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Business Cycles

and Aggregate Demand

'l'he

la,ttl.t, d.ear lJrulus, is not

in

1,l'.s-,ll

in outs

ue.s.

\{'il lianr Shakcspcalc


.lulius (,rn.sar

The Arnerican economv has been subjecr ro brsilress


cvclcs since the earlv davs clf the Republic. Somerilrres.
btrsirress conditions are healthr,, rrith rapidlv grorving
cnrplo\ ulcnt. fctories rtorking or-ertime, rnd rohust
profits. The "fabulo.ts I990s" iras such :r period for
thc rrcrican econom\'. The econornv grerv rapidll';
crr)plovnlent and capaci6, utilization trere exceptiotrallv higlr. ancl unemplo,r'ment \{as low. Y-et, unlike lte
crsc in carlier long expansions, inflatiorr reruirint'd
Iorv tl.rroughout the 1990s.
Srrch pcliocls of pr-osperitr' <ften come ro n
trnhappv clltl. hl the nineteenth arrd earlt,rwenrit'th
ccttturics, arrd again in 2007-2009, fin:rnciirl crises
turncd ir)t() rvaves of contagiotrs pessirnisnr, businesscs

failcd, cedi conditions tighrened, trrd

clon'ntuln in the banking and financial secrors ripplccl thr ough the rest of the econonrr'. Drrrirrg brrsincss (lowlrturris, jobs are hird to find, factories :u'e

has -rroleti t() be oDe

ill all ol

rhtngls in ugq"g(t( dmnnd utn hare pounful impads


rn lhe ouen l lauls oJ outltut, tmpkrynenl, and prices in
lh sho | ru n.
'l'his chapter rlescribes the basic featnres of the
busirrcss cvclc antl presents the sirnplest theories of
()utl)ut clctcrnliu:rtion. The stmcttrre of this chapter
is as lir Uorvs:

r \\t' bcgirr with a description of he key elemenm


ol tht' llrsirrcss

\\t tllcn

From tilnc to tirne the contraction mal,persisr for a


dccaclc and cause rvidespread econt>nric h:rrdships,
as clurin the 1930s in tlre Grear Depressior.r of rhe

.()30s

ol

irr.f

apar in the

1990s.

Tlrt'sc slrt-r t-tcrln lltrctrratiolls in ccononrit.


actir,itv, kno*n as busincss c1r1e.s, are tlre centr:rl
topic of tl.ris chaptcr Llnderutanding busiress cvcles

126

rrrost enduring issrres

tcvoltrtiolrarr rn:rc roecononl ic theories of .fohn


-\{avnalrl Kcvues highlighted the imporrance of the
{il ccs ol aggr cgirte demand in deterrnining busincss cvclcs. Kcylresian economics emphasizes that

icllc, an<[ profits are low. These dorvnturns:rre usrr:rlly


short antl rlild, as r,,'as the case in the rect ssiorr tlrat
bcgan in Nlarch 2001 and ended in Novernber 20()L

of the

lrncroeconomics. \\'hat causes brLsiness


lluctrrations? Horv can governnrent policies redrrce
thcir virrrlcucc? Economists rvere largell,unable to
ansrvcr tlrese questions ulttil the 1930s. lvhen the

cvcle.

sLrnrrnarize

the basics of

aggreg;rte

rlcrrrancl ancl slrorv Ir<xv the modertr brsiness


cvclc lits into that lianrervork.
Next, wc clcrclop the multiplier ntodel-the sirnrlcst Kcvrresian exarrrple of r model of :rggregate
rlcrna rrrl.

. !\t'

close *ith irrr application of the nttrltiplier'


rlodcl to thc clrrcstiorr of the inrpact of fiscal poltc\' on oulPUt.

a27

FEATURES OF THE BUSINESS CYCLE

FEATURES OFTHE BUSINESS CYCLE

A. WHAT ARE BUSNESS


GYCLESI
Economic history shows at no economy grorts in a
smooth and even pattern. A country may enjoy several years of economic expansion and prosperity,
rapid increases in stock prices (as in the 1990s)
or housing prices (as in e early 2000s). Then, the
irrtional exuberance may flip over to irrational pessimism as, during the 2007-2009 period, lenders stop
issuing rnortgages or car loans on favorble terms,
banks slow their lending to businesses, and spending
declines. Consequentl national output falls, unemployment rises, and profits and real incomes decline.
Eventually the bottom is reached and recovery
begins. The recovery may be incomplete, or it may
be so strong as to lead to a new boom. Prosperity
may mean a long, sustained period of brisk demand,
plentiful jobs, and rising living standards. Or it may
be marked by a quick, inflationary flare-up in prices
and speculation, followed by anoer slump.
Upward and downward movements in output,
inflation, interest rates, and employme nt form the busi
ness cvcle that characterizes all market economies.

What exactly do we mean by

*business cycles"?

Business cycles are economywide fluctuations in


total national output, income, and employment, usually lasting fbr a period of 2 to l0 years, marked by
widespread expansion or contraction in most sectors
of the economy'.

Economiss typically divide business cycles into nvo


main phases: uttsion and *Prliirn Peaks and uoughs
mark the turning poins of the cycle. Figure 7-1
shows e successive phases of the business cycle. The

downtum ofa business cycle is called a recession. A


recession is a recurring period ofdecne in total output, income, and employment, usually lasting from
6 to 12 mons and marked by contractions in many
sectors of the economy. A recession that is large in
both scale and duration is crlled a deprcssion.
The semiofficial judge of ttre timing of contractions and expansions is the National Bureau
of Economic Research (NBER), a private research
organization. The NBER defines a recession as 'a
significant decline in economic actity spread across
the economy, lasting more than a few months, normally visible in real GDB real income, employment,

.9
:Et

o
o
o
'6
d

FIGURE 7-1. A Busines Cyde, like e Year, tls lts Seasons


Business cycles are the irregular expa.nsions and contractions in economic actity. (These
are the actual monly data on industrial production for a recent business.cycle period')

t28

CHAPTER

indrrstrial production, and wh<lesale-retail sales.'


(See "\4'ebsites" at the end of rhis chapter for further
informadon on dating of recessions.)
An alternat.ive definion somedmes used is that a
recession occurs when real GDP has declined for two
consecutil'e calendar quarters. (Question l2 at the
end of the chapter reliews the diflerence berween
the two definitions.)
Although we call these short-term fluctuations
"cycles," the actral pattern is irregular. No rwo business cycles are quite the same. No exact formula,
such as might apply to e rev<lutions of rhe planets
or the swings of a pendulum, can be used to predict
the duration and timing of business c''cles. Rarher,
business cycles more closely resemble the irregular
flrctuations of the weather. Figure 7-2 shows the
American business cycles throughout recent history. Here you can see that business c;rcles are like
mountain ranges, th some valle;n that are deep and

'

BUSINESS CYCI.F,S AND AGGREGATE DEMAND

broad, as

in the Great Depression, and others that

are shallow and narrort as in the recession of 1991,


l!'hile inclividual business cycles are not identical,
ey often share a family similariry. If a reliable eco
nomic forecaster announces at a recession is about

to arrive, what are the typical phenomena that you


should expect? The follong are a few of the customar1 characte.stics of a rccessior:

Investment usually flls sharpl,v in recessions.


Housing has gcnerally been the first to decline,
either because of a financial crisis or because the
Federal Resene has raised interest rates to slow
inflation. Consumer purchases often decline
sharply as well. As businesses slow production
Iines, real GDP falls.
Ernplo),ment usually falls sharply in e early stages
of a rccession. It sometimes is slow to recover in
rvhal are often called "iobless recoveries."

World War ll

c
o
o

62c
Koraan War

Vietnam War

o)

Primary
postwar

o
.9
.q

oo)

-40

Bearmament
The Greal
Depresson

1930

1940
Year

FIGURE 7-2. Business Activity since

l9l9

Industrial production has fluctuated irregularlv around


rnrrc suble economy in recent ],ears?
Solcc: Fcdcral Re3nr Board, derrenrled

rrthors.

it.s

l'ng-rtrn trend. can you detect

ltL sl

Ess-c\'(:l,ll 'l lll.( )Rll.-s

,{s output falls, infladon slorr,s and the dernand


for cnrde rnaterials declines, and materials'
prices tumble. llages and the prices of senices
alc unlike'ty- to fzrce a sinlilar decline, brtt thel'
tcncl to risc lcss rapidlv irr economic dotlntttrns.
Busincss plolits Iall sharplv iu lecessions. In anticipatiorr ol this. conrrnon-stock prices usrralll'fall as
irrrcstors snill thc scctrt ofa brsiness dorvrttrrn.
Gencrall), as busincss conclitiotts dctcriorate :rtrd
emplo\rncllt llls, thc l'c<lcral Rcscn'c bt'girrs to
lo\\'er sholt-term intercst ratcs to stilllulrtc it)\cstmeDt. rDd othcr illterest ratcs tlcclirtc as wcll.

BUSIN ESS.CYCLE THEORI ES


Exogenous vs. f ntemal Cyclet, Over the vears, rnacrocconornists lravt'engaged in rigorotts debates abortt

rllc rcasons liu business tluctrations. Sonre thirk


tl)cv alc carscd lrr'r.nonetan flttcrtrtior.ts, others b\'
1lr'orltrctir.itv shocks.:urd still others bv chattges in
cxogcr)oLrs spcnding.
'l llerc is ccltainh no encl to possihle explanatit.rrs. ltrt it is rst-lirl to classifl'tlre different theories
irrto t$o catcgorics: cxogeDous ancl irlterllal. The
?xo4?trous tht-orics firrcl the sottrces of the btlsiness
ct,cle in thc fltrctrations oI factors orttside the ecororlic st,stern-irl rvats, r't-rolttions, atrd clectiot.ls;
in oil prices, gold disct.rvcr ics, antl porrrlatiotr nrigrati<ns: itr tliscoveries ol trcw lantls arld Lc-sotrccs: in
scicr-rtifit breakthrorrghs artd tcchrrological irrnovations; cr,cll in sunspots, clintatc clratrgc, and rhe
wcather:
An exaltple ol all cxogcllous cvclc rvas tltc rtttbrcak
of \lbrld rv\-ar II. \\'hcrr Gentant'arrtlJapan lattlrcltctl
rvars on Europe and the Llnitctl Statcs, tltis lctl tr> a
rapid nriliurn builtltrp, latgc iltctr:ascs irr spt-trrling,
ancl aD incrcasc irr aggrcgatc <lcrnir|rd rhat prorelled
thc Llnitecl Statcs or.rt of thc Creat f)epression. Here
\{e sa\v an cxogcl)ous cvcllt-a nra-jor rvar-that led to
a hrrgc incleasc irr rnilitan' srt'trding arrrl to thc biggest

econtullic exparrsiorr t.rl tl)c t\\'cnticth ccnturn. (\^'e ll


rx:unirre this cpiso<lc latcl in tltis chartcr.)

