1. Business Cycle Model KW 28, 29

2. AS-AD Framework Microeconomists use supply/demand framework for thinking about markets. Macroeconomists use Aggregate Supply/ Aggregate Demand as the central framework for thinking about business cycles. AS/AD framework examines the relationship between the level of output (real GDP) and the aggregate price level (GDP deflator). We use the AS/AD to show how different events will affect output & prices in the short run.

3. Long Run Aggregate Supply Central pillar of AS-AD framework is the assumption that there is no long run relationship between prices and firms willingness to produce goods. In the long run, a rise in average prices will affect the price level of outputs and inputs. For any individual firm, a price rise is no incentive to produce more if input prices rise also. Long-run level of output determined by productivity and labor force participation is called trend output or potential output.

4. P Y YPYP Aggregate Demand Curve LRAS

5. Short Run Aggregate Supply In the short-run, there is thought to be a positive relationship between the aggregate price level and firms’ willingness to supply goods. Why is the Aggregate Supply Curve Upward Sloping? For some firms, some input prices, particularly wages, will not rise with the general price level. If wages are sticky, a rise in the price of goods reduces the real cost of hiring workers. Firms profit-maximizing output levels hire more workers, work their existing employees longer hours and produce more output.

6. P Y YPYP Aggregate Demand Curve LRAS SRAS

7. Sticky Wages in HK

8. What causes SRAS to shift? To maximize profits, firms will produce up to the scale that the price level compensates them for their costs. If costs of production drop, output will increase at any price level If costs of production rise, output will decrease at any price level.

9. Cost Shifters 1.Commodity & Oil Prices Energy is a commodity used by all production processes and is a cost factor. 2.Wage Levels Labor is by far the biggest cost for most sectors. 3.Productivity New inventions or techniques may reduce the need for labor and thereby reduce costs.

10. P Y SRAS Short Run Aggregate Supply Curve 1.Oil Prices Fall 2.Wages Decline 3.Productivity Increases SRAS ′

11. Potential Output Potential output is not the maximum output possible for a country. Potential output is the level of production when supply and demand are in equilibrium in labor market. –When output is higher than potential, it is because real labor costs/real wages are low so there is excess demand for labor. Market forces will push wages up! –When output is lower than potential, real wages are high so labor is in excess supply. Market forces will push wages down!

12. P Y YPYP Aggregate Supply in Labor Market Excess Demand In Labor Market Wages Rise SRAS Shifts In Excess Supply in Labor Market Wages Fall SRAS Shifts Out

13. P Y YPYP Aggregate Demand Curve LRAS SRAS

14. Aggregate Demand There is a negative relationship between the price of a single good and demand ceteris parabis. If the price of a good is high relative to other goods, consumers will find substitutes. Aggregate demand curve is the effect of the average price (in terms of money) on demand for all goods.

15. P Y Y LR AD Aggregate Demand Curve

16. Why is the AD curve downward sloping? 1.Wealth Effect: increase in prices directly reduces purchasing power of consumers with savings in money assets. 2.Interest Rate Effect If prices go up, households & firms need more liquidity for spending on a given amount of goods. As consumers shift funds to cash, interest rate in capital markets will rise having negative impacts on demand for investment goods.

17. Cont. In HK, monetary policy is to have a fixed exchange rate with the US dollar. Interest rates are typically at US dollar levels. Take exchange rates as given: 3.International Trade Effect An increase in prices at a fixed exchange rate increases the relative costs of a countries exports and encourages domestic consumers to switch to imports.

18. Demand Matters In the short-run, the position of the demand curve matters for equilibrium output. Over time, the economy’s correction mechanism will restore the economy to a long-run in which the long-term supply factors determine output.

19. P Y Y*Y* AD Short Run Equilibrium: Output Above Potential P*P* SRAS YPYP Labor market displays excess demand A

20. P Y AD Long Run Equilibrium: SRAS shifts in as wages rise P*P* SRAS YPYP Wages rise and the profit maximizing production level falls. A B

21. P Y Y*Y* AD Short Run Equilibrium: Output Below Potential P*P* SRAS YPYP Labor market displays excess supply A

22. P Y AD Long Run Equilibrium: SRAS shifts in as wages rise P*P* SRAS YPYP Wages fall and the profit maximizing production level rises. SRAS ′ A B

23. Business Cycles Economy has a self correcting mechanism, the labor market, that automatically returns the economy to the level of potential output in the long-run. Demand is subject to fluctuations caused by external events. Business cycles are the time between when a shock hits and when the self-correcting mechanism returns the economy to the long run. The labor market is imperfect. Contracts and wages are renegotiated infrequently and matching between employers and employees is time-consuming.

24. Keynesian View of Business Cycles Mainstream economic view is that shocks that affect the demand curve are the main driver of business cycles. Demand is a positive feedback system and thus can be volatile. In business cycles driven by demand shocks, prices rise during expansions and fall during recessions.

25. P Y Y*Y* AD Demand Driven Boom P*P* SRAS YPYP AD 1 2 1.Economy in LT equilibrium 2.Demand shifts out 3.Rising wages leads to return to equilibrium SRAS′ 3

26. P Y Y*Y* AD Demand Driven Recession P*P* SRAS YPYP AD ′ 1 2 1.Economy in LT equilibrium 2.Demand shifts in 3.Falling wages leads to return to equilibrium SRAS′ 3

27. What causes the demand curve to shift? Shifts in Household Consumption –1) Wealth effect; 2) optimism about future; Shifts in Corporate Investment Spending –1) Interest Rates; 2) optimism about future Shifts in Trade Balance –1) Exchange Rates; 2) Foreign business cycles.

