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Business Cycles

Demand-determined Output in the Keynesian System


Equilibrium in the Simple Keynesian System

National Income Determination

UGBS 204: Macroeconomics for Business

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Outline

1 Business Cycles

2 Demand-determined Output in the Keynesian System

3 Equilibrium in the Simple Keynesian System

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

What are Business Cycles?

Denition

Business Cycles are economywide uctuations in total national


output, income, and employment usually lasting for a period of 2 to
10 years, marked by widespread expansion or contraction in most
sectors of the economy

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

What are Business Cycles?

Denition

Business Cycles are economywide uctuations in total national


output, income, and employment usually lasting for a period of 2 to
10 years, marked by widespread expansion or contraction in most
sectors of the economy

Business cycles have two main phases: expansion and recession

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Phases of Business Cycles

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Phases of Business Cycles

An expansion is continuous period of increase in total output,


employment and incomes marked by growth of many sectors of
the economy

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Phases of Business Cycles

An expansion is continuous period of increase in total output,


employment and incomes marked by growth of many sectors of
the economy

A recession is a recurring period of decline in total output,


income and employment lasting usually from 6 months to a
year and marked by widespread contractions in many sectors of
the economy.

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Phases of Business Cycles

An expansion is continuous period of increase in total output,


employment and incomes marked by growth of many sectors of
the economy

A recession is a recurring period of decline in total output,


income and employment lasting usually from 6 months to a
year and marked by widespread contractions in many sectors of
the economy.

A depression is a very deep and extended recession

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Characteristics of Recessions

Sharp contraction in consumer spending


this reects in unexpected accumulation of business inventories
especially of consumer durables

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Characteristics of Recessions

Sharp contraction in consumer spending


this reects in unexpected accumulation of business inventories
especially of consumer durables
Fall in labour demand
rst fall in work hours, followed by layos

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Characteristics of Recessions

Sharp contraction in consumer spending


this reects in unexpected accumulation of business inventories
especially of consumer durables
Fall in labour demand
rst fall in work hours, followed by layos
Fall in ination rate
as consumer demand falls, the price level increases more slowly
or may decline

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Characteristics of Recessions

Sharp contraction in consumer spending


this reects in unexpected accumulation of business inventories
especially of consumer durables
Fall in labour demand
rst fall in work hours, followed by layos
Fall in ination rate
as consumer demand falls, the price level increases more slowly
or may decline
Sharp falls in business prots

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

Exogenous sources of business cycles are factors outside the


economic system that lead to economic uctuations
eg elections, oil price shocks, discovery of new resources, wars
etc

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

Exogenous sources of business cycles are factors outside the


economic system that lead to economic uctuations
eg elections, oil price shocks, discovery of new resources, wars
etc
Internal sources of business cycles look at mechanisms within
the economic system that generate expansions and
contractions

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or


aggregate supply

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or


aggregate supply

Demand-induced business cycles result from uctuations in


aggregate demand
eg uctuations in business investment are a major source of
business cycles

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or


aggregate supply

Demand-induced business cycles result from uctuations in


aggregate demand
eg uctuations in business investment are a major source of
business cycles
Supply-induced business cycles result from shocks to
production that lead to uctuations in economic activity
eg the oil price shocks of the early 1970s, discovery of new
technology

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Introduction

We consider output determination in the Keynesian model

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Introduction

We consider output determination in the Keynesian model


Output is demand-determined
Factors of aggregate demand play a key role in the
determination of the level of equilibrium output
the determinants of aggregate demand determines the
equilibrium level of output.

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Introduction

We consider output determination in the Keynesian model


Output is demand-determined
Factors of aggregate demand play a key role in the
determination of the level of equilibrium output
the determinants of aggregate demand determines the
equilibrium level of output.
This explains determination of output in the short-run

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Aggregate Demand

Aggregate demand shows the total quantities of goods and


services demanded by households, rms, governments and the
external sector at various price levels
also called the aggregate expenditures

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Aggregate Demand

Aggregate demand shows the total quantities of goods and


services demanded by households, rms, governments and the
external sector at various price levels
also called the aggregate expenditures
Aggregate demand tells us where the GDP we have produced
go

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Aggregate Demand

Aggregate demand shows the total quantities of goods and


services demanded by households, rms, governments and the
external sector at various price levels
also called the aggregate expenditures
Aggregate demand tells us where the GDP we have produced
go

AD = C d + I d + G + NX
where C d is desired consumption, and I d is desired investment

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Determinants of Aggregate Demand

To understand the determinants of aggregate demand, we


need to understand the determinants of the various
components of AD

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Determinants of Aggregate Demand

To understand the determinants of aggregate demand, we


need to understand the determinants of the various
components of AD

To start with the level of government purchases, it is plausible


that this depends on the level of economic activity
If the level of economic activity is low, the government might
spending more to boost the level of AD

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Determinants of Aggregate Demand

To understand the determinants of aggregate demand, we


need to understand the determinants of the various
components of AD

To start with the level of government purchases, it is plausible


that this depends on the level of economic activity
If the level of economic activity is low, the government might
spending more to boost the level of AD
We will assume that the level of government purchases is xed
at an exogenous level G0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Determinants of Consumption