Bv c<lrrtlast. tlrc intrnal thcor-it-s look [<rr nrechrrisrns rvithin thc cconornic svsterl itself. In tlris

apploaclr. c\:cr] exp?rnsion breeds recessiou and


contraction, and e\'en contr-actioll breeds revival and
lVf anv business cvcles in LI.S. ec<>nornic historn werc illternal cvcles tlrat originated in the nancial scctor'. lt is [or-this reas()r] that rve devote rnttch of
orrr attcntir)n to Ir)onct?r|J and financial ec<tnonlics.

cxr:rnsion.

a29

Financiol Crises ond Business Cycles


One common feature of capitalism around the rvorld
is rhe speculative booms and busls that occurred freqlrently in the nineteenth centun, prodtrced the
upheaval of the Creat f)epressior.r, arrd reappeared
in tl'rt'tlnired States several times over the last nvo
clecades. Relorv ar-e sorne ir.nportant exanrples.
Ponics of Eorly CaPitolitm. The nineteenth cenrur.r
rvitncsscrl f rcnzics of inrcstrncnt spcculation-notablv
il canals. larcl, and railroarls. Incr itablr', 'anintal spitits" worrltl takc ovcr'. Raill oarls rlorld bc ovcr'brrilt,
larrd price s rvotrlcl risc too higlr. ancl pcoplc rvottlrl
take on too rrruch dcbt. Banknrptc- rvor.tkl lcad to

bank fiilures, a rrul oll thc burks, iurd a banking crisis. Outpr.rt and prices rvould fall sharpl,v in the panic.
Eventuallr,, rfter the rr'orst excesses \vere \\'rlrng out,
the economy rt'oLrld begin to exp:urd again.

Hyperinflotion Sometimes, an overheatcd economr, leads to high inflation. or even hvperinflation.

Hvperinflation occurs rthen prices rise at 100 percent ()f' more prr tnonlh- The most f'amous hl'perinf lati<r.r in histor,v occr.u'red in Gernranv in 1923.
The government wars unable to nleet its financial
obligations throlrgh taxing and borrowing, so it
trrrlred t< the monetrn printing press. Bv the end
of lfl23. crlrlencv rvas prinf ed rvitlr more ancl more
digits. and tlre largest banknote ir circrtlrtion was
for 2ir billion marks! Central banks todav are vigilant in their defense agrinst even the most nroderate infl:rtion.
The New-Econ omy Bubble. The classic pattern of
specrrlatire hoonl rvas seen again irt the late 1990s.
The phenornetral pattern of gr<xvth irnd irttcr'arion in the "nerr'-econom\i' sectors-itrcltrcling soliware, the Internet, and the nervlv inr elttcd dot.corll
conr pan ies-prrdttced ir speculative boont in nerveconornv stocks. Oornpanies sold online dating se[vices, gave a\{at free electronic birthda' cards, antl
issued stock for Flooz.conr, rvhich soltl il rvo thlcss
digital ctrrrencr'. Oollegc stltdents droppt'tl otrt of'
school to becotne ittstattt rnilliolraircs (ol so thcl
dreirmed). All ol this spttrtctl tcal irlvcstltrcttt in contputcrs, sofiware, arrrl tclccorn lrr u n icaf ions. Investment il infbnnation-proce ssiug cquirrncrrt rose by
70 percent from 1995 to 2000. rcprescntilrg onefiftlr
of the entir-e rise in real (iDP tlrtring this pcriotl.

t30

CHAPTER 7 . BLISINUSS (l\'(:t.:S AN-D,\(;(;Rll(;,\Tl- DE\lA\l)

Eventrralll, investors her'rnre skeptical aborrt tlre


frndrmental valrre of rnarrr' of these finls. l.oss<.s
piled rrp orr top of losses. Tlre rrrge to brn'the stocks
before prices rose higher was repl:rced bv thc panickl desire to sell bef<re tht'y < oll:rpsed. The stock
price of a typical n e\r'{'('()n()nrv conrpalr): fcll f rorn
$100 per share ro perrrrit's bv 2003. Marry srrch conrpanies rvt'rrt b:rnknrrt. (,ollcge drop()lrls rvt'nt back
to sch<ol wiser brrt seldorl richer:

The changecl expect:rtions aborrt (lrc

nclv

the lesrrlting stock tnarkct ([cclinc


cont'iblrted to thc rcccssion and slcrv grorvtlr in
the 2(X)0-2002 pcriorl. lrtvcstrncnt ilt inlirrlltatiorrpro<'t'ssing eqrritnrt'nt f'cll lrf l0 pcrccrrt, antl
econ()n.l\' rnd

t'r-s f'cll lx' twicr. as rtrrch. 'l hc


irnpressive ir.rnor,ations of the rt-rv cconolllv havc
beconre:r st:rple fi'atrlre o[ nrodcnr tt.chnologv, br.rt,
rvitlr a ferv cxccl)tions. invcstols hr,c littlc or rro -rrol-

credir-brrt it rvas llving against powcritrl lrearlwilrds.,,\s tht'r'alrrc ol stocks fi'll nore sharplv than
af anv lirn(' irr ir cclrtrrr-y, nrarrr,fillarrcial irrstitrrti<lns
werc on lht'r'clgc ol bankrrrptcv. Nlarrl ol the l:rrge
invcstrncrrt banking f ir rns clisappcarcd. The Fe<leral
Rcscrr c anrl L. .S. Ii-casu v loarrctl rrrassir,c amornts
of ltrlcral nrorrc\ artl lailctl orrt severrl financial
lirrns.

\tt.

cvcrr rvitlr tlrc strong cou rr tercvclicrl

activilics. tllc ccOrrorrrr rvcnt illto a tleep recessiOn


at tlrc cn(l ol 2007 .
Yrrtr bcin to scc tlre thernc runnirrg throrrgh all
tlrcsc cvents. The ncxt f'era'chapters sul-\'ev orr econorric thetries to explain thern.

irrlt'stnrent in cornrrrf

its to shorv lirr

thcil cllbl

ts.

The HousingBubble. [,ess rhalt;rdt't irdc latcr, arrrtllc

financial crisis erlrpted, arrd this was:rgain tlrt'r'srrlt


of rapid inovrtirr'r. Brrr irr this c:rsc, tlre innovati<lrr

rlas the Dr()cess of firrancial "sccrr r-itizat iolt. " l'his


occrrrs when a financial ilrstrrrrDcrrt, such :rs:r sinr;lc
l-torne rtrortgage, is sliced and diccd, repackagcrl. antl
then sold on secrrrities rr)nrkets. \{lrile st-crrritiatior
iuself rv:r.s r)ot 1l ltew phenornenor.r, the scop(' of packaging and repackaginf{ f{rerv shirrplr,. R;rtirrg agencies
failctl to proride accrr :.rte rirtinf{s of the riskiness of
thcsc new secrrities, and ntrnv people bt>rrgltt thenr
thinking thev were irs g()od as gold. The w<rst examplcs rvcre "subprirne rnortgirees," mortgages provided
to people for the entilt'v:rlrre ofa lrrrse rr.t tlre basis

ol'little or no

docrrrettaf ion of their inconre and


e:rrlr' 2007, the toml valrre of rhese nerv
securities rvas over Sl trillion.

.iob status.

B1,

All went rvell as long:r-s horrsirrg rrices lvere risirrg. as thev did starting in 1995. I\rr tlren in 2006
tlte hotrsing bubble burst---echoirrg the errd r'f Ih<'
speculative dot.com stock-narket brrbble f'orn

tlccade earlier. Ntanv of the nelr'se<'rrrities lost v:rlrc.


It turncd otrt they \\ere nor top-4rade A{A secrr'itics
brrt junk bonds. As banks and <ther filraltci;rl institrrtions srrflered larqe losses, thev begarr to tifllrten
credit, redttce l<ans, and cut b:rck sharplv orr nc*'
nlortgages. Risk prern ir rrrs rost'shar-plv.

B. AGGREGATE DETIAND AND


BUSINESS CYCTES
\lt havc rrow bcgrrrr to tnderstutd the short-tet'nr
changt-s irr outlrut, crnployrncrrt, antl priccs that char-actt-rizc brrsiDcss ltrctLrirti()ns irr nrirrket ecollol ies.
Nlost cxplauatiorrs of btrsincss cvcles rell upon the
thcorv ol aggrcgirtc clerna.nd. Tlris section expl:rir.rs
,.V) lhcon' irr grcatcr tlctail.
THE THEORY OF AGGREGATE
DEMAND
\Alttt a'e tlre nr:rjor- c()nll)onct)ts of

agr-cgatc

denrand? Hr:w clo thcy illtcract tvith aggrcgatc strp


ph't() dctcnninc ()utput arrtl pliccs? f,xactlv horv do
sholt-rrn fhctuations irl rlll af1l'ct (iDP? \\'e first
r-xanirc aggrcjatc rlcrualrtl irr rnore detail ir <rder
l() gct a bcttcr tr nrlcrst:r ndir rg of tlre firlccs driving
ihc cconorn\,. 'l'ltclt, irr thc Iirllorlirrg scctions, rve
rlcr-ivc thc sirrrrlcst ruorlcl ol a{grcgatc rlernand: thc
nrrrltiplicl nrorlcl.
Aggregate demand (or ,4/)) is the tot:rl or :rggregatc quantit\'()l ()utput that is willinglv botrglrr at a
given lt-r'cl of pr iccs. othcr tllilU{s [rcltl consuult. ,{1)
is the desircd srcndirrg in all prorlr-rct scctors: (on-

slnnl)ti()n. l)r'i\'al(' (lonrcstit irrrtstrlrrrt. go\ernrDrt)l


ptrlclrascs tl goods ard sclriccs, and net exp()rts. It
llas brrl ronlp()ncnls:
f

con

Thc Feder':rl Reserve to()k slcps to casc tnonctan


ditiorrs-lorverirr g irrtt'rt'st r-atcs alrrl cxtcn(ling

l. ()tnsunllion. As rve sarv in the lirst chapter'.


consunrption ((i) is prinrarily deternrined b1'

t3l

THE DOWN\r,\RD-S[.OPINC A(;CREGATE DEMAND (lLlRVE

clisposable income, which is personal income


lcss taxcs. Other factors affecting consrtmption
arc longcrrtcrrn trer'ds irr income, household
wealth, ard thc aggrcgatc price lcvcl. Aggregate
dernand arralysis fbcrscs or thc detclrninants

of

r,l

c<-rrrsrrrnption

tlrat is, tronr iral or clolb,v thc price index [<r

lar corrstrrnption dividcd


consunlptr0ll).

