Set 5 - Business Cycles and Aggregate Demand

Business Cycles Theory of Aggregate Demand Keynesian model Empirical Evidence
Economics 2: Macroeconomics
Set 5: Business Cycles and Aggregate Demand
Nordhaus and Samuelson, Economics 19e, Chapter 22
Dr. Christoph Bierbrauer

Professorship for Economics
Cologne Business School
Winter Term 2016/2017
1/ 58 Economics 2: Macroeconomics
created by: Christoph Bierbrauer
Short-term Fluctuations in Economic Activity
Business cycles are economy-wide fluctuations in total output, income

and employment, usually spreading over a period of 2-10 years, marked
by expansion or contraction of most sectors of the economy
Business Cycles
The ups and downs of the business cycle strongly affect

our daily life. Obviously, we are less concerned about times
of prosperity but fear recessions as they may imply times
of blemish. There is a huge public interest in identifying
recessions up to the point that changes in GDP are
announced monthly in the evening news
It might come as a surprise that there is no generally

agreed scientific definition of a recession. Moreover, there
is no definitive or standard empirical method in order to
identify booms and busts from data
Definition: Recession
National Bureau of Economic Research (NBER): A recession is ”a

significant decline in economic activity spread across the economy,
lasting more than a few months, normally visible in real GDP, real
income, employment, industrial production and wholesale-retail
sales”
A commonly used definition: A recession occurs when real GDP

has declined for two consecutive calendar quarters - we will stick to
this definition throughout the lecture
Finally, there are several other approaches, defining a recession as

a deviation of actual output growth from potential output
growth, which in turn depend on various approaches to identify
potential growth using empirical observations
German Business Cycles throughout Recent History
Source: Statistisches Bundesamt
Business-Cycle Theories
An idealized business cycle is based on the notion that

output fluctuates around the long run growth rate of the
economy. But why is economic growth erratic and not
steadily progressing?
The pre-dominant theories identify exogenous and internal

sources for the momentum of business cycles, respectively
Exogenous Business-Cycle Theories
Based on the seminal work of Kydland und Prescott (1982), the

microfounded Real-Business-Cycle Theory explains the fluctuations of
output by exogenous shocks to the real economy
Typically, RBC models assume technology shocks or other sources

outside the economic system being responsible for fluctuations in
economic activity:
• Political sources like wars or
revolutions
• Technological innovations
• The discovery of natural resources
• Changes in climate, e.g. global
warming
The RBC Theory: Exogenous Business Cycles
The RBC approach allows for a wide variety of exogenous

disturbances which in turn trigger a disequilibrium between
supply and demand - ultimately the microfounded RBC models
are based on the Euler equation (permanent income hypothesis),
i.e. the intertemporal optimizing behavior of economic agents
such as households, producers and policymakers
The underlying theoretical model is the dynamic stochastic

general equilibrium model (DSGE), which is adjusted by using
empirical observations. DSGE models reflect unique properties of
particular economies or regions and are the pre-dominant
approach used in modern macroeconomic research. The
required calculus is far beyond the scope of this lecture
Internal Business-Cycle Theories
Internal business cycle theories trace back to the original

theory of Keynes (1930s). While introduced in ad hoc
models like the Keynesian IS-LM approach, these shocks can
be easily implemented in RBC models
According to this theory, sources causing fluctuations in

economic activity, lie inside the economic system:
• Shocks induced by the financial sector
• Asset price bubbles
• Fluctuations in monetary and fiscal policy
The traditional Keynesian approach is

focused on demand shocks
Business-Cycle Theories: Summary
Arguments which of the approaches is more adequate to

describe reality still occur. In terms of the model applied,
the DSGE approach is the pre-dominant one
Both types of disturbances, internal and exogenous, play a

role in determining the business cycle. But it remains
unclear, whether an so-called internal shock - like a financial
crisis - was caused by exogenous sources such as
insufficient regulation of financial markets
This lecture focuses on simple ad-hoc Keynesian models.

