1. Aggregate Demand and Economic Fluctuations
Chapter 9
Aggregate Demand and Economic Fluctuations
© Dünhaupt, Dullien, Goodwin, Harris, Nelson, Roach, Torras

2. After today‘s lecture, you will be able to:
Learning Goals
After today‘s lecture, you will be able to:
Describe how unemployment and inflation behave over the business cycle.
Model consumption and investment, the components of aggregate demand
Describe the problem that “leakages” present for maintaining aggregate demand, and the classical and Keynesian approaches to leakages.
Understand how the equilibrium levels of income, consumption, investment, and savings are determined in the Keynesian model
Explain how, in the Keynesian model, the macroeconomy can equilibrate at a less- than-full-employment output level.
Describe the workings of “the multiplier,” in words and equations.
Chapter 5

3. Macroeconomic Modeling and Aggregate Demand
Chapter Outline
The Business Cycle
Macroeconomic Modeling and Aggregate Demand
(including the Classical Model)
The Keynesian Model
Chapter 9

4. What makes an economy experience …
GDP expansion or contraction?
high or low employment?
good or bad business conditions?
Chapter 9

5. The Business Cycle

6. What happens during the Business Cycle ?
Business cycles = recurrent fluctuations of recession and boom
Periods of growth (several years) interrupted by times of falling output or stagnation
Recession: two consecutive quarters of a fall in GDP
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7. Figure 9.1 Euro area GDP and Recessions 1995–2015
After 2008, the euro area experienced two recession within five years. During these periods, real GDP fell.
Source: Eurostat quarterly data 1995–2015, and CEPR.
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8. If less is produced, firms need less workers
Stylized Fact #1
During an economic downturn or contraction, unemployment rises, while in a recovery or expansion, unemployment falls
If less is produced, firms need less workers
If more is produced, firms need more workers
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9. Okun’s “law”
An empirical inverse relationship between the unemployment rate and real GDP growth
In the early 1960s, economist Arthur Okun estimated that a real GDP growth of 3 percent used to lower unemployment by 1 percentage point in the US
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10. Figure 9.2 Euro Area Unemployment Rate and Recessions, 1995–2015
During the and recessions, unemployment shot up sharply and continued to increase after the recession formally ended, reaching a peak of 10 percent in 2010.
Source: Eurostat monthly data 1995–2015, and CEPR.
Chapter 9

11. If demand is strong, firms can more easily increase prices
Stylized Fact #2:
An economic recovery or expansion, if it is very strong, tends to lead to an increase in the inflation rate. During a downturn or contraction, pressure on inflation eases off (and inflation may fall or even become negative)
If demand is strong, firms can more easily increase prices
If unemployment falls, at some point, wages start to increase more quickly
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12. Figure 9.3 Euro Area Inflation Rate and Recessions
During the , and 2011–3 recessions, inflation fell sharply. Inflation generally reflects the business cycle, along with other factors.
Source: Eurostat monthly data 1995–2015; CEPR.
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13. Stylized Fact #3:
Over the business cycle, business investment moves in parallel with GDP, but it varies much more strongly than GDP or household consumption
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14. Figure 9.4 Investment Growth, GDP Growth, and Recessions in the euro area
Since 1995, investment has moved in tandem with GDP, albeit changes have been stronger. During the , and 2011–3 recessions, investment fell much more strongly than GDP.
Source: Eurostat quarterly data 1995–2015; CEPR.
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15. Stylized Business Cycle
During a contraction, GDP falls until the economy hits the trough, or lowest point
During an expansion, GDP rises from a trough until it reaches a peak
At full-employment output, there is no problem of unemployment (though it is not zero)
goal of stabilization policy: keep economy in the gray area, avoiding threats of inflation and unemployment
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16. Figure 9.5 A Stylized Business Cycle
In this hypothetical economy, GDP contracts from peaks to troughs, and expands from troughs to peaks. A range of output indicating “full employment” is indicated by Y*.
Year
Trough
Contraction
Expansion
GDP Y*
Peak
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17. The Downturn Side of the Story
The Great Depression ( )
Stock market crash 1929 (Black Tuesday)
drop in production
increase in unemployment
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18. Table 9.1 Unemployment in Industry During the Great Depression
1929
1932
1935
France
1.0
15.4
14.5
Germany
13.3
43.8
16.2
Netherlands
2.9
25.3
31.7
Norway
30.8
Sweden
10.2
22.4
15.0
U.K.
10.4
22.1
15.5
U.S.
5.3
36.3
30.2
Source: Barry Eichengreen and Tim Hutton, “Interwar Unemployment in International Perspective”, Institute for Research on Labor and Employment, University of California Berkeley Working Paper, 1988.
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19. Classical Economists’ Interpretation of the Great Depression
Economy was in the “trough” stage
Soon start to expand again
In the long run, the economy would recover by itself, as it had recovered from other downturns in the past
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20. Keynes’ Response to the Classical Economists” “
In the long run, we are all dead. (John Maynard Keynes)
Economies can fall into recessions and stay there for a long time
Public policy might help economies get out of the trough more quickly
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21. Macroeconomic Modeling and Aggregate Demand