In7'6lm?n1.. lnvcstllrcnt (/) spcnding inclrrdes


purchases of buildings, soltlvarc, and cquipnenl
and accurrrulation ol irl'cntorics. Ottr analvsis in
Chapter ti shorvccl lhat thc nrqior clctcrtninauts
of investrnenL al.e thc lcvcl of outptt, the cost of
capital (as detcrrlincd by tax policics along s,ith

interest rates ard olcr financial conditions),


and expectations aborrt the firture. 'I'he nrajor
channel by which econorric policv can allect
investment is monctary policr,.
3. ()oucrnnenl

A third coulponcnt ol aggt cgrte demand is govcrnrncnt ptrlchascs o[ goods


and sen'iccs ( (J). This illclutlcs thc ptrrchascs of
g<,rotls like tanks ancl school lrooks, as wcll as thc
sen'ices of jutlgcs ancl prrblic-school tcachers.
Unlike privatc consunrption and ilrvcslnrcr)1, tltis
purc.rs.

cornponent ol aggrcgatc dcrrand is clctct'rnincd


directly b,v thc govelnrrtcnt's srncling dccisiotrsi
rvhen the Pentagort btty's a trclv fightcr' :rilcra[t,
this outDut dircctlv adrls to tlre GDP.
4. licl txports. A final cornponcnt ol' aggrcgatc
demand is net exports (X), whiclt c<tral thc

value of exports ninus the valttc <.f iruPol ts.


hnpors are determined by cltrnestic itrcontc
and output, b1' the ratio of dorrrestic to fbreigrt
prices, and b1' the foreign exchange rate of the
dollar. Exports (which are imports of other
collntries) are the mirror image of imports,
and they are determined bv foreign incomes
and outputs, by relative prices, and bv fcrreign
exchange rates. Net expors, then, will bc deterrn ined by dome stic and foreign outputs, relative
prices, and exchange rates.
Figrrre 7-3 shous the A/J cune and

is

four

major conrpouents. At price level I we can read the


levels of consrm ption, investment, government purchases, and net expor$, which sum to GDP, or Q
The sum of the four spending streams at that price
lcvcl is aggregate spending, or aggregate demand, at

tllat

Dl

icc lcvcl.

o
Real GDP

FIGURE 7-3. Components of Aggregate Demand


Aggrcgatt' tlt'rnarr<l (zll)) (()nsisl-s of fi)rrl cr)nlponcnt.sconsrrmption (C), donrestic rrivatt' invcstrnt'rrt (/), governnrent spending on goods and sen'ices ((i), antl net

expors (X).
Aggregate demand shifLs when drere rre changes in
policies (such as monetaw-policy changes
or clrangts irr grlr'(.lrrrrrt'nt <'xX'rt<lil ulr:s {)r tax rates) or
whcn exogertotts ev('Irts changc sx'tt<litt (as rvorrlrl llt'
the case rr'ith chirnges in foreigu outpttt, affctting X, or itr
brrsiness conlidence, affecting / ).
nrac r<ccrnornic

THE DOWNWARD.SLOPING
AGGREGATE DEMAND CURVE
One importarrt point 1'ou should noticc is that the
aBgregate demand curve irr l-igurc 7-3 slopcs downward. This lneans that, lolding othcr thilrgs constant,
the level of real spcncling dcclincs as the overall Price
level in thc ecorrornv liscs.

What is tlc rcason for thc downs,arcl slope?


The basic reason is that lhcrc arc sonre eler.nents of
incorne or wealth tllat do not rise lvhcn the price
level rises. For exatnple, srrnc itctns of pcrsoual
income might be set

in rrorninal dollar tcrnrs-

alrsll'r' pavlll('Itts. tlrc Initrilntln


rvage, and cornpanv pcrrsiorts alc exatnplcs. When
the price level oes up, tllcrelblc, r'cal disposable
income falls, leading to a declilre in tcal conslttnp
tion exoenditures.

some govcrl)rlrctIt

tt

t32

CHAPTER

In addition, sorne elements ofrvealth rnay bc lixccl


nominal terrns. Exanrples hcre rvotrld be holdings
of monev arrd bonds, wl.rich usually contain promises
to pay a certain number of dollars in a given pcriod.
If the price level rises, therefore, the real valtre o[
wealth declines, and this would again lead to lor.r'er
levels of real consumption.
!!'e illustrate the impact of a higher price level
graphicallv in Figure 7-4(a) on page I34. Say that
the economt,is in equilibrium at poir.rt B, with a
price level of 100 and a real GDP of$3000 billion.
Next assume that prices rise by 50 percent, so the
price index P rises from 100 to 150. Srrppose that
at that higher price Ievel, real spending declines
because of lower real disposable income. Total
it.t

real spending declines to $2000 billion, shorvn


at point C. \'!'e see here how higher priccs havc
reducerl real spending.

Varible

7 .

T<

RUS NESS CYCI-F,S ,{N 1)

A(:C;REG.{IE DEMANI)

surnrnarize:

The A/) crrrve slopcs downrvalrl. -fhis tl<wnn'ard


slope irnplies that rcal srcnrling rlt-clincs as thc plice
level rises, ()ther things held colrstant. Rc-al spcnding
declines rrith a l.righer-pricc lcvcl plinrarily ltccatrse
of the effect of higher plices orr r-cal inctncs aud
real ivealth.

Shifts in Aggregote Demand

in the economy
to decline as the price level rises, holding

We have sccn that total spending

tends

othcr things constanr. But those other things do in


fact tend to change, therebl, producing changes in
aggrcgatc denrand. What are the key determinants
of changes in aggregate demand?
!!t can separate the determinants of AD into mo
categories, ari shown in Table 7-1. One set includes

Impact on atgrcgate demand


PtollcyVedebler

Monetary pocy

Monetaw expansion may lower interest rates and loosen credit conditions,
inducing higher levels of investment and consurnption ofdrrrable goods. In an
open economy, monetary policy also affecs the exchange rate and net exports.

Firal policy

Increases in government purchases of goorls and sen'ices dirc.cdy increase


spending; tax reductions or increases in trnsfers raise disposable income and
induce highel consumption. Tax incentives like an investment tax credit can
induce higher spending in a particular sector.
Erogenour Variabler

Foreign output
Asset Yalues

Output gronth abroad leads to an increase in net exports.


Risc in stock market increass household wealth and ereby increases
consumption; also, higher stock prices lower the cost ofcapital and thereby
increase business investmenL

Advnces in lech"olog[

Technological adr"ances can open up new opponunities for business investment. Impoftant examples have been the railroad, e automobile, and
comPuters.

Other

Defeat ofa socialist government stimulates foreign investment; peace breaks


out, with an increase in world oil production, and lowers oil prices; good
weather leads to lower lood prices.

TABLE 7- l. Many Factoni Can Increase Aggregate Demand and Shift out e ,4D Curve
The aggregate denrard cun'e relates totrl spending to the price level. But nunr(:rrllrs ('thcr
influences aflect aggregate demand-sor.rre policy var-iables, otlrcn <:xor'rrorrs facton. Tlrc
mble Iists changes thar rvould tend to increasc agglr:at<' tlt'rnand anrl slrift orr rhe ,{1) cune.

I IIt.. l)(

t33

)\\ N\{rARt)-St.()PtN(; {(;(;RF.(;,\TF. t)t.\f AND (.t'RvF,

the rnacroecorl otrric poli( t^ uoiabh\ rrhich are rrnder


g()verntrrent control. These rre mol)etary policv
(steps by rvhich the central brnk can rffect interest
lates:rrrd other ranciirl conditions) and fisc:rl polic\: (taxes zrncl goverrtment expenditrrres). Table 7-l
illustlatcs horv thcse go\ernrnent policies can aflect
dillL'rcnt colnPoncDts of agglcgate denrancl.

In the aggregate demand curve, the general price

level is on the venical axis, while total outDut and


ncomes vary along the horizontal axis. By contrast,
total incomes and output are held constant for the
mcroeconomic demand curve
Finall the negative slope of the microeconomic
demand curve occurs because consumers substitute
other goods for the good in question when its price rises.
lf the price of mear rises, rhe quantiq/ demanded falls

'l'lrc scconcl sct includcs ?xog?tous tnrinbles, ot'


rariablcs that al'c clctcrnrirrcd orrtside the A.S-,'l/)
liarncwtr'k. As'Ihblc 7-l shows, sornc of thcsc varial;lcs (strch As l{ars or rcvolutions) alc outsiclc thc
scope of rnacroeconorric arrahsis propei sontc (strch

because consumers tend to substitute bread and potatoes for meaL using more of the relatively inexpensive
commodiries and less of the reladvely expensive one.
The aggregate demand curve is downward-sloping
for completely different reasons: Total spending falls
when the overall price level rises because consumer

foreign econ<rnic activitv) arc ttLsitlc thc coutrol


of drmestic policv. antl othe I s (sucl) as tltc stock Inal.
irs

ker) have significant independent rnovcrncn1..


What are the effects of changes in the variables
lving behind the ,{/) cunel' Corsider the econornic
cffects of a sharp increase in miliun' spendirg, sucll
as took place in \\'orlrl \\hr II. The additiorral crsts
cf the war irclrrded pa1 fol the troops. purchases of
anrrrrrr.rition and eqrripnrent, and costs of transportatiorr. Thc cffect of these prrrchases rvas an increase
in (i. L'nlcss sourt' otheL conlponelrt of sper.rdirrg
<lcclcascd f() oflset tlre increase in fl, the tor:rl ,.1/)
crrrrc world slrift orrt and to the right as C increased.
Sinrilarlr,.

a radical lrerr innovation

thrt increased

tlrc plofitabilits of nert irrrestnrenl, rr arr incre:se in


consr-uncl wcalth bccatrsc of higher-lrorrsing prices,
rvttrlcl lcarl [o an illclcasc irr aggr-cgate dcnrand and
an otrtrvirrtl shili of thc ;11) crrl vt'.
I'igrrrr T*l() ()n pagc 134 shorvs how the
changcs in thc valiablcs listcrl in Trble 7-l rvould
alli'ct thc ,'ll) crrl vc. Ib tcst rotrr rrndcrstanding, corrstl trct a sinrilar tablc showirtg firrccs that rvottld tcncl
to rlccrcasc aggrcgatc dcnrand (st'c qrtcsticltr 2 at thc
crtl ol tlrc clrautcr-).

