Economics THIRD EDITION By John B Taylor Stanford

Chapter 23 (Macro 10) The Nature and Causes of Economic Fluctuations Copyright © 2001

Overview This chapter develops an initial explanation of economic fluctuations that is based on changes in aggregate demand. To illustrate the concept that changes in aggregate demand lead to short-run fluctuations in real GDP, a description of how real GDP is forecast is included. Unconditional and conditional forecasts are used to introduce the aggregate expenditures' dependence, via the consumption function, on income. The spending balance is carefully developed in both graphical and tabular form. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3

Teaching Objectives • Introduce an explanation of how and why economic fluctuations occur. • Introduce the simple consumption function and discuss its properties. • Develop an Aggregate Expenditures (AE) -income spending balance relationship in which only consumption depends on income. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4

1. Changes in Aggregate Demand First Lead to Changes in Output 1 a. Figure 23. 1 places the problem of economic fluctuations in the familiar setting of the previous chapters. In Figure 23. 2 the distinction between potential GDP and real GDP at a point in the business cycle is used to emphasize that changes in aggregate demand explain economic fluctuations. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5

Figure 23. 1 (Macro 10) Narrowing the Focus on Economic Fluctuations Copyright © 2001

Figure 23. 2 (Macro 10) The First Step of an Economic Fluctuation Copyright ©

1. Changes in Aggregate Demand…. (cont. ) 1 b. The decisions of individual firms depend on capacity utilization. Firms generally increase or decrease production, not prices, in the short run or over the business cycle. Firms have the ability to vary production over a range of utilization, for example, between 70 and 90 percent. High utilization rates in factories and unemployment below the natural rate occur during booms, while the opposite occurs in recessions. Firms respond to changes in demand through changes in production in all areas, not just in manufacturing. For example, construction employment is quite sensitive to changes in demand. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 8

1. Changes in Aggregate Demand…. (cont. ) • 1 c. The explanation of why changes in demand result in changes in production relies on two factors. • 1 c. 1 Firms operate with limited information, uncertain about whether an increase in demand is permanent or temporary. Firms are often reluctant to raise prices because of uncertainty and an implicit contract with customers. Similar arrangements with workers lead to nominal wage rigidities. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9

1. Changes in Aggregate Demand…. (cont. ) • 1 c. 2 The response of the typical firm is illustrated in Figure 23. 3. Demand is uncertain: It can be high, medium, or low. The flexible price assumption views the firm as adjusting price; under the sticky price assumption, the firm adjusts quantity. If demand becomes certain or is viewed as permanent, a firm is more likely to adjust price than quantity. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10

Figure 23. 3 (Macro 10) Alternative Short-Run Responses of a Typical Firm to a

1. Changes in Aggregate Demand…. (cont. ) • 1 d. Another explanation of economic fluctuations is the real business cycle theory. Under this explanation, the source of economic fluctuations is found in frequent shifts in potential GDP. This would mean that the determinants of aggregate supply (labor, capital, and technology) must shift frequently. However, these determinants tend to change slowly over time. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12

2. Forecasting Real GDP • 2 a. The case for viewing shifts in aggregate demand as the source of economic fluctuations can be seen as a forecasting problem. To forecast real GDP, a forecast of each component is made and then added together using the GDP identity: Y = C + I + G + X. As the underlying factors for each spending component change, the value in the forecast changes. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 13

2. Forecasting Real GDP (cont. ) • 2 b. Another approach is to make a conditional forecast, one in which alternative assumptions about the value of an underlying factor or the value of one of the spending components is made. This approach to forecasting real GDP makes clear that it is changes in the spending components, or aggregate demand, that are responsible for economic fluctuations Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14

3. The Response of Consumption to Income • 3 a. The consumption function describes how consumption depends on income. This relationship is illustrated by Table 25. 1. From this data we are able to determine the marginal propensity to consume (MPC). Figure 23. 4 graphs the consumption-income relation. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15

Figure 23. 4 (Macro 10) The Consumption Function Copyright © 2001 by Houghton Mifflin

3. The Response of Consumption to Income • 3 a. 1 The measure of income used, whether real GDP, income, or disposable income, depends in part on the purpose of the analysis. However, because taxes and transfer payments tend to be a constant proportion of income, the measures bear essentially the same relation to consumption, as in Figure 23. 5. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17

Figure 23. 5 (Macro 10) Consumption versus Aggregate Income Copyright © 2001 by Houghton

3. The Response of Consumption to Income (cont. ) • 3 b. Other influences, such as the interest rate and wealth, are less important in the short run and so are ignored in the initial explanation. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19

4. Finding Real GDP When Consumption and Income Move Together • 4 a. There are now two income-related parts to the determination of aggregate demand or spending: the GDP identity and the consumption function. Taken together they determine GDP for a given forecast change. 4 b. The 45 -degree line in Figure 23. 6 is used to determine the income-spending equality. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20

Figure 23. 6 (Macro 10) The 45 -Degree Line Copyright © 2001 by Houghton

4. Finding Real GDP… (cont. ) • 4 c. The aggregate expenditure ( AE ) line results from adding up the spending components successively, as in Figure 23. 7. • 4 c. 1 The slope of the AE line depends at this point on the consumption-income relation and is the MPC. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22

Figure 23. 7 (Macro 10) The Expenditure Line Copyright © 2001 by Houghton Mifflin

4. Finding Real GDP… (cont. ) • 4 c. 2 Changes in any autonomous spending component shift the AE line. For example, an increase in I will shift the AE line up, as in Figure 23. 8. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 24

Figure 23. 8 (Macro 10) Shifts in the Expenditure Line Copyright © 2001 by

4. Finding Real GDP… (cont. ) • 4 d. The level of real GDP is determined through the spending balance between AE and income using the 45 -degree line, as in Figure 23. 9 and Table 23. 2. These examples illustrate a temporary equilibrium for actual GDP, not necessarily potential GDP. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 26

Figure 23. 9 (Macro 10) Spending Balance Copyright © 2001 by Houghton Mifflin Company.

4. Finding Real GDP… (cont. ) • 4 e. The AE -spending balance approach gives a different conditional forecast for the proposed $100 billion decline in G discussed as an example, as in Figure 23. 10. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 28

Figure 23. 10 (Macro 10) From One Point of Spending Balance to Another Copyright

5. Spending Balance and Departures of Real GDP from Potential GDP • Figure 23. 2 was used to illustrate the type of departure from potential GDP that is characteristic of economic fluctuations. In Figure 23. 11 we return to this setting to show changes in AE explain departures from potential GDP. Although the departures are short-run balance points, they are first steps in a process that brings GDP back to potential GDP. • Successive downward shifts in AE are a key reason for the Great Depression. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 30