22. Simplifying Assumptions
Full-employment output level does not grow
households and businesses only actors in the economy
all income in the economy goes to households
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23. Output, Income, and Aggregate Demand
“Y” represents GDP expressed as output, product, or income interchangeably
Production by firms generates labor and capital incomes to households
A macroeconomy is in an equilibrium situation when output, income, and spending are all in balance
Chapter 9

24. (Aggregate Expenditure or AE )
Figure 9.6 The Output-Income-Spending Flow of an Economy in Equilibrium
A macroeconomy is said to be in equilibrium when the incomes that arise from production give rise to a level of spending that, in turn, stimulates producers to produce the original level of output.
Output
(Y )
Income
Spending
(Aggregate Expenditure or AE )
Spending stimulates firms to produce
Production generates incomes
Incomes give actors the ability to spend
Chapter 9

25. AE depends on the spending behavior of households and firms
The Keynesian Model
aggregate expenditure (AE) may (at least temporarily) fall out of balance with the other flows
AE depends on the spending behavior of households and firms
Household consumption C (actual spending = intended spending)
Firms investment I (actual investment ≠ intended investment II)
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26. The Keynesian Model (cont.)
Accounting Identity
Y = C + I
GDP = Consumption + Actual Investment
involves the actual level of investment
Behavioral Equation
AE = C + II
Aggregate Expenditure = Consumption + Intended Investment
involves the level of planned, desired, or intended investment
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27. Behavioral Equation
in contrast to an accounting identity, a behavioral equation reflects a theory about the behavior of one or more economic agents or sectors. The variables in the equation may or may not be observable
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28. The Problem of Leakages
Households receive all the income
spend some income on consumption
save the rest
S = Y – C
Saving: “leakage” from the output-income-spending cycle
Chapter 9

29. Businesses make investment plans
Injections
Businesses make investment plans
They need funds and might borrow from households (via the banking sector)
Investment demand is an “injection” to aggregate demand as it creates demand
Chapter 9

30. Figure 9.7 The Output-Income-Spending Flow with Leakages and Injections
When households save rather than spend part of their incomes, funds are diverted from the income-spending flow. When firms spend on investment goods, this creates a flow into the spending stream.
Production generates income to households
Saving (S )
leakage
Intended Investment ( II )
injection
firms decide how much to invest
households decide how much to consume and save
Output (Y )
Spending (AE )
Income (Y )
Consumption (C ) ?
Sufficient to sustain output at a steady level
Chapter 9

31. Macroeconomic Flows in Balance
In equilibrium:
leakages = injections
S = II
Y = AE
spending is exactly sufficient to buy the output produced
Chapter 9

32. What happens if flows are not in balance?
In the case of insufficient aggregate demand:
leakages > injections
S > II
Y > AE
What happens now?
Classical and Keynesian Economists give different answers to this question!
Chapter 9

33. The Classical Solution to Leakages
Remember: In the classical world, if markets are flexible, there is only frictional unemployment
If there was unemployment, wages would fall and employment increase again
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34. For now, we neglect the labor market and look only at another question: How does an economy keep leakages exactly equal to injections coming from investment spending? Answer: Classics argue with the “market for loanable funds”
Chapter 9

