Post on 18-Jun-2018
Lecture 6
Aggregate Demand and Economic Fluctuations
The Business Cycle
• Goal of economic stabilization: keeping unemployment and inflation at acceptable levels over the business cycle
• Stylized Fact 1:
During an economic downturn or contraction, unemployment rises, while in a recovery or expansion, unemployment falls.
Okun’s «law»: an empirical inverse relationship between the unemployment rate and rapid (above-average) real GDP growth
U.S. Real GDP and Recessions
Source: BEA quarterly data 1985–2012, and NBER
U.S. Unemployment Rate and Recessions
The Business Cycle
• 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)
-15
-10
-5
0
5
10
15
Infl
ati
on
Rate
(Pe
rcen
t A
nn
ual)
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
Contraction ExpansionG
DP
Y*
Peak Peak
A Stylized Business Cycle
A stylized business cycle
• Full-employment output Y* (or potential output):
At full-employment output Y* the economy is not suffering from an unemployment problem (but there will always be some short-term, transitory unemployment)
• The goal of stabilization policy is to keep the economy in the grey area of the previous slide
Economic downturns
• Great Depression of the 1930s
• Classical school’s argument:
The economy is merely in a «trough» stage, it will soon start to expand again
• Keynes’ argument:
«In the long-run, we are all dead»
1929 1933
(a) Real Standard and Poor’s
Stock Index100.0 45.7
(b) Unemployment rate (official) 3.2% 24.9%
(c) Price level (CPI) 100.0 75.4
(d) Real gross domestic product 865.2 billion 635.5 billion
(e) Real personal consumption
expenditures 661.4 billion 541.0 billion
(f) Real gross private domestic
investment 91.3 billion 17 billion
(g) Real private debt 88.9 billion 102.0 billion
(h) Bankruptcy cases 56,867 67,031
(i) Non-farm real estate
foreclosures134,900 252,400
(j) Food energy per capita per day
(calories)3460 3280
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
http://www.bea.doc.gov/bea/dn/nipaweb/TableView.asp#Mid; (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 (http://academic2.american.edu/~mhansen/transform.pdf ); (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
Assumptions:
• Households only consume, firms invest (government and households do not invest)
• Full-employment output level does not grow (For Part III of the book
• The only actors in the economy are households and businesses (for the present lecture)
• All income in the economy goes to households, in return for the labor or capital services they provide (no retained earnings!)
• Booms and inflationary pressures are not analyzed, just recessions and rising unemployment due to potentially insufficient aggregate demand (for the present lecture)
Output
(Y )
Income
(Y )
Spending
(Aggregate Demand or AD )
Spending
stimulates firms
to produce
Production
generates
incomes
Incomes give
actors the ability
to spend
The Output-Income-Spending Flow of an Economy
in Equilibrium
Output, income, and aggregate demand
Leakages and injections
Leakages and injections
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 (AD )
Income (Y )
Consumption (C )?Sufficient to
sustain output at
a steady level
The Output-Income-Spending Flow with Leakages
and Injections
How is the adjustment process in such a disequilibrium case?
• The Classical school:
The interest rates in the loanable funds market will adjust quickly to equate leakage and injections. We are back to macroeconomic equilibrium again (full-employment level of output Y*)
• Keynes:
Aggregate demand can stay persistently low. The case of full-employment is just a special case.
The Classical School’s solution
• Market for loanable funds will adjust in cases of macroeconomic disequilibrium.
• Assumptions:
– Households supply loanable funds by looking at the going rate of interest
– Firms demand loanable funds by looking at the going rate of interest
– The higher the interest rate, the more do households save
– The lower the interest rate, the more do firms invest
– The interest rate adjusts quickly
Quantity of funds
borrowed and lent
Inte
rest
rate
140
5%
Supply of
Loanable
Funds
Demand for
Loanable Funds
E1
The Classical Model of the Market for Loanable
Funds
Quantity of funds
borrowed and lent
Inte
rest
rate
140
5%
Supply of
Loanable
Funds
Original
Demand
E1
New Demand
60
3%
E0
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
(II ) is equal to S
Output (Y* )
Consumption (C )
Income (Y* )
Spending sufficient
to sustain full
employment
AD = Y*
Macroeconomic Equilibrium at Full Employment in
the Classical Model
The Keynesian Model
• Any excess leakages over injections into the aggregate demand stream will lead to progressive rounds of declines in consumption and income, until savings are so low that a new, lower-output equilibrium is established
• Hence, deficiencies in aggregate demand (due to drops in investor or consumer confidence) may lead to long-term, deep slumps like in the Great Depression
Consumption and Saving in 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 = 20 + 0.8 Y
= column(2)
+ column(3)
(5)
Saving
S = Y–C
= column(1)
–column(4)
0 20 0 20 -20
100 20 80 100 0
200 20 160 180 20
300 20 240 260 40
400 20 320 340 60
500 20 400 420 80
600 20 480 500 100
700 20 560 580 120
800 20 640 660 140
The Consumption Schedule (and Saving)
45
Consumption (C )
(= + mpc Y)
Income (Y )
Co
nsu
mp
tio
n(C
)
Consumption =
Income Line
400
Saving (S)
100
C
500
400
300
200
100
0
= 20
340
C
Slope = mpc
The Keynesian Consumption Function
What can shift the consumption schedule?