Two Reminders

We oause for two imDortant reminders.

l. We first emohasrze the difference


beNveen macroeconomic and microeconomic demand curves. Recall from our studr of supply
and demand that the microeconomic demand curve has

the price of an individual commodity on the vercal axis


and producon of that commodry on e horizontal
axis, with all other prices and total consumer incomes
held constant.

real incomes and real wealth fall, reducnt consumpton,


and interest rates rise, reducint nvestment spending.

2.

Remember also the imoortant distinction between


the movement olong a curve and the shrf of a curve.
Figure 7-4(o) shows a case of movement along the
agtregate demand curve. This might occur when
higher oil prices reduce real disposable income.
Figure 7-4(b) shows a shift of the aggregate demand
curve. This might occur because of a sharp increase
in war spending. Always keep this distncton in mnd
as you analze a particular policy

or shock.

Eusiness Cycles ond Aggregote Demond


One inrrort:lrt s()lrrce cf hrsiness flrrctrratiors is
shocks fo aggregate denr:rnd..\ tvpical c:rse is illustrated irr Figrrre 7-1 on page 1.34. rthich shows horv
a declir.re in af{grefl?rte denrand lowels ortput. Say
that the econonly beins in shr'r't-run eqrrilibrirrnr:rt
roint Il. Then, perhaps becarrse of a firrancial p:rrtic
or a l:lx inclease. the ?rggfef+rte demand crrn'e shifls
leftu,'ard to ,4/)'. [f there is no chirnge in aggregirte
supplri thc ec()ll()rnv will reach a rrerv eqttilibrium at
poinr C. Note that orrtput declirres from Q to Q'. In
addition, prices are norv l<rvcr thiur thel'welc at the
rrevious equilihriurn, arld the rite of inflati<rr falls.
Tlre case oI at ec<tornic expansiotr is.jtrst tlre
opposite. Srrpposc thirt r rral lends to a shalp incre:rse
in government spendirrg. .ds a restrlt, the AI) cunc

shift to the right, or.ltpr.lt iurd ctrtplovtttetrt


rvould increase, and pliccs attd ittf latir.rt wrrultl I isc.
rv<trld

Brrsiness<-r'cle fluctrrations

in

ortt.rtrl, t'ntpkrt,

rrt,llt. and pr-ices ale tficu carrsccl lrv shilts irt :r4glcg:rtt' dcnrnrtd. Thcsr occrrr:rs consunler:, lnsincsses,

t34

CHAPTER

I]I.ISI\LSS (;\'(]LES AND ACGREGATE DElI{AND

(a) Movements along the Aggregate Demand Curve

-o

200

-9

.3

(b) Shifts of Aggregate Demand

1s0

fi

rso

'E

fL

100

'1

1,000 2,000 3,000 4,000

5,000

00

1,000 2.000 3,000 4,000

Heal GDP (billons)

5,000

Real GDP (bllions)

FIGURE 7-4. Movement along rs. Shifts of the Aggregate Demand Curve

Iu (a),

a higher price level rvith giverr rrorninal rlorrcy irrcornt.s lrwt'rs r'al rlisxrsablt.
irrcorne; this lcads to lright'r' intt:rt:st rat<.s arrrl <k'r'linirrg srcn<ling on ill terest+cnsitive
irrvestnl('nt an(l consurrr[)(()n, T]ris illrrstrat<'s m.ntm"nl atngthc -,lI) curre om I to
ll wlr<'n olh<'r thirrgs arr.hcl(l (()nstar)1.
In (b), other rhings are no longer constant. Changes in rariables rrnderlring ,V)-such
as the monev suppl;-. nx policy, or militan spending-lead to changes in total spending at a
giren price lerel. This leads to a shiJi oJ the.{,D cun'e.

()r govcnrrncnls change total spending relative [o the


ccononrv's productive capacit): lthen these shifts in
aggrc5tc clcnralrl leacl to sharp llrsiness dlwrtnms,
tllt- cctnolnv strlll' s ccessir.rrls or evcl;. clepressions. A
sharp trptrrru in ccr.nornic acr,iw can lead to inflation.
o

I
Qr)

FIGURE 7-5, A Decline in Aggregate Demand Leads to

fs the Business Cycle Avoidable?


The histon of brrsiness clrles ir.r the f.hrited States
shows a remarkable trend toward greater stability in
the last qllarter-cen run' (look back at Figure 7-2).
The period through 1940 witnessed nlrmeroln crises and depressions-prolonged, cumulative slrrrnps
like those of the 1870s, 1890s, ancl 1930s. Since
1945, business cycles ha\e become less freqrrent and
milder, and many Americans have never rritnessed

an Economic Downturn

a real Depressior'r.

A downward shifi in thc rll) r'urlc akrng a rt'lativcly' flat


and rrnclranging r1S cun't' lcatls to lower levcls of otrtput.
Nott' tlrar as a result of the leftward shifr in the A.I) cune,
attual otrtptrt declines reladve to potential outpur and

What were the sources of the Great Modemtion? Some believe that capitalisrn is inlre rcntly nrorc
stable norv than it rra-s in earlicr tirrres. Sornc of that
stabilitv colnes from a larger and nrore rrcdictablc

3b,

(L

Polential

o'o
Ral outpul

makes a recession w<rse.

government sector. Eqrrally inpotfant is

a better

OTI

II'I

I'I)I.] II.,RVI\f D BYTOTAI- I,X PI, }IDITT

'

undcrstanding ol nlacloccollonl ics that tr()\{ pertnits


the governrnellt to con(luct its rrronctar-\,atrd fiscal
policies so as to prevelrt sltocks li onl l.r.rlrtirtB illto
recessions rnd to keep recessitrts

liottt sttorvballirtg

irrto depressior-rs.

f)rrlin traruquil periods, people oftert declirrc


tlrrt the business cvcle has been vanqrtislted. Is tlris a

realistic possibilitv? While busincss ct'clcs ltalc trtotlerated in America over the lirst quarte r-tcntttry, thcy
have arcttralll' become rnole prevalcttt in otlte r ccottr>
mies. So take heed of the fbllowing propltctic rvortls

of the great macroeconotttist Artltur Okttrr. lvhicll


are prrticltlarly approp ate as the w()rld cc()llollrv
herds irrto recessior.r

t35

RES

in 2007-2009:

ale now generallr consi<lcred to bc firndarrlr'rtallr' l)r('vcnt;rl)l(:, likc airrlane crrshes urd rtulike
hurricirrrcs Btt rvt'lllrt'rrot lanislttrl i ctasltcs liorl
tlre hnd. lnd it is n<t clcar that rtt lravc tht rvistlrllt tr'
the ability to elintinlte rect'ssiotrs. 1'lre diurgcr has ttot
rlisappe;uec[. l he t<rces tl)at pr()ducc recurrcnt recessirrs ar c still irr the rlings, rnerelv rr;aiting lil theil'clrc.
Rr.t cssitns

in CDP. The kev asslrnrptiolls rnderl).


ing the rrrrltiplier rnodel are thrt wages arrd prices
alc flxccl alrd thaf thele ar-e rrnernployecl resoru ces
in thc ccononrv. ln addition, in tl.tis irrtrodrtcton'
chaptcr', wc alc igrroling thc rolc ol- r'nonctart' rolicv
and asstrnring tlrat Iinancial rnirlkcts do not lcact
to cllallHcs in tlle econortr. Atlditiortally. rvc alc fbr
rrolv assrrnring that thcrc is no intcr-rrafional tr-ade
and linirncc. l hcsc liu'thcr clabor-ations will be intrc
d ucctl in latcr clraplcls.
cl.rar.rge)

OUTPUT DETERMINED BY
TOTAL EXPENDITURES
Our initial discussion of tlre nrultiplicr rrtrlcl anal1'zes how ir)\estnrent and constttttption spencling
intemct rvith incornes to detennille rlatiolrrl otttput.
This is callecl rbe lolal ulnndilurc altprcurh t() determining national orrtptrt.
Recarll Chapter-6's picttrre of the Itatiottirl cortsumption firnction. \Aie have dr. r,tr a retttitttler gt aplt

irr Figure 7-6, whcre the c<-rnstrmptiort litttctiort

is

C. THE MULTPLIER MODEL


Thc basic nacrocconontic thcol-r'of brtsitress ct'cles
Iltlds that shilis in rggrcgatc clcrnancl prodttce the
fictrrcnt anrl rrnprctlictablc fltctttirfions itr ()lllPrtt,
priccs, ancl crnployrncnt krrorvn :ts bttsitress cvcles.
Ecorrrrrrrists tr1 to undcrstant d lle nprhtn isr by rvlrich
changcs in s-rcncting gct trnnslated ir.tto chatrges itt
outprrt anr[ crnplovrrrcrtt. l'hc sirnplcst approaclr
to rrrtlelstarrcting brrsirrcss cvclcs is knorvlr :rs the
Kqnsian n ultiplin nodd.
\4/lrcr ccononrists attcrnpt to rurderstatrd rrhv
major inclc:tscs irr rnilitarl spcrrtlirrg lcd to r-a:id
increascs in GDP, or rthl thc tax cuts ol'thc l9(i0s
or 1980s rrsllcrctl in lortg lcliods of bttsittcssrycle
expansiorrs, or rvhv thc itrvcstmenl boonr o[ the lztte
1990s prodtrcccl Anlclica's longcst cxpansion, thel'
ofien trrn tt thc Kcvncsian rrtr.tltirlict- rnoclcl lor rhe
plest explirn:rtit-l I l.
\41rat exactly is tlrc multiplier model? lt is a tnacroecor()t'nic thcor t' t-tsccl to crplain Irorv orttrrtf is
deternrined irt tllc shol-t ruIr.'I'llc tratnc "tnttltiplier"
comes frorD tlrc hncling that cerch dollat'change
in exogent-rtts expcn([itures (such as itrvcsttnctrt)
leads to more than a dollar change (or il rntrltiplictl

si m

=o.
E

GDP

0
Gross domeslrc producl

FIGURE 7-6. National Income Determines thc Lcvel


Consumption

of

Recall the consurnption filnctior, (l(1. that rvas descr-ibed


-l'his shorvs tlre level ol cotrsunrptiotr expenirr Ohartcr (i.
r
or
rt'srorrrlirr.
to crcr-' k'rcl ol itrcoure (wheIe
ditulcs

inconre cquals (lDP in tlris siutrlt' t'xatttrlc). Tllc two


points mlrked '5(X)" emptrasizc tltc itttxrt lattt l)r()l)(:rtv ()f
the 'tf.' line. Arrl point on the -15" line dcpicts r't r tit al
rlistarcc cxactlv eqrral to the horiz<rtirl distruce. Thc blue
bantl rnarkcrl p,,Q,.shows tlrr'lcrr'l tl polentirl (;Dl'.

r3

CHAPTER

C+

l=TE

F.
(l)

c
o
o.
o)

7 .