35. Market for Loanable Funds
Households’ saving decision based on the interest rate
High interest rate: worthwhile to save savings earn more
Firms:
the payment of interest is a cost
Low interest rates: firms borrow more for investment projects because borrowing is inexpensive
High interest rates discourage firms from borrowing
Chapter 9

36. Figure 9.8 The Classical Model of the Market for Loanable Funds
In the classical version of the macroeconomic model, household saving creates the supply of loanable funds and firms’ borrowing for investment creates the demand for loanable funds. At the equilibrium interest rate, the amount households save and the amount businesses invest are equated.
Quantity of funds borrowed and lent
Interest rate
140 5%
Supply of Loanable Funds
Demand for Loanable Funds E1
Chapter 9

37. Figure 9.9 Adjustment to a Reduction in Intended Investment in the Classical Model
In the classical model, smooth adjustments in the market for loanable funds keep saving equal to investment, even if firms or households change their behavior.
Quantity of funds borrowed and lent
Interest rate
140 5%
Supply of Loanable Funds
Original Demand E1
New Demand 60 3% E0
Chapter 9

38. Spending sufficient to sustain full employment
Figure 9.10 Macroeconomic Equilibrium at Full Employment in the Classical Model
Leakages always equal injections in the classical model, because of smooth adjustments in the market for loanable funds. The economy is always in equilibrium at a full employment level of output (Y*).
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
AE = Y*
Chapter 9

39. Summing up the Classical Model
flexible markets keep the economy at a full-employment level of spending and output
households’ saving activity and firms’ investment spending are sensitive to changes in the interest rate (“price of loanable funds”)
an adjustment in the interest rate will quickly correct any threat of imbalances between the leakage of savings and the injection of investment..
in the Classical model, output cannot fall short of the full employment output!
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40. The Keynesian Model

41. He called it The General Theory
The Keynesian Model
Keynes’ major contribution: develop a theory to explain why aggregate expenditure (or aggregate demand) could stay persistently low
the case of full employment (Y*) represents only a special case, one that may not often be achieved
He called it The General Theory
Chapter 9

42. Consumption Demand in the Keynesian Model
C is “autonomous” consumption
Consumption not related to income
mpc is “marginal propensity to consume”
How much one would increase consumption if income increases by 1 unit of money
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43. Marginal Propensity to Consume
the number of additional dollars of consumption for every additional dollar of income (typically a fraction between zero and one)
the change of C resulting from a change in Y
the change in Y
e.g. for every additional €10 in aggregate income, households will spend an additional €8  mpc of 8/10 or 0.8
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44. Marginal Propensity to Save
the number of additional dollars saved for each additional dollar of income (typically a fraction between zero and one)
As S=Y-C, marginal propensity to save (mps) is given by:
Chapter 9

45. Table 9.2 The Consumption Schedule (and Saving)
(1)
(2)
(3)
(4)
(5)
Income (Y)
Autonomous Consumption
The part of consumption that depends on income, with mpc = 0.8
Consumption C = Y
Saving S = Y – C
= 0.8 × column(1)
= column(2) + column(3)
= column(1) – column(4) 20
–20
100 80
200
160
180
300
240
260 40
400
320
340 60
500
420
600
480
700
560
580
120
800
640
660
140
Chapter 9

46. Figure 9.11 The Keynesian Consumption Function
In the Keynesian model, consumption rises with income according to the equation 45
Consumption (C )
(= C + mpc Y)
Income (Y )
Consumption (C )
Consumption = Income Line
400
Saving (S)
100
500
300
200
C= 20
340
Slope = mpc
In the Keynesian model, consumption rises with income according to the equation C = + mpc Y
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47. Factors That Might Impact on the Consumption Function
Wealth
Consumer confidence
Attitudes towards spending and saving
Consumption-related government policies
Income distribution
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48. Classical and Keynesian Economists on Savings
Classical Economics
Saving decision depends on the interest rate
Keynesian Economics
Saving decision depends on income
It is not sure if people save more or less if interest rates increase
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49. Keynes on Investment Spending
Investment spending determined by:
the cost of borrowing (the interest rate)
the prices of investment goods
accumulated assets and debt
the willingness of people and banks to lend to them
But most importantly:
the general level of optimism or pessimism that investors feel about the future: “animal spirits”
Chapter 9

