Chapter 3: Business Cycle

• Changes in economic activity over a short time horizon are called business cycles.
• Macroeconomists analyze business cycles using models like aggregate demand and how it interacts with market equilibrium and output.
• Small changes in aggregate demand can lead to large changes in output.

The Business Cycle

• Business cycles show that economic growth isn't a smooth process.
• Business cycles are alternating periods of positive and negative growth rates.
• Economies go through expansions (booms) or recessions (busts); growth swings from positive to negative.
• There is not a standard definition for ‘boom’ or ‘bust’.
• Post-industrial revolution, the population depends on paid employment from firms for income instead of harvesting.
• Negative growth means the economy produces less, employs fewer people and machines.
• Less employment means some people go without income leading to periods where output is below its potential.

Recession Definitions

• NBER defines a recession as when output is declining, and is over once the economy grows again.
• Alternatively, a recession means the level of output is below its normal level, even if growing, until output returns to “normal.”
• The movement from expansion to recession and back is known as the business cycle.
• Unemployment is when people want to work but can't.
• The International Labour Organization defines unemployment as a person not working, seeking to be employed, and ready to work within 2 weeks.
• A person is counted as unemployed even if they are awaiting one to begin soon.
• Not all unemployment claimants are actually unemployed.
• This unemployment definition signals economic distress; if people are not working by choice, they are out of the labour force (OLF) or inactive.
• Demand shocks and supply shocks are two major explanations for business cycles

Fluctuations in GDP

• Analyzing expenditure components of GDP helps explain economic growth and decline.
• GDP is calculated as Consumption + Investment + Government spending + (Exports – Imports).
• Each component of GDP growth depends on its share of GDP and its growth over the previous period.

Investment Volatility

• Investment is more volatile than consumption, especially in rich countries like the UK and US, and middle-income countries like Mexico and South Africa.
• Investment spikes are larger than those for consumption which suggests that investment behavior is key to explaining booms and busts.
• Volatility is the amplitude of fluctuations one indicator experiences over time.

Consumption Smoothing

• Consumption is less volatile than GDP, especially in rich countries which is known as consumption smoothing.
• This is less evident in middle-income countries because households are less able to borrow to maintain consumption when incomes are shocked.
• A burst (or collapse) of investment transmits through the economy.
• Investment is more volatile then consumption.

GDP as Expenditures

• In a simplified model, GDP as expenditures is only a function of consumption and investment omitting government spending and net exports.
• This can be expressed as Y = C + I, where Y denotes total output.

Aggregate Demand

• Aggregate demand is the total demand for goods and services produced in the home country.
• In a simplified model, aggregate demand is how much households and firms want to spend on output, expressed as AD = C + I.

Aggregate Consumption Function

• The aggregate Consumption Function is defined as C = Co + C₁Y
• C₀ represents autonomous consumption: spending independent of current income and expectations about future income and subsistence level consumption.
• C₁Y represents variable consumption: household consumption dependent on income.
• C₁ is the marginal propensity to consume (MPC): how much of each additional dollar of income is spent on goods and services.
• Between 0 and 1, or 0 < C₁ < 1.

Investment

• Investment (I) represents firm spending on new equipment and structures, including residential housing.
• Fixed investment does not depend on the level of output.
• Investment value is exogenous, or does not depend on other variables within the model.
• Distinguish between endogenous (determined within the model) and exogenous variables (determined independently of the model).

Equilibrium in the Goods Market

• Demand for goods and services is aggregate demand consisting of aggregate consumption and investment, AD = C + I.
• Supply of goods and services is the aggregate output in the economy, Y.
• Goods market equilibrium requires supply to equal demand, Y = AD = C + I.
• Using the AD equation, the equilibrium output can be calculated: Y = 1/(1 – c₁) [c₀ + I].
• Solving for Y yields the equilibrium output.
• If aggregate demand is lower than output, inventories of unsold goods pile up, causing firms to decrease production.
• If aggregate demand is greater than output, goods ‘fly off the shelves’ and inventories fall, signaling firms to increase production.
• Demand shocks can arise from changes in investment or autonomous consumption, which are exogenous variables.
• Changes in spending decisions amplify direct shocks: this shock is then further amplified through the economy via employment.

