CHAPTER 10

CHAPTER 23

BUSINESS FLUCTUATIONS AND THE THEORY OF

AGGREGATE DEMAND
 BUSINESS FLUCTUATIONS
Business cycles or fluctuations are
swings in total national output, income,
and employment, marked by
widespread expansion or contraction in
many sectors of the economy. They
occur in all advanced market
economies. We distinguish the phases
of expansion, peak, recession, and
trough.
 The Phase of the
business cycle when
the economy moves
from a trough to a
peak. It is a period
when business
activity surges and
gross domestic
product expands
until it reaches a
peak.
 FEATURES OF THE BUSINESS CYCLE
1. RECESSION
A Recession in economics, is a business
cycle contraction, a general slowdown in
economic activity. Various macroeconomic
indicators during recessions, vary in a
similar way. Production, as measured
through GDP, employment, investment
spending, capacity utilization, household
incomes, business profits, and inflation all
fall, while bankruptcies and the
unemployment rate rise. It generally occurs
when there is a widespread drop in
spending, often following an adverse
supply shock or the bursting of an economic
bubble. Governments usually respond to
recessions through adopting expansionary
macroeconomic policies, such as increasing
money supply, increasing government
spending and decreasing taxation.
 CUSTOMARY CHARACTERISTICS OF A
RECESSION
a) Often, consumer purchases decline sharply

b) The demand for labor falls

c) As output falls, inflation slows

a) Business profits sharply in recessions

 2. DEPRESSION

In economics, a
depression is
a sustained,
long-term
downturn in
economic
activity in
one or more
economies.
CHARACTERISTICS OF DEPRESSION
 It is a more severe downturn than a recession, which is seen by some
economists as part of the modern business cycle.
 A rare and extreme form of recession, a depression is characterized
by its length, by abnormally large increases in unemployment, falls in
the availability of credit— often due to some kind of banking or
financial crisis, shrinking output—as buyers dry up and suppliers cut
back on production, and investment, large number of bankruptcies—
including sovereign debt defaults, significantly reduced amounts of
trade and commerce—especially international, as well as highly
volatile relative currency value fluctuations—most often due to
devaluations.
 Price deflation, financial crises and bank failures are also common
elements of a depression that are not normally a part of a recession.
Business fluctuations (e.g)
 BUSINESS CYCLE THEORIES
There are Three main theories in Business cycle
which are as follows:

1.Exogenous
2.Internal
3.Multiplier -accelerator
EXOGENOUS & ENDOGENOUS FACTORS

 Exogenous (External) Growth Factors:

include items such as the rate of technological advancement or
the savings rate.

 Endogenous (Internal) Growth Factors :

would be capital investment, policy decisions, and an expanding
workforce population.
MULTIPLIER –ACCELERATOR THEORY

A Keynesian concept, stipulates that capital

investment outlay is a function of output. For
example, an increase in national income, as
measured by the gross domestic product
(GDP), would see a proportional increase in
capital investment spending.
 AGGREGATE DEMAND (AD):
• is the total demand for goods and services
produced in the economy over a period of
time.
• Aggregate planned expenditure for goods and
services in the economy  = C + I + G + (X-M)
AGGREGATE DEMAND COMPONENTS
• C: Consumers' expenditure on goods and
services: This includes demand for durables &
non-durable goods.
• I :Gross Domestic Fixed Capital Formation -
i.e. investment spending by companies on
capital goods. Investment also includes
spending on working capital such as stocks of
finished goods and work in progress.
• G: General Government Final Consumption. i.e.
Government spending on publicly provided goods
and services including public and merit goods.
Transfer payments in the form of social security
benefits (pensions, job-seekers allowance etc.) are
not included as they are not a payment to a factor of
production for output produced. A substantial
increase in government spending would be classified
as an expansionary fiscal policy.
• X: Exports of goods and services - Exports sold
overseas are an inflow of demand into the circular
flow of income in the economy and add to the
demand for UK produced output. When export sales
from the UK are healthy, production in exporting
industries will increase, adding both to national
output and also the incomes of those people who
work in these industries.
• M: Imports of goods and services. Imports
are a withdrawal (leakage) from the circular
flow of income and spending in the economy.
Goods and services come into the economy -
but there is a flow of money out of the
economic system. Therefore spending on
imports is subtracted from the aggregate
demand equation.
• The Aggregate Demand Curve:
• Aggregate demand normally rises as the price
level falls.
 Three Main Ways of AD:
1. Real money balances effect:
As the price level falls, the real value of money balances held
increases. This increases the real purchasing power of
consumers.

2. Prices and interest rates:

A lower price level increases the real interest rate - there will
be pressure on the monetary authorities to cut nominal
interest rates as the price level falls. Lower nominal interest
rates should encourage an increase in consumer demand and
planned investment.
3. International competitiveness:
If the UK price level is lower than other
countries (for a given exchange rate), UK
goods and services will become more
competitive. A rise in exports adds to
aggregate demand and therefore boosts
national output
SHIFTS IN AGGREGATE DEMAND:
A change in one of the components of aggregate demand will cause a shift in the
aggregate demand curve. For example there might be an increase in export
demand causing an injection of foreign demand into the domestic economy. The
government may also increase its own expenditure and businesses may raise the
level of planned capital investment spending.
THANK YOU