50. Keynes on Animal Spirits“
Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (John Maynard Keynes) ”
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51. Keynes on Investment Spending
Investment is future directed, rather than related to any current, observable economic variables,
investors intend to invest whatever investors intend to invest
All of intended investment is considered “autonomous” in this model
Chapter 9

52. Figure 9.12 The Keynesian Investment Function
In the simplest Keynesian model, intended investment is a constant, no matter what the level of national income, being determined instead by long-term profit expectations.
Income (Y )
Intended Investment (= II )
Intended Investment (II )
(= II )
II = 60
Chapter 9

53. Table 9.3 Deriving Aggregate Expenditure from the Consumption Function and Investment
(1)
(2)
(3)
(4)
Income (Y)
Consumption (C)
Intended Investment (II)
Aggregate Expenditure AE = C + II = column (2) + column (3) 20 60 80
300
260
320
400
340
500
420
480
600
560
700
580
640
800
660
720
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54. Table 9.4 Aggregate Expenditure with Higher Intended Investment
(1)
(2)
(3)
(4)
Income (Y)
Consumption (C)
Intended Investment (II)
Aggregate Expenditure (AE) 20
140
160
300
260
400
340
480
500
420
560
600
640
700
580
720
800
660
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55. Figure 9.13 Aggregate Expenditure
The AE curve is derived by adding the autonomous intended investment to consumption, at each income level. So at each level of Y, AE is the vertical sum of C and II.
Consumption (C )
Income (Y )
Consumption, Investment, and Aggregate Expenditure
400
Aggregate Expenditure (AE ) = C + II
Intended Investment (II )
340 80
C +II =
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56. Figure 9.14 Aggregate Expenditure with Higher Intended Investment
If intended investment increases (or autonomous consumption increases), the aggregate expenditure curve shifts upward.
C +II =
Income (Y )
Aggregate Expenditure
400
100
1000
800
700
600
500
300
200
AE (II = 140)
C +II =
AE (II = 60)
480
160 80
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57. The Possibility of Unintended Investment
Recall: manufactured capital stock includes structures, equipment, and inventories
There might be an unintended change in inventories:
Unintended inventory investment: inventories build up unexpectedly
excess inventory depletion: goods “fly off the shelves” and the warehouse empties out
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58. what businesses plan to invest
Actual Investment
what businesses plan to invest
plus what they inadvertently end up investing if AE and Y do not match up exactly
I = intended investment (II) + excess inventory accumulation or depletion
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59. Table 9.5 The Possibility of Excess Inventory Accumulation or Depletion
(1)
(2)
(3)
(4)
(5)
(6)
Income (Y)
Aggregate Expenditure (AE)
Excess Inventory Accumulation (+) or Depletion (–) = column(1) – column(2)
Intended Investment (II)
Investment (I) = column(3) + column(4)
Check that the macro- economic identity still holds: Y = C+I
300
320
–20 60 40
400
500
480 20 80
600
560
100
700
640
120
800
720
140
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60. Figure 9.15 Unintended Investment in the Keynesian Model
If income and output in an economy are above the level of aggregate expenditure, excessive inventories accumulate. This is illustrated for the income level of 800. 45
Income (Y )
Aggregate Expenditure and Output
Output = Income Line
400
100
1000
800
700
600
500
300
200
Aggregate Expenditure (AE ) E
unintended investment (build up of inventories) 80
720
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61. Movement to Equilibrium in the Keynesian Model
If inventories are building up more than intended, firms cut back on production until the level of what is actually produced matches what they can sell
reductions in Y will continue until Y = AE
reduction in output leads to reduced income
which leads to reduced consumption
AE is a moving target
changes in aggregate income, and the resulting changes in consumption and saving, cause leakages and injections to become equal again
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62. Equilibrium in Keynesian Economics
Equilibrium just defines a situation in which output, spending and income are in balance
Equilibrium might be a good or a bad thing
There might be high unemployment and low unemployment equilibria
There is no mechanism which automatically brings back full employment
Chapter 9

