ECON 2133 Class Outline 5

ECON 2133 Class Outline 5

Chap. 9 – Economic Fluctuations; Chap. 10 – The Short-run (Keynesian) Model

Chap. 9 – Economic Fluctuations

Economic fluctuations (“business cycles”) are periodic ups and downs in an economy’s real output (Yr).

Terminology: Expansion

Peak (turning point)

Contraction / Recession

Trough (turning point)

Contraction / Recession: A period during which an economy’s real GDP (Yr) ______

During a recession

·  Yr falls below its “______” (i.e., full employment) level

·  Employment decreases (______increases)

See Fig. 1, pg. 231 – 7 recessions since 1960 (shaded on graph)

With each, the U rate increased sharply (Fig. 2, pg. 232)

Even after a recession “officially” ends, it may take some time for

·  Yr to return to its “potential” level

·  The empl. / unempl. levels to return to a “full empl.” condition

(See Fig. 1 (top) and Fig. 2)

Usually, recessions are relatively brief (months), but the potential aftereffects make any recession a serious economic event (rf. pg. 230)

Key focus of chapter

The Classical model does not recognize or explain econ. fluctuations, especially those that are long or have lasting effects on Yr and employment (pg. 231, 235)

So what causes econ. fluctuations?

Answer: ______changes (or econ. “shocks”)

(see pg. 2364 – 239; Table 1, pg. 238)

So we need a model that explains the short run effects of “spending shocks”

This short run macro model (a.k.a. the Keynesian model) is introduced in Chap. 10

Chap. 10 – The Short-run (Keynesian) Model

This model is based on

Output Y = C + I + G + NX

vs. Aggregate Expenditures AE = C + Ip + G + NX

If AE ≠ Y, then Ip will ≠ I

And it is these inequalities that trigger a ______or ______phase of a business cycle.

The short run (Keynesian) model focuses on

1.  What determines AE?

2.  What happens when AE ≠ Y?

The components of AE

1. Consumption spending ( C ) is affected by

·  Disposable income (Yd)

·  Interest rates

·  Wealth

·  Expectations (pg. 242 – 243)

Yd is the most important of these for modeling

3 key relationships

(1) Yd = Y – T

(2) Yd = C + S

(3) C = Co + mYd

C is ______consumption spending

Co is “______” C spending

m is the “marginal propensity to consume”

(a.k.a. the “mpc”)

See pg. 243 – 247; Fig. 2, pg. 245

The C function relating C to Yd is the basis of the Keynesian model, but it is more useful to relate C to total Y (rather than Yd) This is called the consumption – income (C – Y) line

Fig. 3, pg. 248

Note that on the C – Y graph

(1)  Y (tot. income, or GDP) is on the horiz. axis

(2)  Slope of the C – Y line = mpc

(3)  Co(y) = Co(d) – mpc*T (See pg. 248)

On Fig. 2, Co(d) = 2000

mpc = 0.6 and T = 2000

So on Fig. 3, Co(y) = 2000 – 0.6*(2000) = 800

Note also that in this model

·  A ∆Y will cause a movement ______the C – Y line (e.g., A to B on Fig. 3)

·  While a ∆ in any other determinant of C ______the C – Y line (either up or down)

(See pg. 249 – 250; Table 3, pg. 251

2. Investment: In the AE model, I ______∆s in inventories

i.e., Ip is ______capital and new housing investment, with inventories ______

In other words, Ip is assumed to have a given (constant) value in the model (pg. 251)

3. G and NX are also assumed to have given (constant) values

(pg. 252 – 253)

So the complete AE model is

AE = C + Ip + G + NX

See Fig. 5, pg. 257

Notes on Fig. 5

·  The AE line (top line on graph) has the same slope as the C – Y line (slope = mpc)

·  The vert. intercept of the AE line = Co + Ip + G + NX (the Ip, G, and NX values are stacked on top of the C – Y line) (Co + Ip + G + NX) is called “autonomous spending”)

Interpreting the AE – Y graph

1. ______is where the AE and 45° lines intersect

At $8 tril. (Fig. 7, pg. 259)

i.e., Y = $6 tril. and AE = $6 tril.

so that ______= ______

But what if Y ≠ $8 tril.???

1)  Suppose Y = $12 tril.

Then AE = $10.4 tril. (see Table 4, pg. 254)

So AE < Y

What happens to the output (Y) that is produced but not bought (AE)?

Ans.: Unsold output accumulates as ______

i.e., when Y > AE, then inventories ______

This increase in inventories is ______investment so that, when Y > AE, ______I is > ______I !

When this happens, what will business owners / managers do???

They will ______to reduce excess inventories

Bottom line: If Y > AE, then future Y will ______

2) Suppose Y = $4 tril.

Then AE = $5.6 tril. (Table 4, pg. 254)

AE > Y and inventories will ______

i.e., I < Ip

so that businesses will ______output to restore inventories to desired levels

Bottom line: If Y < AE, then future Y will ______

Summary

Let INVe mean equilibrium (optimal) inventory level

INVa mean actual inventory level

q  If Y < AE, then INVa < INVe (I < Ip)

and Y will increase ---- ______

q  If Y > AE, then INVa > INVe (I > Ip)

and Y will decrease ---- ______

q  If Y = AE, then INVa = INVe (I = Ip)

and Y will not change ---- ______

Study pg. 254 – 260

Other points re. the Keynesian model

1.  Employment

q  In the classical model, equilibrium is always at full employment

q  In the Keynesian model, AE – Y equilibrium can occur either below or above full employment

(pg. 260 – 263)

2.  How changes in Co, Ip, G, or NX affect the economy

E.g., with equilib. At AE = Y = $8 tril.

If Ip increases by $1 tril., then AE and Y could increase by much more (pg. 263 – 265)

How / why? Because increased spending creates increased incomes, which generates more spending,

. . . .

I.e., there is a ______of the initial change in spending

How much? The potential total effect of a change in Ip is

DY = DIp * [ 1 / (1 – mpc) ] pg. 266

the “expenditures multiplier” (EM) = [ 1 / (1 – mpc) ]

pg. 265

If mpc = 0.6 and DIp = $1 tril.

q  EM = [ 1 / (1 - .6) ] = 2.5

q  DY = $1 tril * 2.5 = $2.5 tril.

And a change in Co, G, or NX have the same potential effects as a change in Ip pg. 267

Note that a decrease in Co, Ip, G, or NX will ______AE and Y by a multiple of the initial change in spending

(pg. 266)

Multiplier effects in the real world

For the U.S. economy, the mpc ≈ 0.9

So the EM = [ 1 / (1 – 0.9) ] = 10

But the actual mult. effect of a change in Co, Ip, G or Nx is only ≈ 1.5

Why? “Automatic stabilizers”

As Y increases

Taxes ______, so that Yd and C do not increase in proportion to the increase in Y

Transfer payments ______, so that G decreases

Interest rates ______, so that Ip (and C) decrease

Net exports ______because more is imported with higher Y and AE levels (IM increases, EX may remain constant or decrease)

“Forward looking behavior” (also called “Consumption averaging”) may occur -- C may not rise as much as expected for a given increase in Y (the mpc decreases) See pg. 269 – 270

We will consider the role of fiscal policy (pp. 271 – 276) in counteracting undesirable business cycle movements later.

XXX Chap. 10