The Multiplier

• During business cycle upswings, more people are employed; a second household member may get a job or more hours of work.
• Households buy more goods and services, demand increases, firms increase employment, and output increases.
• This increases total wage and profit income which fuels more demand for goods and services.
• The reverse happens during a downturn.
• This process is known as the multiplier process.
• Demand shocks arise due to investment or autonomous consumption changes.
• Shocks affect aggregate demand (AD) which in turn alters output and employment.

The Multiplier effect

• Initial change in investment generates further rounds of income, output, and spending.
• Output falls by more than the initial investment fall.
• Subsequent rounds of aggregate demand decrease continue until a new equilibrium point is reached.
• The increase in final income, output and spending is called ‘the multiplier effect’.

Modelling Demand Shocks

• Equilibrium output can be written as: Y = 1 / (1 – c₁) × [c₀ + I]
• In a simple model, demand shocks arise due to: Changes in investment I; changes in autonomous consumption c₀ .
• Changes in autonomous consumption or investment displace the old equilibrium because they change aggregate demand.
• This alters the level of output and employment.

Negative Demand Shock Model

• In the event of a negative investment shock a fall will occur in investment.
• With AD decreased, this also means there will the production is lower and incomes are lower (because firms will lay off workers).
• Households have less income, therefore consumption falls impacting AD once more.
• This process continues until a new point of equilibrium is reached.
• Output has fallen by more than the initial €15 billion because the multiplier effect is now in play.

Decreases in AD

• The negative investment shock shifts the intercept of the AD curve downwards. The first decrease is €15 billion.
• Each successive reduction of AD is lessened.

Final Effect of a Demand shock

• This will cause the aggregate decrease to be: Final decrease = 15 + 15 × C₁ + 15 × C₁ × C₁ + 15 × C₁ × C₁ X C₁
• The sum of all decreases in each round gives the effect to be: Final decrease = 15 + 15 × c₁ + 15 × c² + 15 × c³ +
• This is an infinite sum of a geometric series, which converges to be: Final decrease = (1 / (1 - C₁) )× 15 If c₁ = 0.6, then Final decrease = . 1/(1-0.6) × 15 = €37.5 billion.

Multiplier Summary

• A demand falls leading output to fall and subsequently incomes will also decrease.

• This will continue and create production to further fall in a slightly lessened manner and so on.

• The Multiplier has a sum of all these successive decreases in Production

• Production is eventually fallen by a larger change than the start.

• Production adjusts to Demand as firm supply adjust and adapt based on demand at prices. The model assumes that they do not adjust their prices.

• Production adjusts to demand firms supply the amount of goods demanded at the prevailing price.

• Demand falls and firms will adjust production downwards.

• It is assumed within the model, they do not adjust their prices.

• Output changes for one with the Initial change in demand, change and adds to the beginning.

General Model

• The model includes two Components of aggregate Demand ‘The multiplier is Equal.
• Expanding the Model will bring Government spending and net Exports ( X –M)
• The formula for the Multiplier is a little different because it has taxed to determine the level of Income.
• It is always because the lecture has had The Multiplier Will be a little different.
• "The principle of the multiplier will be the Same."

The Keynesian Multiplier

• John Maynard Keynes concepts were First described by John Maynard and His Book' General Theory Employment money, interest and the Economic theory.
• Born : 4/21/47"
• Keynasin Economics Effect
• It is the Father.
• It can have fluctuation of GDP,small component with a larger impact and effects.

Wrapping Up

• It has shown how the Shock is an amplified version of the economy.
• Investment is a small Component of the Multiplier.
• The AD has shocks and Multiplier is and AD shocks and Income .
• These results has led "Why?" to these results.
• Why consumption doesn't seem to have much effects in the AD Shocks.
• This is the results of the Next Lecture.