- Study Guide (Course-wide Content)
A. What are Business Cycles?
- Business cycles or fluctuations are swings in total national output, income, and employment, marked by widespread expansion or contraction in many sectors of the economy. They occur in all advanced market economies. We distinguish the phases of expansion, peak, recession, and trough.
- Most business cycles occur when shifts in aggregate demand cause changes in output, employment, and prices. Aggregate demand shifts when changes in spending by consumers, businesses, or governments change total spending relative to the economy's productive capacity. A decline in aggregate demand leads to recessions or even depressions. An upturn in economic activity can lead to inflation.
- Business-cycle theories differ in their emphasis on exogenous and internal factors. Importance is often attached to fluctuations in such exogenous factors as technology, elections, wars, exchange-rate movements, and oil-price shocks. Most theories emphasize that these exogenous shocks interact with internal mechanisms, such as financial market bubbles and busts.
- Ancient societies suffered when harvest failures produced famines. The modern market economy can suffer from poverty amidst plenty when insufficient aggregate demand leads to deteriorating business conditions and high unemployment. At other times, excessive government spending and reliance on the monetary printing press can lead to runaway inflation. Understanding the forces that affect aggregate demand, including government fiscal and monetary policies, can help economists and policymakers smooth out the cycle of boom and bust.
- Aggregate demand represents the total quantity of output willingly bought at a given price level, other things held constant. Components of spending include (a) consumption, which depends primarily upon disposable income; (b) investment, which depends upon present and expected future output and upon interest rates and taxes; (c) government purchases of goods and services; and (d) net exports, which depend upon foreign and domestic outputs and prices and upon foreign exchange rates.
- Aggregate demand curves differ from demand curves used in microeconomic analysis. The AD curves relate overall spending on all components of output to the overall price level, with policy and exogenous variables held constant. The aggregate demand curve is downward-sloping because a higher price level reduces real income and real wealth.
- Factors that change aggregate demand include (a) macroeconomic policies, such as fiscal and monetary policies, and (b) exogenous variables, such as foreign economic activity, technological advances, and shifts in asset markets. When these variables change, they shift the AD curve.
- The multiplier model provides a simple way to understand the impact of aggregate demand on the level of output. In the simplest approach, household consumption is a function of disposable income, while investment is fixed. People's desire to consume and the willingness of businesses to invest are brought into balance by adjustments in output. The equilibrium level of national output occurs when planned spending equals planned output. Using the expenditure-output approach, equilibrium output comes at the intersection of the total expenditure (TE) consumption-plus-investment schedule and the 45° line.
- If output is temporarily above its equilibrium level, businesses find output higher than sales, with inventories piling up involuntarily and profits plummeting. Firms therefore cut production and employment back toward the equilibrium level. The only sustainable level of output comes when buyers desire to purchase exactly as much as businesses desire to produce. Thus, for the simplified Keynesian multiplier model, investment calls the tune and consumption dances to the music.
- Investment has a multiplied effect on output. When investment changes, output will initially rise by an equal amount. But that output increase is also an income increase for consumers. As consumers spend a part of their additional income, this sets in motion a whole chain of additional consumption spending and employment.
- If people always spend r of each extra dollar of income on consumption, the total of the multiplier chain will be
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The simplest multiplier is numerically equal to 1/(1 − MPC). - Key points to remember are (a) the basic multiplier model emphasizes the importance of shifts in aggregate demand in affecting output and income and (b) it is primarily applicable for situations with unemployed resources.
- The analysis of fiscal policy elaborates the Keynesian multiplier model. It shows that an increase in government purchases—taken by itself, with taxes and investment unchanged—has an expansionary effect on national output much like that of investment. The total expenditure TE = C + I + G schedule shifts upward to a higher equilibrium intersection with the 45° line.
- A decrease in taxes—taken by itself, with investment and government purchases unchanged—raises the equilibrium level of national output. The CC schedule of consumption plotted against GDP is shifted upward and leftward by a tax cut. But since the extra dollars of disposable income go partly into saving, the dollar increase in consumption will not be quite as great as the increase in new disposable income. Therefore, the tax multiplier is smaller than the government-expenditure multiplier.