Unformatted text preview: Economic Fluctuations
Economic fluctuations: departures of the economy from the longterm growth trend. Recessions: periods in which the economy declines sharply (a minimum period of two consecutive quarters), moving below its longterm trend. Booms: periods in which the economy rises sharply, moving the economy above its longterm trend. Potential GDP
Potential GDP: the economy's longterm growth trend for real GDP determined by the available supply of capital, labor, and technology. Economic Fluctuations
Figure 1 illustrates the potential GDP and the real GDP of the United States from 1960 to 2004, with a focus on the period from 1999 to 2004. Narrowing the Focus on Economic Fluctuations Changes in Aggregate Demand Lead to Changes in Production
The next picture illustrates the idea used to explain economic fluctuations: Increases or decreases in GDP to levels above or below potential GDP occur because of increases or decreases in the aggregate demand in the economy. The First Step of an Economic Fluctuation Changes in Aggregate Demand Lead to Changes in Production
The graph on the left in Figure 1 illustrates a decline in the real GDP below the potential GDP in year 3. This effect is caused by a decrease in aggregate demand. The graph on the right in Figure 1 illustrates a rise in the real GDP above the potential GDP in year 3. This effect is caused by an increase in aggregate demand. Changes in Aggregate Demand Lead to Changes in Production
When the economy is operating above its potential, the unemployment rate drops, because firms require more workers to produce more goods and services. When the economy is producing below its potential, the unemployment rate rises, because firms require fewer workers to produce fewer goods and services. Changes in Aggregate Demand Lead to Changes in Production The unemployment rate drops below the natural rate when the GDP is above potential GDP. The unemployment rate rises above the natural rate when the GDP is below potential GDP. Narrowing the Focus on Economic Fluctuations Could Economic Fluctuations Be Due to Changes in Potential GDP?
So far, our discussion about economic fluctuations has focused on changes in aggregate demand. However, economic fluctuations can also be caused by changes in aggregate supply. Economic theories that emphasize changes in potential GDP as a source of economic fluctuations are called real business cycle theories. Could Economic Fluctuations Be Due to Changes in Potential GDP?
Real business cycle theory: a theory of macroeconomics stressing that shifts in potential GDP are a primary cause of fluctuations in real GDP. The shifts in potential GDP are usually assumed to be caused by changes in technology. Could Economic Fluctuations Be Due to Changes in Potential GDP?
One criticism regarding real business cycle theory: Potential GDP tends to grow relatively smoothly over time, compared to business cycle fluctuations. Could Economic Fluctuations Be Due to Changes in Potential GDP?
Reasons why the potential GDP changes slowly: Populations do not increase or decrease very quickly. Capital grows slowly over time. The impact of technological change spreads throughout the economy only gradually. There is no sudden decrease in technological know how. Forecasting the Real GDP
GDP can be broken down into four kinds of spending: consumption (C), investment (I), government purchases (G), and net exports (X). Y = C + I + G + X A Forecast for Next Year
To forecast the value of GDP for next year, an economist must forecast the value of each of the components of GDP. For example: If we forecast that C = $8,000 billion, I = $1,500 billion, X = $500 billion, and G = $2,000 billion, then GDP for next year should amount to $11,000 billion. The Response of Consumption to Income
Consumption function: the positive relationship between consumption and income. Table 1 gives a simple example of a consumption function for the U.S. economy. Note that an increase in income will result in a smaller increase in consumption. The Response of Consumption to Income
Notes on Table 1: A higher income level results in a higher level of consumption expenditures. At very low income levels, consumption is greater than income. The increase in income is larger than the increase in the consumption expenditures. The Response of Consumption to Income
Marginal propensity to consume (MPC): the slope of the consumption function, showing the change in consumption that is due to a given change in income. The Consumption Function
MPC = Change in consumption Change in income The next slide graphically illustrates the consumption function and the relationship between consumption and marginal propensity to consume. The Consumption Function The Consumption Function
As seen in the previous slide, the marginal propensity to consume is the slope of the consumption function. The value of the marginal propensity to consume is Change in consumption = MPC = Change in income 600 = 0.6 1,000 The Consumption Function
Notes: Although the MPC illustrated in Figure 3 and Table 1 come from a simplified example, the magnitude of the MPC in the U.S. economy approximates this magnitude. A higher marginal propensity to consume is illustrated as a steeper consumption function. A lower marginal propensity to consume is illustrated as a flatter consumption function. Measure of Income
