Economic

1
Chapter 12

• Economic
• Fluctuations

2
Equilibrium

• Inventory changes.
• ? Unintended changes in inventories cause
  price levels and real outputs to reach
  equilibrium.
• ? Two possibilities the results of an
  inventory increase and of an inventory
  decrease.

3
An Economy in Equilibrium
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Results of an Inventory Increase

• Positive Unplanned Investment
• an unintended increase in inventories a
  surplus

Results of an Inventory Decrease

• Negative Unplanned Investment
• an unintended decrease in inventories a
  shortage

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The Role of Unplanned Investment
? Unplanned investment plays a central role in
stabilizing the economy, whether there is an
inventory increase or decrease.
? Unplanned investment is positive when the price
level is above its equilibrium value and negative
when the price level is below its equilibrium
value, and in each case unplanned investment is
identical to the discrepancy between aggregate
demand and aggregate supply.
6
Injections and Withdrawals

• Injections additions to an economys
  income-spending stream
• Investment (I)
• Government purchases (G)
• Exports (X)

• Withdrawals deductions from an economys
  income-spending stream.
• Saving (S)
• Taxes (T)
• Imports (M)

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Investment and Saving
There are 3 reasons the amount saved and the
amount invested in an economy is not equal

1. companies keep a portion of their profits to
   reinvest

1. governments also borrow money

1. foreign funds

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Government Purchases and Taxes

• If government purchases exceed taxes
• governments will borrow funds in financial markets

If taxes exceed government purchases?
governments can use their excess revenues to pay
off some of their outstanding debt.
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Exports and Imports

• imports were greater than exports from 1989 to
  1993

? that means Canadians are spending more on
foreign goods than they receive revenue from
selling products to foreigners.
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Total Injections and Withdrawals
? comparing these two provides a way of
explaining macroeconomic equilibrium that
complements the approach using aggregate demand
and aggregate supply. ? total injections ( I
G T ) ? total withdrawals ( S T M
) Expanding economy total injections gt total
withdrawals ? flows into the income-spending
stream falls are less than output
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• ? the income-spending stream falls and slows down
• Contracting economy total withdrawals gt total
  injections
• flows into the income-spending stream are less
  than outflows
• ? the income-spending stream falls and slows down
• Equilibrium total injections total withdrawals
• ? inward and outward flows match, the
  income-spending stream circulates at a steady
  rate, so that real output and spending in the
  economy stay constant

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Equilibrium With Injections and Withdrawals
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An Economy at Its Potential Output
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Equilibrium Vs. Potential Output
? it is possible for equilibrium to occur at the
economys potential output. In this case, actual
unemployment equals the natural unemployment
rate Recessionary Gaps ? an economys real output
rarely equals its potential output. ? if
equilibrium output is below its potential level,
unemployment is above the natural unemployment
rate. ? recessionary gap the difference between
equilibrium output and potential output
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Inflationary Gaps
? if equilibrium output is above its potential
output, unemployment is temporarily below the
natural unemployment rate. ? inflation will
accelerate if this situation persists. ?
Inflationary Gap when equilibrium output exceeds
potential output  
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Recessionary and Inflationary Gaps
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John Maynard Keynes and the Transformation of
Macroeconomics

• John Maynard Keynes (1883-1946)
• His father was an economist and his mother was a
  city politician.
• Studied mathematics at Cambridge University
• Published The General Theory of Employment,
  Interest, and Money.
• During the Depression, Keynes and his followers
  were able to convince most politicians and
  economists that government intervention with a
  coherent theory, which stressed the role-played
  by aggregate demand in determing output in the
  macroeconomic,.
• Keynesian ideas dominated macroeconomics from
  after WWII to the end of 1970s.

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Neoclassical Theory

• Prior to Keynes, most economists believe that
  economic slowdowns are self- correcting, this is
  referred to as the neoclassical theory.
• Two major assumptions flexible labour markets
  and Says Law.

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Flexible Labour Markets
The demand and supply of labour depend on the
real wage rate, or wages expressed in constant
basted-year dollars, rather than the nominal
wage rate, which is valued in current dollars.
        Both workers and employers adjust
their behavior only when the purchasing power of
wages changes.         Employers demand less
labour at higher real wage rates, while workers
choose to supply more.
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• Voluntary unemployment when workers decide that
  real wages are not high enough to make work
  worthwhile.
• Involuntary unemployment when someone wants to
  work at the current real wage rate but cannot
  find a job.
• Involuntary unemployment occurs when market
  demand and supply create a surplus, and as long
  as labour markets are flexible, the market forces
  of demand and supply eradicate the surplus.

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A Flexible Labour Market
22
Says Law

• First outlined by a French economist
  Jean- Baptiste Say.
• Using the circular flow of money in the
  economy, Say argued that supply automatically
  creates its own demand.

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Keynesian Theory

• Keynes challenged both of the assumptions of
  neoclassical economics.
• A theory that explained how involuntary
  unemployment and under spending had become
  chronic problems during the Depression

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Challenge to Flexible Labour Markets
Keynes believed workers were influenced by
money illusion.         Workers would respond
to changes in nominal wages, rather than real
wages and purchasing power.
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Challenge to Says Law

• Keynes proved Says Law is only valid if all
  income in an economy is spent.
• According to the law, reduced spending is only
  temporary total expenditures and production
  soon balance each other out. This occurs since
  total withdrawals and injections can be equal at
  any output.
• Interest rates charged in financial markets
  will vary until withdrawals leaving the circular
  flow are matched by injections.
• However, Keynes proved that output levels, not
  interest rates, adjust to bring about a balance
  between total injections and withdrawals.
• Says Law is only true when injections are less
  than withdrawals, output falls until a new
  equilibrium level is reached, and it is only at
  this equilibrium that this law is true.

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An Inflexible Labour Market