The Multiplier Principle The multiplier concept is based upon the proportion of additional income that households choose to spend (here assumed to be 75% = 3/4).

Assume the people will spend.8 (80%) of a change in their income and the change in business investment is $10 (billion). Complete the table below. How much will they save? ______ change in income change in consumption change in savings increase in invest-ment of $10 billion + $ nd round rd round th round th round all other rounds Totals504010

MPC Size of multiplier 9/10 4/5 3/4 2/3 1/2 1/ M =M = %spent Higher Spending Means a Larger Multiplier As the spending % increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher spending, higher multipliers result, specifically the relationship follows this equation:

Change in investment% savedmultiplier effect $10 20%________ $10 10% ________ $10 25%________ $20 20%________ Calculating the effect of the multiplier: change in the injection % not spent (saved)

The phase of the business cycle where real GDP, or output, reaches its maximum is the: a. limit b. trough c. peak d. expansion Money received by a household from the government for which there is no work directly performed in return is: a. a surtax b. a payment-in-kind. c. a transfer payment. d. an income tax refund. Which of the following is a leakage from the spending stream by households? a.saving b.a decrease in earned income. c.the receipt of transfer payments. d.borrowing from financial institutions.

A decrease in interest rates would a.have no effect on investment decisions b.make investment projects less attractive. c.make more investment projects attractive d.make investment spending as stable as personal consumption expenditures. The 2 main categories of government expenditures are: a. defense expenditures and tax refunds b. purchases of goods and purchases of services c. purchases of goods and services and transfer payments d. income determined and non-income-determined spending. The multiplier effect is the change in: a. income-determined spending generated by a change in total output. b. total output generated by a change in income-determined spending. c. total output generated by a change in non-income-determined spending. d. non-income-determined spending generated by a change in total output