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