Lecture 3

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
Outline
1 Business Cycles
2 Demand-determined Output in the Keynesian System
3 Equilibrium in the Simple Keynesian System

Business Cycles
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
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

Business Cycles
Phases of Business Cycles

Business Cycles
An expansion is continuous period of increase in total output,

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

Business Cycles

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.

Business Cycles

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

Business Cycles
Characteristics of Recessions
Sharp contraction in consumer spending

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

Business Cycles

Fall in labour demand
rst fall in work hours, followed by layos

Business Cycles

Fall in ination rate
as consumer demand falls, the price level increases more slowly
or may decline

Business Cycles

Fall in ination rate
as consumer demand falls, the price level increases more slowly
or may decline
Sharp falls in business prots

Business Cycles
Sources of Business Cycles
Two main theories of business cycles: exogenous and internal

Business Cycles
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

Business Cycles
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

Business Cycles
Sources of Business Cycles (2)
Business cycles may also be induced by aggregate demand or

aggregate supply

Business Cycles

aggregate supply
Demand-induced business cycles result from uctuations in

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

Business Cycles

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

Business Cycles
Introduction
We consider output determination in the Keynesian model

Business Cycles
Introduction

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.

Business Cycles
Introduction

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

Business Cycles
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

Business Cycles
Aggregate Demand

Aggregate demand tells us where the GDP we have produced
go

Business Cycles
Aggregate Demand

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

Business Cycles
Determinants of Aggregate Demand
To understand the determinants of aggregate demand, we

need to understand the determinants of the various
components of AD

Business Cycles

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

Business Cycles

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

Business Cycles
Determinants of Consumption
The main determinants of consumption are

Current income
Future income
Wealth
Interest rates
Taxes

Business Cycles
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

Business Cycles

C = α +βY d

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

Business Cycles

C = α +βY d

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

Business Cycles
The Keynesian consumption function as specied has a

number of properties

Business Cycles

The MPC is constant

Business Cycles

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
+β

Business Cycles
The Keynesian Savings Function
Recall that the part of disposable income that is not spent on

consumption is saved

Business Cycles

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

Business Cycles

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

Business Cycles
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

Business Cycles
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

Business Cycles
Net Exports (NX)
Recall that net export is total exports minus total imports

Business Cycles
Net Exports (NX)
Net exports depends on

domestic income
foreign income
real exchange rate

Business Cycles
Net Exports (NX)
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

Business Cycles
Basic Model
We start with a basic model by assuming a closed economy

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

Business Cycles
Basic Model

with no government
Then AD=C+I

Business Cycles
Basic Model

with no government
Then AD=C+I
This economy will reach equilibrium when Y=AD

Business Cycles
Basic Model in Pictures

Business Cycles
Basic Model: Algebriac Solution
The basic relationships in this economy are:

C = a + bY
I = I0

Business Cycles

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

Business Cycles

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

Business Cycles
Autonomous Spending multiplier
1
The term:
1−b is called the autonomous expenditure multiplier

Business Cycles
1
The term:
It is a multiple by which a change in any component of
autonomous expenditures increases equilibrium output

Business Cycles
1
The term:
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

Business Cycles
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

Business Cycles

government to it
We will continue to assume that government purchases are

exogenously determined

Business Cycles

government to it
We will continue to assume that government purchases are

exogenously determined
We will make the same assumption about government taxes

Business Cycles

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

Business Cycles

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

Business Cycles

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

Business Cycles

Lecture 3

Uploaded by

Document Information

Original Description:

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

Lecture 3

Uploaded by

Copyright:

Available Formats

Business Cycles

Demand-determined Output in the Keynesian System

National Income Determination

UGBS 204: Macroeconomics for Business

UGBS 204: Lecture three

2 Demand-determined Output in the Keynesian System

3 Equilibrium in the Simple Keynesian System

UGBS 204: Lecture three

What are Business Cycles?

Business Cycles are economywide uctuations in total national

UGBS 204: Lecture three

What are Business Cycles?

Business Cycles are economywide uctuations in total national

Business cycles have two main phases: expansion and recession

UGBS 204: Lecture three

Phases of Business Cycles

UGBS 204: Lecture three

Phases of Business Cycles

An expansion is continuous period of increase in total output,

UGBS 204: Lecture three

Phases of Business Cycles

An expansion is continuous period of increase in total output,

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

UGBS 204: Lecture three

Phases of Business Cycles

An expansion is continuous period of increase in total output,

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

A depression is a very deep and extended recession

UGBS 204: Lecture three

Sharp contraction in consumer spending

UGBS 204: Lecture three

Sharp contraction in consumer spending

UGBS 204: Lecture three

Sharp contraction in consumer spending

UGBS 204: Lecture three

Sharp contraction in consumer spending

UGBS 204: Lecture three

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

UGBS 204: Lecture three

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

Exogenous sources of business cycles are factors outside the

UGBS 204: Lecture three

Sources of Business Cycles

Two main theories of business cycles: exogenous and internal

Exogenous sources of business cycles are factors outside the

UGBS 204: Lecture three

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or

UGBS 204: Lecture three

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or

Demand-induced business cycles result from uctuations in

UGBS 204: Lecture three

Sources of Business Cycles (2)

Business cycles may also be induced by aggregate demand or

Demand-induced business cycles result from uctuations in

UGBS 204: Lecture three

We consider output determination in the Keynesian model

UGBS 204: Lecture three

We consider output determination in the Keynesian model

Business Cycles are economywide uctuations in total national

Business Cycles are economywide uctuations in total national

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

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

Demand-induced business cycles result from uctuations in

Demand-induced business cycles result from uctuations in

The Keynesian consumption function species consumption as

The Keynesian consumption function species consumption as

The Keynesian consumption function species consumption as

The Keynesian consumption function as specied has a

The Keynesian consumption function as specied has a

The Keynesian consumption function as specied has a