However, we’ll discuss the pitfalls of the models as well as
the state of the art of economics in theory and look at
empirical evidence

Hyperinflation: Germany’s Great Inflation

A frequently cited example for an
internal business cycle is Germany’s
Great Inflation 1914-1923
During that period, the German

government printed substantial
amounts of money in order to cover
reparations after World War I
However, we might also interpret

the crisis as an exogenous shock:
World War I
Hyperinflation; when prices rise at 100% or more per month

Contagion: Global Financial Crisis
Subprime Mortgage Crisis (2007):

• June 2007: Two of Bear Stearns’ hedge funds lost $20 billion while
betting on future decreases in US real estate prices
• In the aftermath, US real estate prices decreased indeed
• By October 2007, nearly every bank in Western countries was
suffering huge losses, e.g. IKB, West LB, Sachsen LB in Germany

Fiscal Policy: Euro Crisis
Source: Sondergutachten des Sachverständigenrates vom 5.7.2012
Germany: Recapitalization of Banks 480bn, stimulus package of 50bn

Review: Aggregate Demand
Most theories of business cycles rely upon the theory of aggregate

demand Y d :
• Consumption; primarily determined by disposable income
and household wealth. Tax rates have strong effects on
consumption
• Investment; determined by the costs of investment (interest
rates) and tax legislation
• Government spending; public consumption and investment
• Net exports; omitted in this chapter, closed economy
Tax rates T are not part of the model, but enter as exogenous
shocks by affecting the level of disposable income DI

Theory of Aggregate Demand
Aggregate demand (AD) is the

total quantity of output
willingly bought at a given
level of prices P (constant π),
other things held constant
Yd = C +I +G+X (1)
For now, we restrict our

attention to real demand
Multiplying the AD curve with

P yields aggregate demand in
current prices

Downward slope of the Aggregate Demand Curve
The downward slope of the AD curve implies a decrease in AD, when the
overall price level rises, similar to the demand curve derived in
microeconomics:
• Microeconomics; downward slope stems from the income and
substitution effect of a price increase
• Macroeconomics; nominal rigidities, i.e. income and wealth do not
respond one-to-one to changes in the overall price level
Short-run approach: A key characteristic of Keynesian models is the

assumption of sticky prices!
If the price level rises (π > 0), the real disposable income of households
will decline by diminishing real income and real wealth, which implies
a decrease in real consumption expenditures

Forces affecting Aggregate Demand

Aggregate Demand: General Rules
Changes in variables that are

underlying the model, i.e.
changes in the level of C , I, G
and/or X, shift the AD Curve
Examples are exogenous

changes in technology,
demand shocks or a change in
the level of public spending at
a given price level
In open economies, changes

in the trade policy of foreign
governments may affect X

Aggregate Demand: General Rules, cont.

Given constant levels of the
components of AD, the level
of the AD curve is fixed,
changes of variables inside
the models cause a
movement of AD along the
AD curve
Examples for shocks that

trigger a movement along a
given AD curve, are c.p.
changes in price level and
interest rates which affect
the distribution of disposable
income between consumption
and saving

Example: Shock to Aggregate Demand
According to Keynesian theory, aggregate demand shocks are an important

source for business cycles
A global financial crisis causes uncertainty among consumers and

investors: Consumption and investment decrease

Example: Shock to aggregate Demand, cont.
Initial Equilibrium B
• Output is below potential output
Demand shock: Decrease in aggregate demand, inward shift of

the AD curve
New equilibrium C
• Output declines Q < Q0
• Supply-side adjustment P > P0
• π↓
In case of a positive demand shock, all effects are reversed

Exogenous demand shock: Recession vs. Boom
Exercise: Fiscal policy measures are not restricted to times

of economic downturns. The AS-AD approach allows us to
evaluate the effects of fiscal policy both, in times of
expansions and contractions
Select an arbitrary fiscal policy measure and compare its

impact on aggregate demand and the endogenous variables
P and Q in times of a recession vs. an economic expansion
What are the general conclusions you draw from this

exercise?