63. Figure 9.16 Full Employment Equilibrium with High Intended Investment
Supposing that Y = 800 represents full employment, an intended investment level of 140 generates spending sufficient to maintain this as an equilibrium. 45
Aggregate Expenditure and Output
400
100
1000
800
700
600
500
300
200 E0
Full Employment Y*
160
AE0 (II = 140)
Income (Y )
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64. Figure 9.17 A Keynesian Unemployment Equilibrium45
Income (Y )
Aggregate Expenditure and Output
400
100
1000
800
700
600
500
300
200
AE0 (II = 140) E1 E0
Full Employment
AE1 (II = 60)
Persistent unemployment equilibrium Y* 80
160
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65. A Keynesian Unemployment Equilibrium
A fall in investor confidence causes the equilibrium level of output to fall. The initial excess of leakages over injections caused by low investment spending is corrected by a contraction in output, income, and saving. At E1, leakages and injections are again equal.
Chapter 9

66. Figure 9.18 Movement to an Unemployment Equilibrium
An excess of leakages over injections causes aggregate expenditure to be insufficient for a full employment level of output. Output and income fall until equilibrium is restored.
Income (Y* )
Insufficient Spending
AE < Y*
Production generates income
Income goes to households
If leakages are larger than injections…
Lower Income
Lower Spending
AE = lower Y
Lower Output
Output (Y* )
Chapter 9

67. There is a multiplier effect:
The Multiplier
A small change in autonomous investment might bring about a large drop in output
How is this possible?
There is a multiplier effect:
Investment creates income
Income creates consumption
Consumption creates income …
Chapter 9

68. Table 9.6 The Multiplier at Work
Change in Intended Investment
Change in Aggregate Expenditure and in Output and Income
Change in Consumption ΔC = mpc ΔY = .8 × Column (2)
1. Investors lose confidence. ΔII = −80
2. Reduced investment spending leads directly to ΔAE = −80.
Producers respond to reduced demand for their goods by cutting back on production.
ΔY = −80
3. Less production means less income. With income reduced by 80, households cut consumption by mpc ΔY = .8 × −80 ΔC = −64
4. Lowered consumption spending means lowered AE ΔAE = −64
Producers respond.
ΔY = −64
5. Households cut consumption by mpc ΔY
= .8 × −4
ΔC = −51.2
6. ΔY = −51.2
7. mpc ΔY = .8 × −51.2 ΔC = −40.96
8. ΔY = −40.96
9. ΔC = −32.77
10. ΔY = −32.77
etc.
11. ΔC = −26.21
Sum of changes in Y
= −80 + −64 + − − − = −400
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69. The Multiplier and a Decrease in Investor Confidence
The mathematics of infinite series implies :
Plug in
figures from the current example:
The income/spending multiplier:
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70. Multiplier and a Decrease in Consumer Confidence
The value of the multiplier would be the same if it had been a decrease in consumer confidence, acting through a change in that started this cascade in incomes, instead of a decrease in investor confidence.
Chapter 9

71. Three stylized facts about the business cycle:
What to Take Home
Three stylized facts about the business cycle:
Unemployment rises during downturn and falls during recovery
Inflation rises during a recovery and may fall during downturn
Business investment moves parallel with GDP
Chapter 9

72. What to take home Classical Economics Keynesian Economics
an economy should never go into a slump (at least it should not stay in one very long)
any deficiency in aggregate demand would be quickly counteracted by smooth adjustments in the market for loanable funds
Keynesian Economics
deficiencies in aggregate expenditure due to drops in investor (or consumer) confidence
any excess of “leakages” over “injections” into aggregate expenditure stream lead to progressive rounds of declines in consumption and income, until savings are so low that a new, lower-output-level equilibrium is established
government action required to get the economy out of its slump and to achieve a higher equilibrium level
Chapter 9