28. Income and Expenditure KW Chapter 28

29. Income and Expenditure Two components of expenditure may depend strongly on income levels 1.Consumption 2.Imports – Net Exports = Exports – Imports: the trade balance is negatively impacted by domestic income. To simplify, assume a zero trade balance and no government spending, NX = 0, G = 0

30. Consumption Function Consumption is in the form Where A = Autonomous Consumption not directly dependent on current income mpc = marginal propensity to consume the fraction of extra income that will go to spending YD = Disposable Income

31. What causes the Consumption Function to shift? The determinants of autonomous income: Real wealth – Stock or property market prices changes will shift A. Expectations of Future Income – Optimism and pessimism of the household sector affects spending patterns.

32. Consumption Function Disposable Income Real Consumption A ΔCΔC ΔYD

33. mpc≈.78

34. Shift Up in Consumption Function Disposable Income Real Consumption A A'A'

35. In Recent Years, the consumption function in HK has shifted down! 1998

36. Investment We can divide investment into two categories: 1.Planned Fixed Investment: Building P&E for future production 2.Unplanned Inventory Investment

37. What causes Planned Investment to shift? Changes in the Foreign Interest Rate – Real interest rate affects corporate investment spending, residential investment spending, consumer durables etc. Expected Returns to Capital – Optimism and pessimism of the business sector affects spending patterns. Capital Overhang – If firms have built up too much plant & equipment in a previous investment bubble, investment spending will decline.

38. Expenditure Curve Income C+I Planned Planned Expenditure mpc A+I Planned

39. Q: Why is demand so volatile? A: Demand is multiple feedback loop Total Expenditure is an increasing function of aggregate income. Expenditure = C+I –Consumers will spend more if they have greater income. But Expenditure creates production Production creates income….

40. Expenditure =Income = GDP Income = Y = Expenditure Planned Expenditure 45º C+I Planned Planned Expenditure = Actual Expenditure -I Unplanned I Unplanned

41. Expenditure =Income = GDP Income C+I+G+NX Planned Expenditure Y* 45º Output above expenditure Inventories increasing Firms cut back on production Reducing income levels. Output below expenditure Inventories declining Firms increase production Increasing income.

42. US Business Cycles begin with accumulation of inventories

43. Autonomous Expenditure Increases Income C+I Expenditure GDP 45º Output Extra Expenditure Increases Output which increases income which increases expenditure which increases output which increases income … Multiplier effect A,I↑

44. Autonomous Expenditure Increases by 100 mpc =.8 ΔAΔAΔCΔCΔGDP Stage 1100 Stage 2080 Stage 3064 Stage 4051.2 Stage 5040.96

45. Multiplier Effect Workers Spenders Firms Savings mpc

46. Multiplier Effect Workers Spenders Firms Central Bank Savings mpc

47. Multiplier Effect Workers Spenders Firms Savings mpc

48. Multiplier Expenditure = I Planned + A + mpc∙Income GDP = I Planned + A + mpc∙GDP (1-mpc)∙GDP = I Planned + A GDP = [1/(1-mpc)] ∙ I Planned + A Expenditure Multiplier = [1/(1-mpc)]

49. Open Economy Multiplier The greater is the fraction of spending that is done on imports, the less income is recycled into extra spending on consumer goods. mpc should be lower for very open economies (like HK) Multiplier should be lower for very open economy.

50. Multiplier Effect Workers Spenders Firms Government Savings Imports mpc

51. Multiplier Effect Workers Spenders Firms Central Bank Imports Savings mpc

52. Multiplier Effect Workers Spenders Firms Government Savings Imports mpc

53. Open Economy Multiplier When we think about the fraction of income that is re-circulated into demand, we are concerned with the fraction that is Define marginal propensity to import, mpim, as the percentage of income Open economy mpc is marginal propensity to consume domestic goods. Open economy multiplier

54. What causes the trade balance to shift? Net Exports Changes in the Exchange Rate – At any given domestic currency price level, a change in the exchange rate will change the r elative prices of domestic and foreign goods. Overseas Business Cycles – Demand in trading partners economy affects demand for our exports.

55. Is Inflation Pro-cyclical or Counter- cyclical? During a demand driven expansion, prices are rising and inflation tends to accelerate. During a supply driven expansion, prices are dropping and we experience disinflation. A supply driven recession is often referred to as Stagflation with low output and high inflation.

56. P Y Y*Y* AD Supply Driven Boom P*P* SRAS YPYP AD 1 2 1.Economy in LT equilibrium 2.Supply shifts out 3.Rising wages leads to return to equilibrium SRAS′ 3

57. How Long does the adjustment process take? In USA, organization called National Bureau for Economic Research has committee to date business cycles. During post war period, average time from trough-to-peak is 10 months, average time from peak-to-trough is 52 months. In the United States during the 1930’s or Japan more recently, we may experience long periods of contraction.

58. Japan Recession

59. Japan Stock Market

60. Students Should be able to Characterize potential output and distinguish fluctuations in output due to demand shocks and supply shocks. Identify the sources of business cycle shocks. Describe the self-correcting mechanism of the economy. Describe the multiplier effect and calculate the size of the simple multiplier in a closed economy with no government.