INTRODUCTION TO

BUSINESS CYCLES AND AGGREGATE DEMAND

Chapter 22
Industrial Revolution, Image Source: https://overthrowingilluminati.files.wordpress.com/2013/08/industrial_revolution.jpg, date accessed 12 March, 2017

Depending on the time period, the survey of the

macroeconomy can be framed on two central themes

Business cycles Economic growth

The short-term fluctuations in The longer-term trends in output
output, employment, financial and living standards
conditions, and prices

1
 Business cycles
Business cycles are economy-wide fluctuations in national output,
income, and employment, usually lasting for a period of 2-10
years, marked by economic expansion or contraction.

Philippines GDP (2018=100), y-o-y growth rate, 1950-2019

Source: Philippine Statistics Authority, date accessed 29 July 2020

12

10

0
1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019
-2

-4

-6
contraction Expansion
-8

2
Macroeconomic market analysis deals with aggregate
supply and demand

Aggregate demand(ad) Aggregate supply,(as)

AD is the total quantity of output
that is willingly bought at a given
level of prices, other things held
constant
AS shows the total quantity of output
supplied given an overall price level. The
curve is upward sloping, or horizontal, in
the short run, and vertical, or close to
vertical, in the long run.

Business cycles can be interpreted as shocks in AD

Fluctuations in output, employment, and prices are often caused by
shifts in aggregate demand. These occur as consumers, firms, or
governments change total expenditures relative to the economy’s
productive capacity.

3
 TE
Consider the initial case where the
only expenditure (TE0) of the
economy is consumption C.
TE1 = C + I
Equilibrium lies at A0* where income
(Y) is equal to TE i.e., 45⁰ line
TE1* A1*
Suppose the economy receives
TE0 = C investments (I). Its expenditures are
now sourced from both C and I.
TE shifts upward equal to the
TE0* amount of investment, I. This results
A0* to a new equilibrium A1*.
Entry of investments increases AD,
45 Y expands output (higher Q*)
Q0* Q1*

Alternatively, the initial condition can

be expressed in AD-AS market,
where AD0 is just equal to C.
Entry of investments increases AD
resulting to an outward shift.
Ceteris paribus, this changes short-
run equilibrium from E0 to E1.
In the short-run, this results to higher
p1* output and inflation (higher P*).
E1*
P0* E0* AD1 = C + I
SRAS
AD0 = C
Q
Q0* Q1*

4
TE
TE1 = C+I
To summarize, the relationship
TE0 = C between income, expenditures and
A1* markets show how AD shifts affect
output and price
At equilibrium, shifts in AD (below)
A0*
are equivalently shifts in TE (left).
45 Y
A shift in TE changes equilibrium
P GDP, or output. Since TE = AD, this
SRAS is also observed in AS-AD market.
The AS-AD market relates how
changes in output changes price. In
P1* this case, increase in AD results to
P0*
E0*
E1*
AD1 = C+I
short-run expansion of the economy.

AD0 = C
Q
Q0* Q1*

Government polices can affect components of AD and

thus, can consequently affect output and prices

fiscal monetary trade

Carried out by the government Carried out by the Central Bank Carried out by the government
through tax rates, levels and through the management of through regulations on the
composition of government interest rates and the supply of external exchange of goods
spending. money in circulation and services.

5
Exercise. Provide what is asked.
Consider a closed economy without government whose only expenditure
is consumption. Suppose further households spend 0.60 cents for every
extra peso in their disposable income. Furthermore, with a total income of
PHP 3700 and a flat tax regime of PHP 50, savings is PHP 1300.
Derive the MPC, MPS, consumption function, and saving function.
Use these information to determine the equilibrium level of disposable
income, consumption, and saving.
Consider an endowment of PHP 200 exogenous investment. Determine
the new expenditure function, as well as the new equilibrium level of
income, consumption, and savings.

Exercise. Provide what is asked.

Consider a closed economy without government whose only expenditure
is consumption. Suppose further households spend 0.60 cents for every
extra peso in their disposable income. Furthermore, with a total income of
PHP 3700 and a flat tax regime of PHP 50, savings is PHP 1300.
MPC = 0.60
MPS = 1 – MPC = 0.40
Given: Y = 3700; t = 50; S = 1300.
Find disposable income:
YD = Y – t + tr = 3700 – 50 + 0 = 3650
If YD = 3650; S = 1300. Since YD = C + S:
C = YD – S = 3650 – 1300 = 2350
Find autonomous consumption, given: C = cYD + C0
2350 = 0.60(3650) + C0
C0 = 160
C = 0.60YD + 160

6
Exercise. Provide what is asked.
Consider a closed economy without government whose only expenditure
is consumption. Suppose further households spend 0.60 cents for every
extra peso in their disposable income. Furthermore, with a total income of
PHP 3700 and a flat tax regime of PHP 50, savings is PHP 1300.
Since YD = C + S and C = 0.60YD + 160
S = YD – C = YD - 0.60YD - 160
S = 0.40YD -160

At equilibrium , Y = TE
Since, TE = C = 0.60YD + 160,
Y = 0.60YD + 160
Y = 0.60(Y-50) + 160
Y = 0.60Y-30 + 160 = 0.6Y + 130
0.4Y = 130
Y* = 325; YD* = 275; C* = 325; S* = -50

Exercise. Provide what is asked.

Consider an endowment of PHP 200 exogenous investment. Determine
the new expenditure function, as well as the new equilibrium level of
income, consumption, and savings.
At equilibrium , Y = TE
Since, TE = C + I = (0.60YD + 160) + 200
Y = 0.60YD + 360
Y = 0.60(Y-50) + 360
Y = 0.60Y-30 + 360 = 0.6Y + 330
0.4Y = 330
Y* = 825; YD* = 775; C* = 625; S* = 150