Aggregate Demand Shocks
Key assumption of Keynesian theory: Demand shocks are

a major source for business-cycle fluctuations in output,
employment and prices
Sources of internal aggregate demand shocks lie in the

behavior of households, firms and fiscal policy that, for
some reason, decide to change their demand relative to
potential output (includes the case that aggregate demand
is growing slower than potential output which is driven by
productivity)
As a result, we observe the ups and downs of the business

cycle

Multipliers
Yd = C +I +G+X (2)
Multiplier; the quantitative response of one macroeconomic

variable to an exogenous marginal change in another, e.g. if
public spending increases by one Euro the change in Y d might be
more, less or equal than a one-to-one response
In times of economic turmoil, the question whether output is

increased in general by expansive G or any particular fiscal
instrument is crucial, when deciding about the composition of a
fiscal stimulus package
Fiscal stimulus packages are a standard policy response in

order to mitigate recessions

Keynesian Multiplier Model
A Keyenesian multiplier refers to a particular case

Yd = C +I +G+X (3)
If the response of Y d to a marginal change in G is more

than one-to-one, we will refer to that special case as
Keynesian multiplier

German Fiscal Stimulus Package
In response to the Financial Crisis (2007), originating from the US’ real
estate market, the German government decided to stimulate aggregate
demand by a fiscal stimulus package in 2009
Decreases in tax rates:

• 2.9bn Euro decrease in income tax rates
• 9bn Euro decrease in health insurance paments
• Lump-sum transfer of 100 Euro per child (below the age of 13)
• A subsidy of 2500 Euro for the purchase of a new car while
scrapping the old one
Increases in public consumption:
• none
Increases in public investment:
• 18bn Euro investment in infrastructure

Key Assumptions of the Total Expenditure Approach
The traditional Keynesian approach models the short-run:

• Keynesian consumption function, i.e. no intertemporal
optimization
• Sticky prices/wages
• Unemployed resources in the economy
• Closed economy, no monetary policy
• No financial market

Review: Consumption and Disposable Income
The consumption function

CC shows the level of
consumption expenditures for
every level of income
The 45◦ −line corresponds to

the break-even point
The gray band marked by

QP QP shows the level of
potential output Y potential

Keynesian Cross
We assume a closed economy

without any public sector, thus
total expenditure is given by
TE = C + I (4)
where we assume that

investment is exogenous, i.e.
determined outside the model
The economy is in
equilibrium at the
intersection of the TE curve
and the 45◦ −line - in point E
planned demand equals
planned output

Total Expenditure Approach
Short-run approach and sticky prices: Output is

demand-determined!
Adjustment process: Any difference between planned spending

and output implies an adjustment of production plans until
planned demand equals output
Equilibrium; Planned spending equals planned production. At

any other output, the total desired spending on consumption and
investment differs from the planned production. Any deviation of
plans from actual levels will cause businesses to change their
production and employment levels, thereby returning the system
to the equilibrium GDP

Multipliers
Aggregate demand in the Keynesian cross

Y d = TE = C + I (5)
For now, we abtract from fiscal policy G = 0 which implies

T = 0. Investment is an exogenous variable. An increase in I
increases Y. At the same time C depends on Y
C = MPC × Y (6)
where we assume that a = 0. Thus, an increase in Y triggers

an increase in C
However, the effect depends on the consumption-saving

decision or more precisely, the numerical value of MPC

Keynesian Multiplier Effect
In the simple total expenditure model, a marginal increase

in the exogenous variable I (exogenous primary spending)
triggers an endless chain of secondary consumption
spending
∆Y = 1 + MPC + MPC 2 + MPC 3 + ... (7)
The underlying idea is that additional investment is

received as additional income by producers of investment
goods, who spend it in accordance with their MPC, which in
turn implies that someone receives additional income. This
constitutes an geometric series
1 1
∆Y = ∆Y = = 10 (8)
1 − MPC 1 − 0. 9

Multiplier vs. AS-AD Model
The Keynesian model assumes sticky prices.

For the special case of constant prices, the
AS curve becomes
• a horizontal line, i.e. Y is demand
determined if Y < Y potential
• a vertical line if Y = Y potential
The model will only be applicable, if the
resources of the economy are
underemployed - we need no AS curve as
output is demand-determined anyway; the
AS-AD approach corresponds to the
Keynesian cross
The Keynesian cross is only applicable to

the case of recessions!

