Regularities in GDP Fluctuations

• Business Cycles are fluctuations about trend in real

GDP.
• The turning points in the deviations of real GDP from
trend are peaks and troughs.
• Persistent positive deviations from trend are booms
and persistent negative deviations from trend are
recessions.

© 2011 Pearson Addison-Wesley. All rights reserved. 3-1

Figure 3.1
Idealized Business Cycles

© 2011 Pearson Addison-Wesley. All rights reserved. 3-2

 Facts about the business cycle
 GDP growth averages 6-7 percent per year over
the last decade with large fluctuations in the
short run.
 Consumption and investment fluctuate with
GDP, but consumption tends to be less volatile
and investment more volatile than GDP.
 Unemployment rises during recessions and falls
during expansions.

CHAPTER 10 Aggregate Demand I 3

 Time horizons in macroeconomics
 Long run
Prices are flexible, respond to changes in supply
or demand.
 Short run
Many prices are “sticky” at a predetermined
level.

The economy behaves much

differently when prices are sticky.

CHAPTER 10 Aggregate Demand I 4

 Recap of classical macro theory

 Output is determined by the supply side:

 supplies of capital, labor
 technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.

CHAPTER 10 Aggregate Demand I 5

 When prices are sticky…
…output and employment also depend on
demand, which is affected by:
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes in
C or I

CHAPTER 10 Aggregate Demand I 6

 The model of
aggregate demand and supply
 The paradigm most mainstream economists
and policymakers use to think about economic
fluctuations and policies to stabilize the economy
 Shows how the price level and aggregate output
are determined
 Shows how the economy’s behavior is different
in the short run and long run

CHAPTER 10 Aggregate Demand I 7

 Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 For this chapter’s intro to the AD/AS model,
we use a simple theory of aggregate demand
based on the quantity theory of money.
 Later we develop the theory of aggregate
demand in more detail.

CHAPTER 10 Aggregate Demand I 8

 The downward-sloping AD curve

P
An increase in the
price level causes
a decrease in the
demand for goods
& services.

AD
Y

CHAPTER 10 Aggregate Demand I 9

 Aggregate supply in the long run

 Recall
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
CHAPTER 10 Aggregate Demand I 10
 The long-run aggregate supply curve

P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L )
CHAPTER 10 Aggregate Demand I 11
 Long-run effects of an increase in M

P LRAS
An increase
in M shifts
AD to the
P2 right.
In the long run,
this raises the
price level… P1 AD2
AD1

…but leaves Y
Y
output the same.

CHAPTER 10 Aggregate Demand I 12

 Aggregate supply in the short run

 Many prices are sticky in the short run.

 For now , we assume
 all prices are stuck at a predetermined level in
the short run.
 firms are willing to sell as much at that price
level as their customers are willing to buy.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:

CHAPTER 10 Aggregate Demand I 13

 The short-run aggregate supply curve

P
The SRAS
curve is
horizontal:
The price level
is fixed at a
SRAS
predetermined P
level, and firms
sell as much as
buyers demand. Y

CHAPTER 10 Aggregate Demand I 14

 Short-run effects of an increase in M

P
In the short run
…an increase
when prices are
in aggregate
sticky,…
demand…

SRAS
P
AD2
AD1

Y
…causes Y1 Y2
output to rise.
CHAPTER 10 Aggregate Demand I 15
 The Keynesian Cross

 A simple closed economy model in which income

is determined by expenditure.
(due to J.M. Keynes)
 Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned expenditure
= unplanned inventory investment

CHAPTER 10 Aggregate Demand I 16

 Elements of the Keynesian Cross
consumption function: C  C (Y  T )
govt policy variables: G  G , T T
for now, planned
investment is exogenous: I I

planned expenditure: PE  C (Y  T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  PE
CHAPTER 10 Aggregate Demand I 17
 Graphing planned expenditure

PE

planned PE =C +I +G
expenditure
MPC
1

income, output, Y

CHAPTER 10 Aggregate Demand I 18

 Graphing the equilibrium condition

PE PE =Y

planned

expenditure

45º

income, output, Y

CHAPTER 10 Aggregate Demand I 19

 The equilibrium value of income

PE AE =Y

planned PE =C +I +G
expenditure

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I 20
 An increase in government purchases
PE Y

=
At Y1, AE PE =C +I +G
2
there is now an
unplanned drop PE =C +I +G1
in inventory…

G

…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 Y PE2 = Y2

CHAPTER 10 Aggregate Demand I 21

 Solving for Y
Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y

Collect terms with Y Solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 

CHAPTER 10 Aggregate Demand I 22

 The government purchases multiplier

Definition: the increase in income resulting from a

$1 increase in G.
In this model, the govt Y 1
purchases multiplier equals 
G 1  MPC

Example: If MPC = 0.8, then

Y 1 An increase in G
  5 causes income to
G 1  0.8
increase 5 times
as much!

CHAPTER 10 Aggregate Demand I 23

 Why the multiplier is greater than 1
 Initially, the increase in G causes an equal increase
in Y: Y = G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much bigger than
the initial G.

CHAPTER 10 Aggregate Demand I 24

 An increase in taxes
PE Y

=
Initially, the tax PE PE =C +I +G
increase reduces 1

consumption, and PE =C2 +I +G

therefore PE:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new PE2 = Y2 Y PE1 = Y1
equilibrium

CHAPTER 10 Aggregate Demand I 25

 Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

Final result:
  MPC 
Y     T
 1  MPC 

CHAPTER 10 Aggregate Demand I 26

 The tax multiplier

def: the change in income resulting from

a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

CHAPTER 10 Aggregate Demand I 27

 The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.

CHAPTER 10 Aggregate Demand I 28

 Deriving the IS curve
PE PE =Y
PE =C +I (r2 )+G
r  I PE =C +I (r1 )+G

 PE I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I 29

 Why the IS curve is negatively sloped

 A fall in the interest rate motivates firms to

increase investment spending, which drives up
total planned spending (PE ).
 To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

CHAPTER 10 Aggregate Demand I 30

 Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
 Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

CHAPTER 10 Aggregate Demand I 31

 Shifting the IS curve: G

PE PE =Y PE =C +I (r )+G
At any value of r, 1 2

G  PE  Y PE =C +I (r1 )+G1

…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y  G Y
1 MPC IS1 IS2
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I 32

 The Theory of Liquidity Preference

 Due to John Maynard Keynes.

 A simple theory in which the interest rate
is determined by money supply and
money demand.

CHAPTER 10 Aggregate Demand I 33

 Money supply

r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 34

 Money demand

r
M P
s
Demand for interest
real money rate
balances:
M P
d
 L (r )

L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 35

 Equilibrium

r
M P
s
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 36

 How the Central Bank raises the interest
rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances

CHAPTER 10 Aggregate Demand I 37

 The LM curve

Now let’s put Y back into the money demand

function:
M P
d
 L (r ,Y )

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P  L (r ,Y )

CHAPTER 10 Aggregate Demand I 38

 Deriving the LM curve

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P

CHAPTER 10 Aggregate Demand I 39

 Why the LM curve is upward sloping

 An increase in income raises money demand.

 Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
 The interest rate must rise to restore equilibrium
in the money market.

CHAPTER 10 Aggregate Demand I 40

 How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P

CHAPTER 10 Aggregate Demand I 41

 The Big Picture

Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

CHAPTER 10 Aggregate Demand I 42