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