Allocational Effects of Fiscal Policy
Fiscal policy reallocates income by a variety of measures

• Progressive tax rates and transfers
• Public investment
• Public consumption
The key insight of the Keynesian approach to
macroeconomic policy is the assumption that fiscal policy
affects the level of output
Witnessing the Great Depression, Keynes suggested to use

fiscal measures in order to steer, in particular increase,
output - the ultimate goal is to smooth the business cycle

Expansion of the Keynesian Cross
TE = C + I + G (9)
• closed economy
• no financial market
• lump-sum taxation and public spending

Consumption
Consumption function
C = MPC · DI (10)
For simplicity, we abstract from autonomous spending,

households spend a fraction of their disposable income for
consumption
Everything that is not spend on consumption goods, is saved

DI = C + S (11)
We assume that public spending G is financed by a lump-sum tax

T and that either T = G or G is financed by public debt and repaid
in the long run
T > 0 drives a wedge between output and disposable income

DI = Y − T (12)

Example: Consumption and Taxation

Y = 3000, T = 0, DI = Y, MPC = 2/3, thus
C = MPC · DI = 2000 (13)
If T = 300 we obtain DI = 2700 and

C = 2/3 · 2700 = 1800 (14)
Why does consumption decrease by less than the nominal

amount of the imposed tax rate?
• DI is not entirely spend on consumption, a fraction is

saved
• T = 300 reduces consumption by 200 and saving by 100

New Consumption Function
The original no-tax

consumption function CC is
shifted downward as T > 0
decreases disposable
income
• rightward shift by T
• parallel downward shift
by MPC · T
A change in T affects C and S,
thus consumption is not
reduced one-to-one

Government spending in the Keynesian Cross
G enters the Keynesian cross

as an additional, exogenous,
expenditure stream
TE = C + I + G (15)
Key assumption: The model

assumes that there is no
difference between private
and public expenditures with
regard to effects on aggregate
demand
E, equilibrium: Total planned

spending equals total planned
output

Taxation
By the considerations above, we know that T affects DI.

However, as only a fraction of DI is spend on consumption
goods, the effect of a change in T is less than one-to-one
In the multiplier approach I, G are exogenous. The effect of a

change in T is restricted to the response in consumption
demand by households
Thus, an increase in T decreases total expenditures; while a

lump-sum transfer has the opposite effect

Keynesian Multiplier
A fiscal multiplier refers to the response of aggregate

output to a marginal change of a variable under the
control of fiscal policy
Consequently, the government expenditure multiplier is

the response of output to a marginal change in government
expenditure
The Keynesian multiplier model does not differentiate

between public consumption and public investment, the
1
government expenditure multiplier in our model is 1−MPC >1
- the ”famous” Keynesian multiplier

Keynesian Government Expenditure Multiplier
An increase in G = 100 shifts

aggregate demand upward
The new equilibrium E 0

corresponds to an increase
in Y by 1−12/3 = 3, i.e. 300

Implications for Fiscal Stabilization
Government purchases of goods and services are an

important force in determining output and employment
In the multiplier model, an increase in G increases Y by

1
1−MPC > 1
The model predicts that government spending is a

powerful tool that allows fiscal policy to smooth the
business cycle

Tax Multiplier
Suppose a balanced budget increase of G = 200, i.e. the

government decides to finance the fiscal expansion by T = G,
with Y = 3000, T = 200, DI = 2800, MPC = 2/3, thus
C = MPC · DI = 1866.67 (16)
The policy measure decreases C by less than the increase in

G which implies an overall increase in Y
1 MPC
− =1 (17)
1 − MPC 1 − MPC

Tax Multiplier
The mitigated response of C is explained by a decrease of DI

which lowers both C and S
Therefore, C declines only according to the MPC, i.e. less

than one-to-one, which implies an overall expansive effect
on Y
Along the same line of reasoning, the multiplier for a

lump-sum subsidy to private households is 1−MPC MPC and
1 MPC
> >1 (18)
1 − MPC 1 − MPC
as a fraction of the subsidy will be saved