Disposable income: the income that households receive in wages, dividends, and interest payments, plus transfer payments from the government, minus the taxes that they pay to the government. Disposable income is the preferred income measure used in representing household consumption because it is what households have available to spend. Which Measure of Income? For the rest of the chapter, we will use aggregate income or real GDP as our measure of income. The next slide illustrates the actual relationship between consumption expenditures and real GDP for the United States. Consumption versus Aggregate Income Finding Real GDP When Consumption and Income Move Together Assume that government spending will decline by $100 billion next year. Our goal is to find out what happens to real GDP in the short run. Finding Real GDP When Consumption and Income Move Together Here is the logic behind the effect of a decrease in government spending on real GDP: 1. A cut in government spending reduces real GDP. 2. Real GDP is income, so income is reduced. 3. Consumption depends on income, so consumption is reduced. 4. A reduction in consumption further reduces real GDP. The 45Degree Line
45degree line: the line showing that expenditure equals aggregate income. The following graph illustrates the 45degree line. For points on this line, the value on the xaxis equals the value on the yaxis. The 45Degree Line The Expenditure Line
Expenditure line: the relationship between the sum of the four components of spending (C + I + G + X) and aggregate income. The next slide graphically illustrates that the expenditure line is derived by vertically adding the value of investment, government purchases, and net exports to the consumption function. The Expenditure Line Negative Net Exports
During the last 10 years, net exports for the United States have been negative. The difference between U.S. imports and exports has increased over time. Negative Net Exports Figure 6A illustrates U.S. real net exports from 1998 to 2007. Notes: The series is negative throughout the period. The gray bar indicates the 2001 recession. Net exports have been improving since 2006. Figure 6A: U.S. Real Net Exports, 19982007 Negative Net Exports
The last time the United States posted a positive net exports balance was in 1982. Figure 6B illustrates U.S. real net exports from 1978 to 2007. Figure 6B: U.S. Real Net Exports, 19782007. Negative Net Exports
How do negative net exports affect the derivation of the expenditure line? If net exports are negative, then (C + I + G) is higher than the expenditure line (C + I + G + NX). Figure 6C illustrates the derivation of the expenditure line if net exports are negative. Figure 6C Expenditure Line with Negative Net Exports
Real Expenditures C +I + G C + I + G + NX C+I C Y (Real GDP) The Slope of the Expenditure Line
The slope of the expenditure line is the same as the slope of, and is parallel to, the consumption function. Because MPC < 1, the expenditure line is flatter than the 45degree line. Shifts in the Expenditure Line
The expenditure line will shift up when any of the following events occurs: G rises I rises T falls X rises Shifts in the Expenditure Line
The expenditure line will shift down when any of the following events occurs: G falls I falls T rises X falls Shifts in the Expenditure Line Determining Real GDP Through Spending Balance
Spending balance: the level of income or real GDP at which the 45degree line and the expenditure line cross; also called the equilibrium income. Figure 8 illustrates that the spending balance is achieved at the intersection of the 45degree line and the expenditure line. This graph is also known as the "Keynesian cross." Figure 8: Spending Balance Determining Real GDP Through Spending Balance
At the spending balance, two relations are satisfied simultaneously: Spending = income Spending = C + I + G + NX Determining Real GDP Through Spending Balance
Table 2 provides a numerical example of spending balance. Only one level of income (11,000 in the table) corresponds to the spending balance, where the first column (income or real GDP) equals the second column (total expenditure). equal Determining Real GDP Through Spending Balance
Notes: At income levels less than 11,000, the total expenditure exceeds real GDP. At income levels greater than 11,000, the total expenditure is less than real GDP. Determining Real GDP Through Spending Balance
The next slide illustrates the effect on the spending balance when government purchases (G) fall by $100 billion. A $100 billion decrease in government purchases results in a more than $100 billion decrease in the equilibrium income level. From One Point of Spending Balance to Another Determining Real GDP Through Spending Balance
The ratio of the decline in GDP to the decline in G is called the Keynesian multiplier. Keynesian multiplier = Change in GDP Change in government spending The Keynesian multiplier must be greater than unity, because the change in GDP is greater than the change in government spending, as illustrated in Figure 9. Spending Balance and Departures of Real GDP from Potential
Figure 10 illustrates how GDP found through spending balance can explain the first steps of a recession or a boom. In a recession, the economy experiences a lower than normal expenditure level. This will bring the economy from point b to point d in Figure 10. Spending Balance and Departures of Real GDP from Potential
In a boom, the economy experiences a higher than normal expenditure level. This will bring the economy from point b to point e in the next graph. With a normal expenditure level, the economy will be at the potential real GDP. This will move the economy from point b to point c in the next graph. Spending Balance and Departures of Real GDP from Potential GDP Spending Balance and Departures of Real GDP from Potential
The previous graph illustrates only the shortrun effects of changes in government spending, investment, or net exports. Other forces exist that will bring the economy back to full employment. These forces will be discussed in later chapters. Key Terms real business cycle theory consumption function marginal propensity to consume (MPC) 45degree line expenditure line spending balance ...
View Full Document
- Spring '10
- Macroeconomics, Keynesian economics