Bt.iSINESS CYCI,ES ANT) AGGRL,C;ATE

investlnent opporttrnities are such that investment


worrld bc exactly $200 bitlion per year regardless of
thc lcvcl of GDP. The investment schedule is stacked
on top o[ thc cousurnption schedule in Figure 7-7.
Note that thc C * ,f cune is higher than the Ccun'e
bv cxactlv drc constant amount <f L This parallel
I'catrrlc illdicates tllat investment is consunt.
This C + .1 cune represents total expenditures
( 7E), which equals desired investment (which is at
fixed level 1) plus consumption. This is drawn in Figure 7-7 as the green C

DI,\,f.{){I)

I I or If

cun'e.

Finallr', rve drarv in a 45' line along which expen-

GDP

M
Gross domestic oroduct

FIGURE 7-7. The Equilibrium l,evel of National Ouaput


ls Determined When Total Expenditure ( TE) Equds
Output

The blrre CC line represens e consumprion funcdon


(shorrn in Figr.rre 7-6). The /1 arrows indicare consant
inrestment. Adcling 11 to CC gives the 7/1 curre ol toral
desired investment plus consunrptiorr srcnding. Akrrrg
the 45' line, expenditurcs cxactlv cqrral GDP Equilibrirrm
GDP conrcs at p(,int E, rvhich is the inrersection of the 7Z'
I inc and the 45' line. This is the only level of GDP at rvhich
the desired spending on ' + /exactlt equals output.

diture on the vertical axis exactly equals output on


the horizontal axis. At anv point on the 45" line,
total desired expenditure (measured verticallv)
exactly equals the total level of output (measured
horizontallr').
1\'e can now calculate the equilibrium lerel of
output in Figure 7-7. !!'here planned expenditrrre,
represented by the Tlicun'e, eqr.rals total outpur, rhe
economy is in equilibrium.
Tlre total cxperrditult' crrrlc ( 7E) shorvs the level
ol planncd b'consurncrs and
brsirresses corresponding to cach lcvcl ol otrtput.
The ecorromv is in equilibriunr ar rhc point rvhere
rhe lli : C * / crrn'c crosscs thc 45' linc-at point
/i in Figrrre 7-7. Point I is thc rnacroccouornic equilibrirur bccausc at that point. the level of desired
of expenditrrre desir-ed

expenditrr rc on consurrrption arrrl irtvestnent exacth,


eqrrals tht' lcvcl of'total output.

the CC linc. Recall that the consumption function


shorvs thc clesired consumption corresponding to
each levcl of income. \\'e have omtted nxes, translers, and other items, so that pe rsonal income eqrrals
national income, and national income eouals GDP.
\{'c ntw develop in Figure 7-7 an importanr nen'
graph shorving the total expenditure-output relationship. 'f his graph is sometimes called rhe "Keynesian
cross," bccatrse it shows hou'otrtput equals expendittre when the expendittrre cune crosses the 45'line.
(If yotr are not sure about the significance of the 45"
lirc, lotk back at Chapter 6's explanation.)
\!e begin by drau'ing the consumption fuucrion,
(.(i.

\4t thcn add rotal

investment to consumDrion.

Nr.rmallr,, investment depencls on irrlerest rot"*. to*


policr', and business confidence. To sintplifu things,
ue treat investment as an cxogcnou,r vrriable, one
whose lcvel is determined outside the nodel. Sav rhat

Reminder on the Meaning


of Equilibrium
\{e often look fbr a n)acroecollomic "equilibrium"
rvheu analvzing busincss cycles or economic growth.
\{'hat cxactlv docs this tern nlean? An equilibrium is
a situation rvhcrc thc clill'crcnt lbrces at work are in
balance. For cxamplc, if vou sec a ball rolling down a
hill, thc ball is not in equilibrirrm because the fbrces
at rvork arc pulling the ball down. This is therefore a
disequilibrium. Whcrr thc ball cornes to rest in a vallev
at thc bottoln ol'thc hill, rhe fbrces operating on the
ball arc in balancc. This is therelbre an equilibrium.
Sinrilarly, in lnacrocct.nornics, an equilibrium
lcvcl of outplrt is onc rvhere rhe different forces of
spcnding ancl outpr-rt arc in balance; in equilibrium,
thc lcvcl of'outprrt tends to persist rrntil there are
clrangcs irr thc fbrccs alll'cting the cc<.rlorny.

t37

OI'TPL'T DI-TT]RNTINED I}\'TOTAI, !]XPI]NDI I L'RT.-S

Applvirrg thc cqtrilibriunr corrccpt to Figrre 7-7,


we see that point /i is an cqr.rili blitt nr. At poir.rt /i,
anrl onl;- at point lt, docs duirul spendiug tn C * I
equal nclual oulpul. Al ant <.tltcl le vcl ol proclttctiort,
clesired spending rl'ottld dilicr lionr prodtrction. At
an1'level other than C, businesses rvoul<l fittcl thctnselvcs prodrrcing too little or too mttch and wotrlcl

$ant to change the level of production birck torsarcl


thc cquilibrirrrn level.

The Adjustment /l4echdnism


It is not enough to sav that poitrt l. is an equilibrium. \\'e
need to understatrcl rr[] a ccrtaitr otrtptrt is an eqrrilifr
rium and tlhat rvoulcl happcn if outrrrt deated from

rhat equilibriunt. Lct's cotrsidcr thrce cases: planned


spending above output, planncd spcrrding below orrtput, and planned spelrding equal to otltptlt.

In the first case, stppose that spcnding is above


output. This is represertted br poirtt D in Figtrrc 7-7.
At this level of outpttt, the C + l spcnrling line is
above the ,15' line, so plannccl (, * l spcnrling rvould
be greater than olttput. This ntcatrs that consrtmers rvorrld be buving more goocls tltarl bttsincsscs
had anticipated. Artto dealers rtottld fittcl thcir ltts
empq'ing, and the backlog for ccrmptttets rrottlcl l;c
gettirrg lorrger and longer.
Irr strch a disequilibrium sitttatior. attto dcalcl s
and computer stores rvottld respotttl bv ittcrcasilrg
their orders. Arttomakers rvould recall rrorkers fi otrr
layoff and gear lrp rheir productior lines, rvhile contpu ter nakers rv<trld add adclitional shifis. As a t csttlt
of this ircreused prodr.rction, otttpttt rvottld irtcrcasc.
'l'hnefon, n di,senpanr bct ,?n total
Pklnnul exlendilurc
nnd lolal out|ut hads lo an adjustmrnt ol outprtl.

\bu shrlrld

through what happens in


rthere outprtt is belorl eqttilibritrrtr.
Firrallr', take the third cuse. rshere plannetl cxpcnditrrre exactlv eqttals <xttpttt. At eqtrilibritrln, firrns
rvill nd th:rt their srles are etttal to their lbrccasts.
thc seconcl

rlso rv<rk

cse,

'l'hcrc
Inventories rvill be at their plarrrted lcvcls.
rvill not be any-' tttrexpectctl orttc s. f it tns cantrot
improle profits bv ch:rrrging otttptrt bccartsc rlatrned
consttmption needs lttr.e lleclt Iltct. So lt'otltrction,
employment. incone, attcl spctrcling rvill rcnrailr tlre
same. Ir this case GDP stavs at poirrt l:, ancl tvc cal]
righ tf v

caf

l ir tn eruilibttn.

1-lrc eqrrilihr-irrrtt level of (iDP ot crrr s ltt ,roint 1:,


rr lrt'rr' rlirtt tr ed s;cltcline t'rttals platt ttc<l rt ttttttt tiot t.

,\t r:lr' <thcl outlrt. the trtal rlesir-crI srerttling


orr consrurrrtiort ;rrt<l itrvestnlerrt clillcls lirrnr the
plarrrrc<l .lrrrdrrctiorr. .\ltv dcviati<>n of platts fi-ottt
lur-rral lcrr'ls rr'ill <irrrse brrsirrt'sst's to chatue their'
rr-orlrrt tiorr arrrl t'rrr rlovrrr er t lt'r't:ls. tltt'r'r'bv retLu'ning tlrt'srstcnr to tlrc t'qrriliblirrrrr (ll)P
A Numericol Anolysis
An crarnplc rnay help show whv the equilibrirrm
levcl ol output occut's whcrc planned spending arrd
planned output arc cqual.
Table 7-2 shows a sinrple exantple of coustttnprion, saving, and output. The break-cven levcl ol'
income, rvhere consumption equals ilrc<.rne, is
$3000 billion (53 trillion). Each $300 billion changc
of income is assumed to lead to a S 100 billi<-rn charrgc
in saring and a $200 billion change in consunrption.
ln other u'ords, the llfPC is assumed to be constant
and eqrral to %.
\4e assume that investment is exogenous and
alwa'r's ststainable at 5200 billion, as shon'n in colrrmn (4) of Table 7-2.