Multiplier Approach
The multiplier model, working together with the dynamics of

investment, provides some intuitive insights on how
alternating forces of optimism, pessimism along with other
exogenous spending changes can lead to the fluctuations
that we call business cycles
The Keynesian approach gives an oversimplified picture of

the economy and the transmission of fiscal policy

Multiplier Approach, cont.
The ideas of Keynes’ original approach are still very

influential and often used in order to justify the use of
fiscal tools to smooth the business cycle
However, stabilizing short run fluctuations is not the same

as to steer the growth path of the economy. Thus, Keynes’
ideas are utterly misinterpreted when politicians
suggest using fiscal measures in order to affect the
growth path of the economy

Fiscal policy
Since the early 1990s, the empirical estimation of fiscal

multipliers has been a major topic of empirical research.
There is a vast number of studies. Today, the approach originally
suggested by Blanchard und Perotti (2002) is commonly accepted
within the profession. As their results have been confirmed
numerous times, we refer to these as ”stylized facts”
In general, we assume that there are five major types of fiscal

policy shocks: Debt- and tax-financed increases or decreases in
public spending (either public consumption or public investment)
and debt-financed tax cuts
Source: Jürgen von Hagen und Charles Wyplosz, ”EMU’s Decentralized System of Fiscal
Policy”, ECONOMIC PAPERS 306, European Commission February 2008 und die
Referenzen darin

Empirical Evidence, cont.
A typical example for the related literature is Mountford and Uhlig (2005).
They find that the responses of consumption and output depend on
the type of the fiscal shock and the corresponding financing
decision:
• In the aftermath of a balanced budget increase in public spending,
output and consumption fall. The depressing effect of the tax
increase dominates the fiscal stimulus
• Deficit spending stimulates output and consumption only weakly
• A debt-financed tax cut has a significant positive effect on
consumption and output
Mountford and Uhlig (2005) conclude that the most efficient fiscal
stimulus is a debt-financed tax cut - would this make sense, if
households follow a behavior as described by the Euler equation?

Empirical Evidence, cont.
We conclude that empirical evidence suggests that the response

of consumption and output to fiscal expansions depends on the
financing decisions of the government
This result highlights the crucial shortcoming of the Keynesian

approach. Its very nature, the focus on the short run, does not
allow us to analyze the long run financing decision of the
government. Regarding the financing decision, we are restricted
to balanced budget changes in public spending
The substantial multipliers suggested by the Keynesian model are,

to a large extend, explained by the omission of any intertemporal
dimension. Because of that, the model fails to capture the impact
of alternative financing decisions of the government on the
consumption demand of households

Pitfalls of the Multiplier Approach
• Oversimplified view of the economy

• No intertemporal dimension/optimization
• No differentiation between public consumption and public
investment
• No financial market
• No monetary policy
• Abstracts from the government’s financing decision
• Closed economy, no interaction with the rest of the world
Keynesian model: Focus on the short run, suggests fiscal policy

as an adequate tool to smooth the business cycle (not to steer
economic growth)

Public investment: Germany
Over the last decades, German governments decreased the level of public
investment continuously
Source: Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen

Entwicklung, in %age of the GDP
Public investment: Germany, cont.
Germany’s public investment is very low in absolute and

relative terms. In particular, public net investment is
negative since the current Chancellor came into office in
2005
When evaluating the German telecommunication

infrastructure, we will find that it is in the bottom third, if
compared to other industrialized countries. Thus, even a net
investment of zero wouldn’t be sufficient to catch up

Public investment: Germany, cont.
With regard to other items like Gemany’s Autobahn we

observe that crucial parts such as bridges are in need of
repair which indicates the need for more public investment.
Or in other words, additional public investment seems
highly advisable
However, Germany has been consolidating its public

budgets by decreasing public investment ever since
Wolfgang Schäuble became the Federal Minister of Finance
Source: Paredes, Joan, Diego J. Pedregal, and Javier J. Prez, Fiscal policy analysis in the
euro area: Expanding the toolkit, Journal of Policy Modeling, 2014, 36 (5), 800-823.

