Economic Fluctuations

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Economic Fluctuations
ECO 105 Lecture 4.2 12 November 2008
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Economic Fluctuations
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The Economy Has Its Ups and Downs

• Most economies grow, but they dont grow
  steadily.
• Expansions are disrupted by occasional recessions.

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Real GDP in 1996 Dollars
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Investment Is Relatively Unstable
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Growth Rates Look More Unstable
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Some Macroeconomic Facts

• Economic fluctuations are irregular and
  unpredictable.
• Most macroeconomic variables fluctuate together.
• As output falls, unemployment rises.

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Unemployment fell during the long expansion of
the 1990s
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Explaining Economic Fluctuations

• Well develop and make use of an aggregate
  demand-aggregate supply model.
• AD is based on GDP expenditure categories.
• AS is based on the production of firms and
  government.

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Aggregate Demand

• Y C I G NX
• Y is real GDP, so the components of aggregate
  demand are in real terms.
• I.e., measured in base-year prices.

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The Aggregate Demand Curve
Price Level
AD looks like an ordinary demand curve but
looks can be deceiving.
AD
Y
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AD Curve (1)

• Whats in the ceteris paribus clause?
• Whats held constant?
• Desire to save ( of income)
• Investment demand curve I F(r, Ye)
• Government purchases (G)
• Tax rates
• Money supply

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AD Curve (2)

• Yd falls as PI rises but not because of the
  substitution effect.
• The wealth effect real asset values
• The interest-rate effect cost of borrowing
• The exchange-rate effect foreign demand
• All combine to produce a negatively sloped AD
  curve

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Shifting the AD Curve

• Americans save more
• Businesses invest more
• An increase in income-tax rates reduces
  consumption spending
• The Fed increases the money supply . . .
• Foreign economies expand . . .

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The Expenditures Multiplier

• When I, G, or NX rises, Y increases.
• Consumption depends on disposable income C
  f(Y T )
• Thus, when a change in exogenous spending causes
  Y to increase, an endogenous increase in C
  follows.
• So, ?Y ?I ?C.

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The Expenditures Multiplier

• The increase in C further increases Y, which
  causes C to rise some more.
• Consumption could rise by several times the
  amount of initial ?I.
• Ultimately, ?Y ?I ?C1 ?C2

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How big is the expenditures multiplier?

• Like the money multiplier, in theory it could be
  large (e.g., 10).
• In reality, several factors (income taxes,
  saving, imports) constrain the multiplier to a
  relatively small number probably 1.5 to 2.5.
• So, e.g., ?Y 1.5 x ?I.