Download - Economic Fluctuations I
What are recessions?What causes them? Why do they end?
A role for government? 25_01 BILLIONS OF
1992 DOLLARS
1988 1989 1990 1991 1992 1993
6,750
6,500
6,250
6,000
5,750
BILLIONS OF1992 DOLLARS
1960 1965 1970 1975 1980 1985 1990 1995
3,000
5,000
4,000
6,000
7,000
8,000
Potential GDP
Real GDP
Potential GDP
Real GDP
This morning’s headlines
First key idea of the theory of economic fluctuations
• Recessions and “booms” are departures of real GDP from potential GDP
25_02
Real GDP(purple line)
Potential GDP(black line)
d
TRILLIONS OF 1992DOLLARS
6.25
6.00
5.75
Year 1 Year 3Year 2
c
b
a
Recession
Potential GDP(black line)
ea, bd
Real GDP(purple line)
TRILLIONS OF 1992
DOLLARS
6.25
6.00
5.75
Year 1 Year 3Year 2
5 4 1 0 1 2 3 4 5 3 2
c
e
b
a
Boom
Percentage deviation ofreal GDP from potential GDP
Second key idea of the theory of economic fluctuations.
• The departures are due to changes in demand (aggregate demand). But why?
25_03
Low
demand
The firm changes production
by the same amount as the
shift in demand; the firm's
price is sticky; it does not change.
Medium
demand
High
demand
FIRM'S PRICE
FIRM'S PRODUCTION
The firm changes production
by less than the shift in demand;
the firm's price must change.
What about fluctuations in potential GDP?
• These are usually too smooth to explain recessions.
• Rarely is there a huge decline in labor, capital, or technology at the time of a recession
• Exceptions are important and have huge effects, but not the typical recession– AIDS epidemic in Africa– Hurricane Mitch in central America
Using the Key Ideas
• Aggregate demand can be obtained by adding up spending: C + I + G + X
• Example: forecast real GDP for 1999
• Y = C + I + G + X– BUT WATCH OUT: C depends on Y, because Y is
income too: example C = 1000 + .6Y Y = C + I + G + X
– To see the implications of this dependence, put I and X on the backburner for now
A consumption function: Algebra example: C = 1000 + .6Y
or in numerical form:25_01T
Consumption Income
1,600 1,000
2,200 2,000
2,800 3,000
3,400 4,000
4,000 5,000
4,600 6,000
5,200 7,000
5,800 8,000
6,400 9,000
7,000 10,000
7,600 11,000
8,200 12,000
8,800 13,000
9,400 14,000
Or the same consumption function in graphical form:
25_04
Consumption function
Change in consumption
Change in income
INCOME (BILLIONS OF DOLLARS)
Slope equals marginal propensity to consume.
CONSUMPTION (BILLIONS OF DOLLARS)
5,000
4,000
3,000
2,000
1,000
1,000 4,000 6,0003,000 5,0002,000
Making sure both relationships are satisfied
• Income (which equals spending) depends on consumption– Or in equation form, Y = C + I + G + X– this is the income-spending identity
• Consumption depends on income– Or in equation from, C = 1000 + .6Y– this is the consumption function
Economists fool around with the second relationship (the
consumption function) a little bit
• They add investment (I), government purchases (G), and net exports (X) to the consumption function– They get a total sum which shows how
C + I + G + X depends on income
• They call this “total sum” the aggregate expenditure line
The aggregate expenditure (AE) line
C
C = Consumption
I = Investment
G = Government
purchases
X = Net exports
C + I
C + I + G
INCOME OR REAL GDP
SPENDING
Consumption function
C + I + G + X
Aggregate expenditure line
25_07
Note that the AE line shifts up and down if G or I or X change (question: what is the effect of the Asian
financial crisis on AE in the United States?)
INCOME OR REAL GDP
SPENDING
Line shifts down if 1) G falls 2) I falls 3) T rises 4) X falls
Two AE lines
Line shifts up if 1) G rises 2) I rises 3) T falls 4) X rises
25_08
Now let’s remind ourselves that spending equals income; graphically
this gives the 45-degree line
45-degree line
A
45°
B INCOME OR REAL GDP
SPENDING
B
A
25_06
Put the AE line and the 45 degree line together to get spending balance
45-degree line
AE line
SPENDING
INCOME OR REAL GDP
Point of spending balance
Level of real GDP at spending balance
25_09
Sometimes numerical examples help one see spending balance better
25_02T
Income or Aggregate Government NetReal GDP Expenditure Consumption Investment Purchases Exports
6,000 7,600 4,600 900 2,000 1007,000 8,200 5,200 900 2,000 1008,000 8,800 5,800 900 2,000 1009,000 9,400 6,400 900 2,000 100
10,000 10,000 7,000 900 2,000 10011,000 10,600 7,000 900 2,000 10012,000 11,200 8,200 900 2,000 10013,000 11,800 8,800 900 2,000 10014,000 12,400 9,400 900 2,000 100
Finally, let’s imagine that the AE line shifts down, perhaps because
of the Asian financial crisis
45-degree line
New AE line
Original AE line
Original income level
New income level
INCOME OR REAL GDP
SPENDING
Income or real GDP falls by this amount (more than $100 billion).
G falls by this amount ($100 billion).
Original point of spending balance
New point of spending balance
25_10
In general, when the AE line shifts, real GDP falls (d) or rises (e)
25_11A
45 line
BoomAE line
e
c
d
NormalAE line
RecessionAE line
INCOME OR REAL GDP
(TRILLIONS OF 1992 DOLLARS)
5.75 6.506.256.00
Threepossiblelines foryear 3
6.50
SPENDING
(TRILLIONS
OF 1992 DOLLARS)
6.25
6.00
5.75
It is hard to imagine the AE line shifting. Can you show how this works with animated graphics or just a blackboard?
These falls or rises take real GDP away from potential GDP
• They are the first steps toward recession (d) or boom (e)
25_11B
SPENDING
(TRILLIONS
OF 1992 DOLLARS
d
6.25
6.50
6.00
5.75
Year 1 Year 3Year 2
c
e
b
a
(Boom)
(Real GDP=potential GDP)
(Recession)
But they are not the final steps
• To see what happens next (and ultimately to see why the economy recovers from recession), we need to look at the forces of adjustment in the economy
• These forces are the subject of the next lecture
END OF
LECTURE