Budget consolidation: Alternative strategies
Quelle: Christoph Bierbrauer, ”Fiscal policy of Germany’s great coalition 2015: A

balanced budget at all cost?”, ISM-Research Journal, 2015 (2)

Fiscal policy: Budget consolidation
For all that we know, decreasing public investment up to

the point where we observe negative public net investment,
is the most harmful way to reduce public deficits and the
stock of public debt. This strategy decreases consumption
and seriously endangers the growth potential of the
economy, in the short and long run
Moreover, the strategy is unsustainable as it requires the

government to increase public investment in future periods
to restore a sufficient level of the public capital stock - the
reduction in debt is short-lived at best

Fiscal policy: Budget consolidation, cont.
The first best strategy to reduce a public deficit as well as

the level of public debt, is to decrease public consumption
Using this alternative strategy stimulates consumption

and does not require future increases in public
spending. Moreover, it will not affect the production and
growth potential of the economy in a negative way

Evaluation: German Fiscal Stimulus Package
Evaluation: (Keynesian prediction/empirical evidence)
Decreases in tax rates, the second best in the multiplier model:

• 2.9bn Euro decrease in income tax rates (+/+)
• 9bn Euro decrease in health insurance paments (+/+)
• Lump-sum transfer of 100 Euro per child (below the age of 13) (+/+)
• A subsidy of 2500 Euro for the purchase of a new car (no prediction)
Increases in public consumption, first best in the multiplier model:
• none (+/-)
Increases in public investment, same effect as public consumption in
the multiplier model:
• 18bn Euro investment in infrastructure (+/+)


Set 5 - Business Cycles and Aggregate Demand

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Set 5 - Business Cycles and Aggregate Demand

Uploaded by

Copyright:

Available Formats

Business Cycles Theory of Aggregate Demand Keynesian model Empirical Evidence

Dr. Christoph Bierbrauer

Cologne Business School

Winter Term 2016/2017

Short-term Fluctuations in Economic Activity

Business cycles are economy-wide ﬂuctuations in total output, income

The ups and downs of the business cycle strongly affect

It might come as a surprise that there is no generally

National Bureau of Economic Research (NBER): A recession is ”a

A commonly used deﬁnition: A recession occurs when real GDP

Finally, there are several other approaches, deﬁning a recession as

German Business Cycles throughout Recent History

Source: Statistisches Bundesamt

An idealized business cycle is based on the notion that

The pre-dominant theories identify exogenous and internal

Exogenous Business-Cycle Theories

Based on the seminal work of Kydland und Prescott (1982), the

Typically, RBC models assume technology shocks or other sources

The RBC Theory: Exogenous Business Cycles

The RBC approach allows for a wide variety of exogenous

The underlying theoretical model is the dynamic stochastic

Internal Business-Cycle Theories

Internal business cycle theories trace back to the original

According to this theory, sources causing ﬂuctuations in

The traditional Keynesian approach is

Business-Cycle Theories: Summary

Arguments which of the approaches is more adequate to

Both types of disturbances, internal and exogenous, play a

This lecture focuses on simple ad-hoc Keynesian models.

10/ 58 Economics 2: Macroeconomics

Hyperinﬂation: Germany’s Great Inﬂation

During that period, the German

However, we might also interpret

Hyperinﬂation; when prices rise at 100% or more per month

11/ 58 Economics 2: Macroeconomics

Contagion: Global Financial Crisis

Subprime Mortgage Crisis (2007):

12/ 58 Economics 2: Macroeconomics

Fiscal Policy: Euro Crisis

Source: Sondergutachten des Sachverständigenrates vom 5.7.2012

Germany: Recapitalization of Banks 480bn, stimulus package of 50bn

13/ 58 Economics 2: Macroeconomics

Review: Aggregate Demand

Most theories of business cycles rely upon the theory of aggregate

14/ 58 Economics 2: Macroeconomics

Theory of Aggregate Demand

Aggregate demand (AD) is the

For now, we restrict our

Multiplying the AD curve with

15/ 58 Economics 2: Macroeconomics

Downward slope of the Aggregate Demand Curve

Short-run approach: A key characteristic of Keynesian models is the

16/ 58 Economics 2: Macroeconomics

Forces affecting Aggregate Demand

17/ 58 Economics 2: Macroeconomics

Aggregate Demand: General Rules

Changes in variables that are

Examples are exogenous

In open economies, changes

18/ 58 Economics 2: Macroeconomics

Aggregate Demand: General Rules, cont.

Examples for shocks that

19/ 58 Economics 2: Macroeconomics