The main determinants of consumption are


Current income
Future income
Wealth
Interest rates
Taxes

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (1)

The Keynesian consumption function species consumption as


a function of current disposable income:
C = α +βY d

where Y d is disposable income

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (1)

The Keynesian consumption function species consumption as


a function of current disposable income:
C = α +βY d

where Y d is disposable income


We call α autonomous consumption:
It is the level of consumption that does not depend on income
ie the consumption when income is zero

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (1)

The Keynesian consumption function species consumption as


a function of current disposable income:
C = α +βY d

where Y d is disposable income


We call α autonomous consumption:
It is the level of consumption that does not depend on income
ie the consumption when income is zero
β is the marginal propensity to consume (MPC)
It measures the change in consumption per unit change in
income

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (2)

The Keynesian consumption function as specied has a


number of properties

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (2)

The Keynesian consumption function as specied has a


number of properties

The MPC is constant

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Consumption Function (2)

The Keynesian consumption function as specied has a


number of properties

The MPC is constant

The Average Propensity to Consume (APC) decreases with


income:
The APC is the fraction of income that is spent on
consumption
APC = C /Y d = α
Yd

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Savings Function

Recall that the part of disposable income that is not spent on


consumption is saved

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Savings Function

Recall that the part of disposable income that is not spent on


consumption is saved

We can use this fact to derive the savings function


S = Y − C = Y − α − β Y = −α + (1 − β )Y
d d d d

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

The Keynesian Savings Function

Recall that the part of disposable income that is not spent on


consumption is saved

We can use this fact to derive the savings function


S = Y − C = Y − α − β Y = −α + (1 − β )Y
d d d d

−α is the autonomous dissaving

(1 − β ) is called the marginal propensity to save

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Investment

The level of desired investment depends on


The user cost of capital (real interest rate)
Business expectation about the future prospects of the
economy
Taxes
Investment tax credit

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Investment

The level of desired investment depends on


The user cost of capital (real interest rate)
Business expectation about the future prospects of the
economy
Taxes
Investment tax credit
In our simplied model, we will assume that the level of
investment is exogenously xed at I0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Net Exports (NX)

Recall that net export is total exports minus total imports

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Net Exports (NX)

Recall that net export is total exports minus total imports

Net exports depends on


domestic income
foreign income
real exchange rate

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Net Exports (NX)

Recall that net export is total exports minus total imports

Net exports depends on


domestic income
foreign income
real exchange rate
In our simplied model, we will assume that net exports is
exogenously xed at NX0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model

We start with a basic model by assuming a closed economy


with no government
ie we assume G=0 and NX=0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model

We start with a basic model by assuming a closed economy


with no government
ie we assume G=0 and NX=0
Then AD=C+I

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model

We start with a basic model by assuming a closed economy


with no government
ie we assume G=0 and NX=0
Then AD=C+I

This economy will reach equilibrium when Y=AD

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model in Pictures

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model: Algebriac Solution

The basic relationships in this economy are:


C = a + bY
I = I0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model: Algebriac Solution

The basic relationships in this economy are:


C = a + bY
I = I0
The equilibrium condition requires that Y=AD

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Basic Model: Algebriac Solution

The basic relationships in this economy are:


C = a + bY
I = I0
The equilibrium condition requires that Y=AD

That is:
Y = AD = a + bY + I0
Y − bY = a + I0 => Y (1 − b) = a + I0
Y e = a1+−b
I0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Autonomous Spending multiplier

1
The term:
1−b is called the autonomous expenditure multiplier

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Autonomous Spending multiplier

1
The term:
1−b is called the autonomous expenditure multiplier
It is a multiple by which a change in any component of
autonomous expenditures increases equilibrium output

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Autonomous Spending multiplier

1
The term:
1−b is called the autonomous expenditure multiplier
It is a multiple by which a change in any component of
autonomous expenditures increases equilibrium output

In this simplied framework, the components of autonomous


spending are
a, I0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

Our model changes in two main ways when we add


government to it
The government make purchases
The government also taxes
We therefore have to make the changes to our basic
relationships to reect these

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

Our model changes in two main ways when we add


government to it
The government make purchases
The government also taxes
We therefore have to make the changes to our basic
relationships to reect these

We will continue to assume that government purchases are


exogenously determined

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

Our model changes in two main ways when we add


government to it
The government make purchases
The government also taxes
We therefore have to make the changes to our basic
relationships to reect these

We will continue to assume that government purchases are


exogenously determined

We will make the same assumption about government taxes

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

The basic relationships in this economy are:


d
C = a + bY
I = I0
G = Go

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

The basic relationships in this economy are:


d
C = a + bY
I = I0
G = Go
The equilibrium condition requires that Y=AD

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

The basic relationships in this economy are:


d
C = a + bY
I = I0
G = Go
The equilibrium condition requires that Y=AD

That is:
Y = AD = a + b(Y − T ) + I0 + G0
Y − bY = a + I0 => Y (1 − b) = a − bT0 + I0 + G0
Y e = a−bT10−b
+I0 +G0

UGBS 204: Lecture three


Business Cycles
Demand-determined Output in the Keynesian System
Equilibrium in the Simple Keynesian System

Adding government to the Basic Model

UGBS 204: Lecture three

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