Colrunns (ir) and (6) are the crucial <.nes. Colurnn (l'r) shorrs the toml GDP. It is simpl,v column
(l) copied agairr into colttmn (5). The gures in
colunrn (6) replesent total plannecl expenditures
at each level of GDP; that is, it equals the planned
consulnprioll spencling plus planned investment. It
is thc ll * / schedule from Figure 7-7 in numbers.
Whcrr busirresses as a whole are producing too
rrrrrch outptrt (higher thatr the sum of rvhat constlmcrs anrl businesses \{ant to purchase). inventories of
trnsold goods rvill be piling up.
Reading 'om the top row of Table 7-2, we see
rhat if fir-ms are ir.ritially producing $4200 billion of'
GDP, planrrcd or desired spendir.rg fshorvn in column
((i) I is orrlv $-1000 billion. In this situation, excess
irrvcntolies will be accrrn rtlating. Firms rvill respond
bv leduciug their prodr-rction lerels, and GDP lrill
fall. In the opposite case, represented in the bottoln
row ofTable 7-2, total spending is $3000 billion but
outprrt is onlv $2700 billion. Inventorics arc being
depleted and firms rvill expirnd opcratiotrs, raising
ouDut.
!V'e see, then. tlrat rvhen bttsirlesses as a wholc antenrporaril'r' producing more than thcy call profitablv
sell, thet'will redtrce prodrtction and GDP *'ill lll.
\{hen thev are sellirrg more thau their cttrrettt prtxluction, thel'lrill ircrese their output, and GDP rvill 'isc.

r38

CHAPTER

BLISINESS (]Y(]LES ,,{ND ,\CGRF,GATE

D[V-\NI)

GDP Determinaton VYhere Output Equals Planned Spending


(billionr of dollars)

(l)

(2)

(3)

Levels

GDP
and DI
4,200
3,900
5,600
3,300
3,000
2,700

of

Planned
Planned

saviDg

consumption

(3)=(l)-(2)

3,800
3,600

400
300
200

3,400
3,200
3,000
2,800

100

-100

(4)

(5)

Planned
investment
200
200
200
200
200
200

(6)
Total planned
consumpon

Level

of GDP
(5) = (l)
4,200
3,900
3,600
3,300
3,000

2,700

(7',

Resulfing
tendency of

and investnen! TE

(6)=(2)+(4)

>
>
=
<
<
<

ouqtut

4,000
3,800 J
3,600
3,400 t
3,200
3.000

Contraction
(lontraction

F4uilibriun
F.xpansion

Expansion
Expansion

TABLE 7-2. Equilibrium Output Can Be l'orrnd Arithntetically at c Level l{here Planned
Spending Equals GDP
The darker green rorv depicts thc cqrrililrrirrrrr (lf)P lt'vcl, rvhcre the $3600 at is being
produced isjnst rnatcherl bv thr: $3600 that hoLscholds plirn to consume and that tirms plan
to invest- Irt trpJrer rows, finrs will be forced into unintended inventon int.estmelrl and u,ill
respond bv cntting back production until equilibrirur CDP is caclrr:rl. Intcrpret the lower
rows' tendencY torvard expansion of-(lDP tormrcl equilibriurrr.

Onlv rvhcn the level of actual ()rrtput in colrnll

(5) cxactlv cqrrals planncd expenrlitrrre (7I;) ill


colrrr.lrn (fj) rvill the econ()ll\ be irr equiliblirrrrr. ln
eqrrilibr-iurn, arrd orrlv in eqtrilibr-irrrn. brrsiness sal<'s
rr'ill be cxactlv sufficiert to.jtrstii the crrrrt nt lt.rtl ol'
aggregatc or.rtput. In equilibrir.rrn. ()Dl' rlill ltcithcl'
erpancl nor contrac t.

THE MULTIPLIER
W'here is the multiplier in all this? To answer this
questiorl. rve neccl to cxaurine horv a change in exogenous investment spcnding aff ects GDP. k is logical
that an increase in investrnerrt will raise the level of

output and employmcnt. But by how much? The


multiplier model shoirs that alr increase in investment \lill increasc GDP by an amplified or multiplied
111s11-ly l arnolult greater than itself.
'I he

multiper is the inrpact of a l-dollar < lrarrgc


t()trl orrttrrt. ln thc
simplc .' * .l rnodel. thc rnultiplier is the r:rrir ol rhc
changc in tot:tl output to the chal)rc in invesrlrcrrt.

in crogcnous expendittrles on

Note that the clefinition ol the rrrultiplier speaks


of the change in output per rrnit changc in exog?nous

exfenditun.s. Th is indicates that we are taking certain

cotnponenLs of sper-rding as given ouside the model.


Itr the case in hand, tlrc exogcrrous cornponent is
investent. Later, we rnll sce that thc same approach
can be usecl to determinc thc cflcct of changes in
governmen t expendittrrcs, cxpot'ts, ard <.ther items

on total outplt.
For examplc, sLtppose investment increases by
$100 billion. If tllis causes an increase in output
of $300 billion, thc rnulriplier is 3. If, instead, the
resulting increase in outprt is $400 billion, the mul-

tiplier is .1.
Woodsheds ond Corpenters. lVhy is

it rhat the mul-

tiplier is greater than l? Lct's suppose that

hire

unemployed rvorkers to builcl a $1000 rvoodshed. Iv{y


carpenfers and lurnbcr prodtrcers will get an extra
$ 1000 of incornc. But that is not the end of the story
If they all havc a margirral propensity to consume of
%, they will now spcncl Sti66.67 on nelv consumption
goocls. The pr-oduccrs of' these goods *ill now have
extrir incornes of $666.67. If their ,trfPC is also %, they
in trrrr rrill spcncl $444.44, or % of 5666.67 (or'% of
j4 of $1000). The process will go on. rvith each nerv
round of spending being % of the prerious round.

THT:

\,I L'I

t39

TIPI,I[-R

'I'lrus arr endless chrin ol' srrondary ronsunplion


slterultngis sct in m()tion b1'rn1 rirrarl investnrellt of
$1000. Brrt. althorrgh :rn endless chairr, it is an evet'dirrrirrishing onc. Eventrr:rlly it adcls ttp to ir finite
atllount.
Llsing straightfbnvard arithlletic. rve crlr find the
totnl irrcrcasc irr spcnding in the following mantter:
X $ I000

$looo.o0

+
'://

666.67

X $tooo

(i'l'

144.14

X $ 1000

+
296.30
+

Q',t'

197.53

('/ )' X

$ 1000

+
s 1000

The Multiplier Model Compored


with the AS-AD Model
As vorr studv the rnultiplier nrodel, 1'ou might begin to
q'onder hou this rnodel ts in uith the ,4.5-,{1) model ofChapter.l. These:rre not, in fact, different approaches.
Ratlrer'. the multiplier model is a special case of the
aggregate demand-irnd-supplv moclel. [t explains how
A/) is affecred by consumption and irrvestnrertt spending rrrrder certairt precise asst ttrt ptiotts.
Oue rf the ke;.' assunrptions in the multiplier
anal't,sis is thart prices and wrges are fixed in the short
rrrrr. Tlris is :rrr or-ersim plificrtion. firr maul ptices
acljust quickly in the real norld. Brrt this assttmption
c?rpturcs th<'roirrr lh?rt if s()rrre wurges:rnd prices are
stickt,-lvhich is rlost definitely the case-thetr some

of'the adjrrstment tr ,'l/) shifs rvill come through


output adiuslrnent-s. \4t rrill retrtrn to this important
roint in la t('r chiptel's.
\\'e c:rn slrorr tlre relationslrip between the lnttltirlier analvsis arrd the ,{.1-,4D apploach in Figure 7-8.

$3000.(x)
sh<rrvs

rnrrltiplier is aln'ats the inverse, or reciprocll, ()f


tht' rnargirral propensitv to save. It is thtts eqttal ttr
| .t'

(l -

t\II)O). Orrr sirnple rnultirlier firrnttl:r

('ll;tltgt
irr orrlrrrt

,l

I x ( lll|lq( in in\('\un('nl
lll\

I - ,\f/-'ll
'

l-r*'+r'+
lorrg

ls ,ll/{l (, ) i\

'I'lrc s:rnre ec()n()nrv crn be described by the mtrltirlicr diirgrarn in the top panel of Figtu'e 7-8. The
nrrrltiplicr eqrrilihrirrrn gives the sanie level of otttpttt
as thc ,'1S-,'11) eqrrilibrirrnr-b()th lead to a real (lDP
of' (l Thev sinrplv stress difl'erent f'eatures of otttpttt
rlt'tcl nrinatirn.

'lhis ctisctrssion agaitt


roints tr a <'t'ttcial featttre
\!'hilc
it is a usefttl nrcdel
ol thc rnLrltiplicr nrotlcl.
lirr describirrg Icccssiors ttt cvctr rlctrcssions, if caltnot applv to prriotls of lirll cIIt rk rvrtrcn t. ( )lrct' factories irrc opcrating at lull czrPacit\ :rlrd all rrorkers
arc errrplovcrl. tlrc ccolronlv sinrplv catrtrot prodttce
ntot e ()utDut.

D. FISCAL POLICY IN THE


MULTIPLIER MODEL
-"+

lcss rhrn

and cqrrilibrirrrn orrtprrt rises.

X t lltttrt irl ill\('\ll)r('rrt

lt' li'rrtLr tf)I uD iDliDitc gc{)rnctt ic

:rs

is

(r)

displavs an ..1.S cune thrt becornes contvt'r'tical


uhelr output equals potential otrtput.
rletelv
Horvever', rvlren there arre unemplo,ved resortrces-to
the le[i of 1-r<itential orrtput in the graph----outpr.tt ltill
be deterrnined prinrarilv bv the strength ol'aggregate
dcrnand. r\s investrnerrt incre:ses, this irrcreues ,'l,l),

Part

that. with a t\{PO ol A. the rr.rtrltiplier is 3:


it corrsists of tlrc I of rr-irnary itrvesttnent rltts 2 extra
of secorr<lan consu nl l)tiotr rt-spcncling.
The sarnc arithntctic rtould give a nrrrltiplier of
-1 ftr'a ,lllt, of :2. l;ccarsc | + :tl + (Y)' + ("1\' +
. . . evcntrrnll! atltls trp to 4. lol a I'IPO cf t/'.t. the r]rrltiplier rrorrltl bc 2.1
Tlrc sic of thc rrtr.rltirlicl thtts clcrctrds ttpotr
horv liuge tllc lll'( I is. lt carr :rlso bc cxpr-esst'd itr
tentts of tltc nvitt ct.tttccrt, thc rllPS. Ftr- a IPS of X,
the ,1f1{ is Z antl thc rntrltiplicl is '{. For a }f/lS of'
%, the mtrltipliel is 3. lf tlle rl'fP,S rvcr c l 'x. tltc nrtltiplit'r' rvorrld bc r.
Rl rhis tirne it shorld be cleitl tltat tltc sirlrplc

This

I in

pr'()l.ir-( ssr()r is

l,

abr<ltrtc valttc.

F()r ccrttllries, ccottorltists llavt' rttldctstood the /lr


cational rtle of fisc:rl policl (govcr-nrnerlt t:lx ?tlld
sperrtlirrg pr'ogr arrrs). lt hirs long lrr-crr knorr'tr thal

t40

CHAPTER

7 .

