Lecture Notes

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Lecture Notes

• November 4, 2003

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Part IV Economic Fluctuations

• Readings Ch. 9, 10, 11

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Chapter 9

• Aggregate Demand and Aggregate Supply
• Aggregate demand (supply) functions are functions
  of price level
• Were going to skip them (the authors dont tell
  you where they come from, except for the
  classical (vertical) aggregate supply curve)
• Conflicts with the Phillips curve analysis in
  dynamic models
• So read Ch. 9 only up to p. 186. Then skip to
  Ch. 10

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Economic fluctuations

• Economies dont always operate at full
  employment, so classical macroeconomics may not
  be relevant to a lot of situations
• (at least the version of classical macro
  presented in the preceding chapter)
• The term business cycles is often used.
  Implies regularity, causation

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Keynesian economics

• Emphasizes demand as a determinant of GDP
• Economic journalists emphasize demand (perhaps
  because theyre mostly interested in the short
  run)
• last week govt announced that GDP rose 7.2 in
  third quarter.
• Explanations centered on demand.
• Multiplier effect

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Keynesian economics

• Peoples desire to spend more might not wind up
  decreasing the quantity of saving
• If decreased willingness to save increases GDP,
  both saving and consumption may increase
• Keynesian models have this prediction classical
  models dont
• Of course, ignoring supply is just as much an
  oversimplification as ignoring demand in the
  classical model

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Economic terms related to fluctuations

• Recession 2 consecutive quarters of declining
  real GDP
• Depression a very severe recession
• no precise definition
• Only one in 20th century 1930s
• Real GDP dropped 1/3
• Trough, peak, expansion, contraction

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Potential GDP

• GDP at full employment
• Connect the peaks

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Potential GDP

• Growth of potential real GDP average rate of
  growth
• When actual growth average growth, unemployment
  stays about constant
• Unemployment rate is highly correlated with
  actual-potential gap (Okuns Law)
• Just what youd expect from the aggregate
  production function
• if output drops, unemployment rises

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Okuns law

• for each 1 that GDP grows faster than potential
  output, unemployment rate falls ½.
• Suppose trend growth of real GDP is 3/year, and
  the current unemployment rate is 5
• If real GDP grows at a rate of 4 for a year,
  Okuns law says that unemployment will drop to 4
  ½
• Most economic variables are procyclical
• A few are countercyclical

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Macroeconomic policy

• Smooth out fluctuations as much as possible
• Very high GDP growth may be as much a problem as
  very low growth
• Its unsustainable look at tech spending over
  the 90s
• It is likely to cause inflation
• Countercyclical macro policy

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Controversial

• Government may do more harm than good in
  countercyclical policy.
• Milton Friedman argued this (see Krugman).

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Chapter 10

• Keynesian Economics and Fiscal Policy

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Keynesian cross

• Morgan E-P analysis
• (expenditure-product)
• Starts from the national income accounts
  identities
• Incomeproduct
• Investmentsaving
• GDPC I G (X-M)
• For now, ignore Government and foreign, so GDPCI

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The accounting framework
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The Keynesian cross

• Interpret the accounting identities as
  equilibrium conditions
• income product, investment savings have to be
  true
• Nonetheless, we can define (the demand for)
  product so it only equals income at a certain
  level of income.
• Thats the equilibrium level of income

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Consumption function

• Ca is autonomous consumption
• level of consumption demand that would occur
  even if income0

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The consumption function
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Marginal propensity to consume

• This is just the slope of the consumption
  function, b
• Says how much out of each dollar, on the margin,
  people will spend.

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Investment

• Take the level of investment as autonomous
  (given)
• You could have investment depend on income, but
  for now, lets not
• Aggregate demand sum of consumption and
  investment
• C I is total product in the economy
• Product must income. Interpret it as an
  equilibrium condition

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Determination of equilibrium income

• Solve for y.
• y equilibrium ( actual) GDP

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The Keynesian cross