• Wealth
• Consumer confidence
• Attitudes towards spending and saving
• Consumption-related government policies
• The distribution of income
Investment in the Keynesian model
• In a drastic slowdown of the economy, a low interest rate will not be enough to motivate business firms to invest
• Rather, the general level of optimism or pessimism that investors feel about the future, the «animal spirits» will be more important to determine aggregate investment spending of firms
• So, investment is future-directed, rather than being related to current level of income
Income (Y )
Inte
nded I
nvestm
ent
(= I
I)
Intended
Investment (II )
(= II )II = 60
The Keynesian Investment Function
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)
0 20 60 80
300 260 60 320
400 340 60 400
500 420 60 480
600 500 60 560
700 580 60 640
800 660 60 720
Consumption (C )
Income (Y )
Consum
ption,
Investm
ent,
and
Aggre
gate
Dem
and
400
400
Aggregate Demand
(AD ) = C + II
Intended Investment (II )
340
80C +II =
Aggregate Demand
Aggregate Demand with Higher Intended
Investment
(1)
Income
(Y)
(2)
Consumption
(C)
(3)
Intended Investment
(II)
(4)
Aggregate Demand
(AD)
0 20 140 160
300 260 140 400
400 340 140 480
500 420 140 560
600 500 140 640
700 580 140 720
800 660 140 800
Income (Y )
Aggre
gate
Dem
and
400100
1000
800
700
600
500
400
300
200
100
0
AD (II = 140)
800
AD (II = 60)
480
160
80
Aggregate Demand with a Higher Level of Intended
Investment
IIC
IIC
=
=
The possibility of unintended investment
(1)
Income
(Y)
(2)
Aggregate
Demand
(AD)
(3)
Excess Inventory
Accumulation (+)
or Depletion (-)
= column(1)-
column(2)
(4)
Intended
Investment
(II)
(5)
Investment
(I)
= column(3)
+ column(4)
(6)
Check that the
macroeconomic
identity still
holds:
Y = C+I
300 320 -20 60 40 300
400 400 0 60 60 400
500 480 20 60 80 500
600 560 40 60 100 600
700 640 60 60 120 700
800 720 80 60 140 800
The Possibility of Excess Inventory Accumulation
or Depletion
45
Income (Y )
Aggre
gate
Dem
and a
nd O
utp
ut
Output = Income
Line
400100
1000
800
700
600
500
400
300
200
100
0
Aggregate Demand (AD )
800
E
unintended
investment
(build up of
inventories)
80
720
Unintended Investment in the Keynesian Model
45
Income (Y )
Aggre
gate
Dem
and a
nd O
utp
ut
400100
1000
800
700
600
500
400
300
200
100
0
AD0 (II = 140)
800
E0
Full Employment
Y*
160
Full Employment Equilibrium with High Intended
Investment
45
Income (Y )
Aggre
gate
Dem
and a
nd O
utp
ut
400100
1000
800
700
600
500
400
300
200
100
0
AD0 (II = 140)
800
E1
E0
Full Employment
AD1 (II = 60)
Persistent
unemployment
equilibrium
Y*
80
160
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 YLower Output
Output (Y* )
Movement to an Unemployment Equilibrium
The multiplier
• When investment spending drops, AD will fall, this leads to a contraction in output, but this will have some feedback effects through consumption. Why?
• Because consumption, itself, depends on income, and when income falls, consumption falls as well, and this will further reduce AD, and so on…
• Until when? Let’s look at the multiplier to find out.
The multiplier
(1)
Change in Intended Investment
(2)
Change in Aggregate Demand
(as C or II 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 II = 80
2. Reduced investment spending leads directly to
Δ AD = 80.
Producers respond to reduced demand for their
goods by cutting back on production.
Δ Y = 80
3. Less production
means less income.
With income reduced by
80, households cut
consumption
by mpc Δ Y
= .8 80
ΔC = 64
4. Lowered consumption spending means lowered
AD
Δ AD = 64
Producers respond.
Δ Y = 64
5. Households cut
consumption
by mpc Δ Y
= .8 4
ΔC = 51.2
6. Δ Y = 51.27. mpc Δ Y = .8 51.2
ΔC = 40.96
8. Δ Y = 40.96 9. ΔC = 32.77
10. Δ Y = 32.77 11. ΔC = 26.21
etc. etc.
Sum of changes in Y
= 80 + 64 + 51.2 + 40.96 + 32.77 +. . .
= 400