I]LISINESS (]Y(]LES AND ACCRECATE DE}ANT)

iscal prograrns are instrumental in deciding how the


natior)'s otrtput should be divided benr'een collecrive
ancl private consumption and how the burden of par.
IrcDt fbr collective goods should be divided among

(a) Multpler Model

thc poprrlation.

C+l=TE

!rJ

o
0)

Onl,v rvith the development of modern macro.


ccononric theory har a surprising fact been uncor.
clcd: (k.vcr-rrrrrent fiscal powers also have a major
marrueron.m.it itnpact trpon the short-run movemenls
ol outpuL, ernployment, and prices. The knorvledge
that liscal policy has powerftrl effects upon economic
activity lcd Lo Lhe KEnesan approach to mtcroeconomic
politl, wlticb is the active use o government action
to rnodelate btrsiness cycles. This approach was
clcst lilr<l by tlre Nt-rbel Prize-winning macroecon()mistJarncs Tobin as fbllorvs:

0Qop
Real GDP

Kevnesian policies are, first, the explicit clcclication ol rnacroeconornic policv instrurnents to real
<'rrrrrlric goals, in panicular full emplovment and
real grorvth of narional income. Second. Ke;-nesian
dem:rnd managemert is activist. 'fhird. Kevrrcsians
have wished to put both fiscal anrl uroncLalv roli< it:s
ir.l col.lsistent and coorclinatcd llar nt:ss irr thc orrrsrrir
ol macr-oecouonric obicctivcs.

(b) AS-AD Approach


P

In tlris

sectior.r we use the multiplier modcl to shorv


horv government purchases affect output.

-g
OJ

HO}v GOYERNMENT FISCAL


POLICIESAFFECT OUTPUT

0o

GDP
Real GDP

FIGURE 7-8. How the Multiper Model Relates to the


Approach

,4S-AD

The muldplier model is a way ol underslantlirrg thc workings of tl.re A.!-,41) equilibrirrrn.
(a) Thc top rancl shors the outprrtrxpendirure equilit>
lirlr in thc rrrrrltiplier nrodel. At point l, the spending line
.just cuts e 45" line, Ieading to equilibnum outprrr ol Q
(b) The equilibriunl can also be sr:r'n in tlrc l)()ttom
p:rnel, where lhe ,,lD curve culs tll('
curve at point ',
^.S
ln this simplesr busincss<yclc model wages
and prices are
assuned lr lx'fixcd, so the Scurve is horizonal until full
(:rrl)l()yrncn t is reached. Both approaches lead to exactly
th(' sanr(: e<rrilibrium output, Q.

To rrndersLrnd the role of governrncnl irr ccolrouric


actry', we need to look at govemmcnt plrrchascs
and taxation, along with the effects o[ thosc activities on private--sector spending. We now moclify otrr
earlier analysis by adding G to C * 1 to get a new
totaf expenditure cu/c 'llt : (: + I + G. This ncw
schedule can describc thc macroeconornic equilib
rirrm wlren govenunent, with its spendilrg and taxing, is in the picture.

It will simpli$'our task in the beginning if we


analyze the effects ol government purchases with
total taxcs collccted held constant (taxes that do not
change witlr incorne or other economic variables are
callerl htnlrsun. lrzres). But even with a 6xed dollar
valte of taxcs, rvc can rro longer ignore the distincf ion befweelr disposable income and gross domestic
prodlct. [Jnder sirnplified conditiots (irrcluding no
foreign trade, tlansfcns, or depreciation), we know

I0\1' (;OvI.:RN

Nf

t4r

F.NT FISCAI. I'()I,I(:IT:S AFFF,( :T OUTPUT

FIGURE 7-9, Taxes Reduce Disposable


Income ard Shift CC Schedule to e Right
and Down

Each dollar of taxes paid shifis the (,'o


schedule t() the right bv thc amount of
the tax. A rightward (.1(,'shifi also rneans a
thrrvrrwalrl (l(l slrifi, llrl thc <krwnrvard (,'(.'
slrili is lcss rhan thc rightrlard shift. \4hv?
Dec:ruse the downwlrd shift is eqr-ral to the
riqhtrr'ard shili tirnes the ilIP( ). Thts, if the
l\1P(l is'/,, thc drwnuard shili is /l tirnes

4,000
_!

=
b

$300 billion

3,500

ll,l,t

= '/:

$200 billion.

\crifi

that

L1''.

3,000

4,000
3.500
Gross domestic product (bilhons of dollars)

from Chapter 5 that GDP equals disposable incotuc


plus taxe

s.

But rvith tax revenues held ctnstaIrt, GDP

will alwa,vs differ by the sarne alnoulrt; tlrus,


after taking account of such taxes, we can still plot
the C(.i consumption schedule against GDP rather
than against /)/.
Figure 7-9 shows holr the cot.tsumption fitnction changes when taxes are present. This figure
drarvs the original nGtax consumption function as
the hlrre C(.'line. ln this case, GDP equals disposable
income. rr{te r,rse the same consumption ftutction as
in Table 7-2 on page 138. Therefirre, coltsurttptit.rlt
is 3000 rvhen GDP (and D1 ) is 3000, and so forth.
Now introduce trxes of 300. At a D/of 3000, GDI'
must equal 3300 : 300 + 3000. Oonsurnption is still
and

t-igrrrc 7-9 shou's, 200 is the result of mrrltiplving a


dccrcasc irr irrcourc of 300 times the MPC of !r',.

'lrrrrring ncxt to tlre different componetrt-s of

D1

3000 rvhen GDP is 3300 because 1)1 is 3000. rr4e can


therefore plot consumption as a fitnctit.rt t-I GDP

b1'shifiing the corrsumption fttnction rightward to


rhe green ll'C" curve. The amount of the rightward
shift is {,T,1 which is exacth'equal to the amoulrt oItaxes,300.

Altelnatively, we can plot the new colrstInption finction as a parallel dotonuarul shift by'200. As

aggrcgatc dcrnand, recall fronr Chapter 5 that GDP


consists oI lbtrr clcmcnts:

Gl)P

consurnption cxrcnclittr re
+ gloss pli\atc dontcstic inlcstmcrll
+ govcrnrncnt prrrchascs ol'goods alrd
sc rvlc cs

rrcL cxp()rls

: (+ I + (;+

n<w, rvc consirlcl a closed economy with no forcign traclc, so orrr GDP corrsists of the first three
cornpor)cnts, (: + I + (;. (\\'e adcl the final compcF
ncnt, nct cxport-s, rvhen we consicler open-economy

For

rnaclocconomics. )
Figulc 7-10 shors thc effect of inclrrding govelnrncnt prrrchascs. 'l his diagrarn is very simil:rr to
the onc trscd carlict'in this charter (see Figure 7-7).
Hcrc, wc havc arklccl a ncrv expendittrre stream, G, to
the constrruption and irrvcstnrerlt amolrnLs. Diagramnlaticalh,, wc placc thc nc.w variable, (J (government

t42

CHAPTER

ll(

SlNl.SS (:\'(:l-l.ls ANI) A(;GRLGATE DEITIAND

FIGURE 7- 10. Government Purchases


Add OnJust like Inrestnent to
Determine \uilibrium GDP
We non'add govr:trtntt'rtI

lu clras('s orr t()p


ltiorr and investment spending. This giles us the nerv tourl planned

of
C+l+G=TE

4,000

0)

rrr

xpenditrf re schedule. 'l E : O+ I+ O.


At li, whcle th< 7Ji scht.rlrlr. int('r\(.( t\
tlc 4l-r" linc, wc firrrl tlrt'cqrrilil>riunt lcvel
e

C+l

=
5

corrsrr

rt (lDP
3,500

Govornment
purchases

l
!
o
()

.o

Inveslmenl
3,000

Consumption

3,000

3.500

4,000

OP

Gross domestic product (billons of dollars)

prlrchases of goods and sen'ices), on top of the corsunrption fttnction and the fixed rmorrnt of itrvestrnent. The vertical distance between the l.' -f / line
and the new 77i : C + I + (; line is.just rhe quanrirv
()l (;.
\\fhv tlo rre simply add G on the t<lp? Becarrse
spcndirrg on government buildings (G) lras rhe salre

rnacroeconomic impact. as spe rrding ot private brrildirrgs (1); the collective expcnditure invoh'ed in buvirrg a government vetricle ((J) has the same effecr olr
jobs as private consllrnption expenditrlres ()u alltorrrobilcs ( (,').
trl'e end up with the three-layer crke rf -fli:
+
C
I + G, calculating the uorrnt of total spending fbrthcoming at each level of GDP lVe norv rnust
Iocate the point of intersection of the 7Z line with
the 45' line to fir)d rhe equilibriun level of CDP. Ar
this equilibriurn GDP level, denoted by poirrr /i in
Figure 7-10, tot:rl planned speudil)g exacrl,v equrls

tolal planned output. Point /l thtrs iltdicares rhe


cquilibrirrm lerel of output when lve add govertrrnenr
prrlchascs to the mrrltipliet' model.

lmpoct of Toxation on
Aggregote Demond
How rlocs govcr nrr)cnt Laxation tcrrtl to rcdrrce aggregatc dcrrraud allrl thc lcvcl ot GDP? Extra taxcs lowcr
orrr disposablc irrcoulcs, anr[ Iowcrtlisposablc incornes

tcnd tcr rcducc oul consruuption s-rcrrdirrg. Clearlr,,


if inl'cstrncnt anrl gover-rrrncnt ptrrc[rascs rernain
unchangcrl a r-cdrrction in ctrnsunrptir.ll spending
n'ill tlrcu lcrlucc Gl)P an(l cnlployrnent. Thus. in thc
nrtrltirlicl rnodcl, higher taxcs rvitllor,rt increrses in
govcnrnrcrrt pulchascs will tetrtl t<. re<luce real GDP.!
.{ look back at l'igrrre 7-9 c<-nfirnls this rciuor.ling. In this figrrle, the uppcr (.'(,'cune represents rhe
lcvcl ol thc c()nsunlption function rvith no txes. But
thc rrprcl curvc carlnot be thc consumption function bccursc c()ltsulncrs clefinitelv pay taxes on their
incornt's. Srrppose that cor)surncru pay $300 billion
ir taxt-s at cvcr y lcvcl t.l irrcorrrc; thus, D1 is exactly
5300 billion lcss tlrarr GDP at even'lerel of outout.
'

Strictlr speaLirrg.l)! "taxcs irr this clrlptcrrvc nlcaD n('t ra\l's,


or tltx s tttint tt tsli,r r>rrrrrents

H()\r (;OVt.R\II[-]-T l-ls(:.\1. l'()l I(llllS

,\FFU(11 ()L

l Pt l

43

I -t (l ctrrrc trpivaltl. antl raiscs ctui-

As slrorr,rr rrr Fignrle 7-9. this ler'<'l of laxes can be


le-lrcscrrtctl bv a Iightu'ard slri[t irl the cr)trsl I tn pt iotl
fiurctiorr ol $300 billicn. I his rislrtrvard sltift rr'ill :rls<r
appeitr:rs ir tlorvrrrlaltl shili: il'thc ,\lP(.is)/,, tlre rightrvar<l shifi tf $3(X) billion will bc sccn as r clortttrr'ard
shift of $2(X) billion.
\\'itholtt a (l()ttl)t, tit\('s lo\\'ct ()utlJttt irr ottt rtrttlti-

slrifis the O =

rlier rnodel, arrd Figtrr-e 7-10 sllou's u'ltr. \\'ltett taxcs


rise, / * (, does not clrarrge, but the incretsc itt taxcs
rvill lou'er disptsahle irrcorne. tlret'ebl shif ting tltc O(i
colrs r pton schedrtle dorvnrv:rtd. I lerrce. thc (l *

plcst mrrltiplit'r- nrodel. Tlle first c<lrrrrrr shorr's a re[crcllct' Icvcl ol' ( )DP, rrhile tht' sccond shorvs :r fixcd
lcvcl ol'taxcs, 5300 billion. Disposahlc ircorne in
coltrnrr (3) is (;l)P lcss taxcs. Plnncd consurnption.
lakclr :rs a firnction ol 1)/, is shrr'n in colrrnrn (4).
Colrrrnrr (ir) shous tlrc lixccl lcvcl of rlanrrccl irrvestrncnt. rrhilc toltrrrr ((i) cxhilits thc lcvcl ol'gorclrrrrrcnt purclrascs.'Ib f inrl total Illannc(l cxrcrrrlitrrrcs,
77j. in colrrnrn ( 7). *c aclcl t()l{cthcl thc (1. 1, arttl (J in
colrurns (4) tlu otrglr (6).
Finallr. rvc conlparc total dcsilctl cx1;crrdittut's

,f

* li

schedrle shilis dorr'nrvard.

lbu

librium (iDP?)

A Numericol Exomple
The poirrts made up to no$ rre illustrated in
Table 7-3. This table is ven sirnilar to Table 7-2.
rrhiclr illrrstrated orrtprrt deterrr inatio r in the sinr-

c:rn pertcil itt ir

ncu'. lrruer (: - I + li schedrrle in Figrrle 7-10. (bnlir-rn tlrat its lrcw int('rsectiotr rrith tht'{ir' line tnltst
bc at a l()wcr cqrrilihrirrrn level of GDP
Kt'cr in lnirrrl that li is gort'rntrtettt pttrchases of
goorls irncl scr-r'ices. It t'xclurlt's spendirrs on tl:rnsfet's
strclr as u ncrrr )lo\ lnen t insttrance or social secttritv
pir\,ncnts. llresc tr:ursfcrs irrc fr('at('d :rs Itegati\1'

Tlt in colrrnln (7) rvith tlrc initial lclel ol CIDP in


coltrrnr (l ). If desired spcrrtlilrg is irlxl'c (lllP, filrns
raise prodrrctioll t() rllcct the lercl ol spclrtling, ant[
()utpr,lt collsequetItl\ riscs: il tlcsilctl spcntting is
bclorl GDB output falls.'I'his tcn<lclrtr', sllorvlt in tht'
last colturut. itsltulcs r.ts tllrtt or.ltllut rvill tctltl lcrv:u d

tl\es, so tllc taxcs (7 ) consirlcr'<'rl ht'r'e carl best bt'


tlrotrglrt ol rs laxt's lcss tr-irnsfi'r-s. Tlrcrel'rlt', if dir-ect
arrrl irrrli|.ccr tax('s r()tal 54(Xl billior. rvhilt'all tralsIt'r .lavrncnts arc $l(X) billion. tlretr net t;rxes, 7: irr('
11400

$l

r)0

irrclcirsc in socitl

billion. (Oarr vott set' rr'hr' :Ltr


sccuritr bcncllls lotlets 7, r'aises /)/,

$3(X)

its equilibritrm lcvel at $3600 billiorr.

Output Determination with Government Spendng


(billions of dollars)

(l)

(2)

(4)

(3)

(5)

(6)

Initial
level

Taxes
of
GDP T
.1,200 300
3.900 300
3,600 300
3,300 300
3,000 300

Planned
inYestment

Government

3.{i00

2(X)

3.4(X)

3,200
3.000

200
200
200

200
200
200

2.r'](x)

:100

Disposable
income

Planned
consurnption

DI

3,900
3,(i(x)
3,300
3,000

2,700

expenditure

2(X)

200

(7)

(8)

Total
planned
expcnditure, TE
(c+ I+ G)

Resulting
tendency
of economy

4,000

3,800 J

3,600

3,400 T

3,200

Corrtlaction
Clontrction

Equilibrium
Expansion
Expansion

TABLE 7-3. Government Purchases. Taxes. and Investment.Also f)etermirrt' Eruilibriunr GDP

llicr.nrrldc|'Itltltist.xatttl|r..ti|\('silt('.'ltttltrsttttt..

()l)l' nrillrrs $3(X) ltillion Trlt:rl spcrrrlirr{ is / - li - tlrt

t rrrrsrrrlrrtiorr dctt'rrIircd lrr the consrtnrptitlr fttnctirn.


.\rlcrcls<lf<ttttlrtt|t'ss|lttllSl3(i(X)|ril|i<Ir.l|atrttctlsJlerttlirtgisf{|1.i|l('|tl|l|()||ll)|l|.s(,(,lltPlttt'xrirtrrls'

tlrat is, rlirrrrrcrl srcntlirtg t'rtt:rls otttrttt.

144

CHAPTER

ISCAL.POLICY MULTI PLI ERS

7 .

IIT SINIJSS (YCLES

-{\D

AGGREGATE DEMANI)

lhc cxpenditure multiplier. In this case, because the


lPO is A, the rnultiplier is 3, so the equilibrium level
of GDP rises by $300 billion
This example, as well as common sense, tells

The multiplier anal,vsis shows that governrrrent fiscal


polic;- is high-powered spcnding rnuch likc irvestnrcnt. The parallel suggests that fiscal policv should
also havc multiplier elfects r"rpon output. And this is

us that the government expenditure multiplier is


exactly the same number as the investment multiplier. They are both called expenditure multipliers.
Also, note that the multiplier horse can be ridden
in both directions. If government purchases $'ere to
fall, with taxes and other influences held constant,
GDP would decline by the change in C times the
nrultiplier.
The eflect of G on output can be seen as well in
the numerical example of Table 7-3. You can pencil
in a diflerent level of G-sar,, $300 billion-and find
the equilibrium level of GDP. It should give the same

cxactly t'ight.

The government expenditure multiplier is the


increase in GDP rcsulting frc.m an increase of $l in
go!'ernme nt purchases of goods ard senices. An iniLial govcrrrment purchase of a g<.rod or service ll
se t in motion a chain of spendirrg: if e governnlent
builds a road, thc road-btrilders will spend some of

their incomes on consumption goods, rvhich ilr tunl


will gene rate adclitional incomes, sorrre of which ll
be spent. In the sirnple rnodel exarnined here, the
ultimate ell'ect on GDP of an extra dollar of G ll be
tlrc sarnc as the eflect of an ex- dollar of 1: the mtrlriplicr-s arc both equal to l/ ( I
&fPC). Figure 7-1 I
shows horv a change in G will result in a higher level
of GDB nith thc incrcase being a rnultiple of the

answer as Figure 7- I I .
!!'e can sum up:

(ioverrrrnt'nt prrrchases tf goods and sen ices ((J)


ale irn irnpor-tnrrt fi)rce in determining orrtltrrt and
crnrlovrrrent. In the nrtrltiplie ' lnodel, if G incleases,

increase in go\ enrnrent prrrclrascs.


To shou'the effecs of an extra $100 billion ol (i,
the C + 1* G cune in Fiprre 7-l I has been shiltcd
up by $100 billion. The ultimate increase in GDP is
equal to the $100 billion of priman'spending tirnes

r.rLrtrrrt

rvill l'isc bv the increase in G tines tlre expen-

c rrrrrltiplicr. (iovcntment purchases therefore


hrvc llrt' potcnti:rl t() incre:tse or declease otrtptrt

ditrrr

ovcr tht' busincss cvcle.

FIGURE 7- |
Output

l.

The Effect of Higher G on

I+ G' = TE' Suppose that the government mises defcnsc


pulchases bv $100 billion in response to
C+l+G=TE
a tht:at to Mideast oil fields. This shifts
C+

rrprvard the C
ro (:+ I+ G'.

_!

+ I + Gline

by $100 billion

The new equilibnum lel.el of GDP is thrrs


read ofl the 45' line at ll' rathcr than at .
Bccause the WC is %, the new level of ontput is $300 billion higher. That is, rhe government expenditure multiplier is

=
o)

.E
(l)

-l =
:,
;__:_;
t7t

.o

(\!'hat would the government expenditure


nruftipfier be if the ,llPC rvere Vt? elo?\

3,600

3,900
Gross domestic product (billions of dollars)

t4s

FIS(:AI--POI,I(]Y MUT.TIPT,IERS

Economlc Stimulus fiom Defense Spending


Peiod of
war or

Real GDP growth

buildup

Increase in defense
spending as
pertent of GDP

World War I
World War II

l9I6-1918

10.2

13.0

Before Pearl Harbor


AII years
Korcan War
Viemam War
Persian Gulf War
haq War

t939-1941

9.7
41.4
8.0

26.7
69.1

1.9

0.3

9.7
_ 1.3

0.1

0.5

lVar

1939-19,14

1950:3-1951:3
1965:&-1967:l

lfX)0:3-1991:l
2003:l-2003:2

over buildup
period (%)

10.5

TABLE 7-4. Fronomic Booms Accompany Large Increases in Military Spending


'I'his table shons tlr<' pr.r'io<l of thc war or buildup, the size of-the milinry
buildup, and e
n:srrlting in< rcasc in real GDP Major wars h:u,e produced sustained econoric boons, brrl
the last two wars, with relatirely little growth in rnilitarr spending, ha<l only a strall impact
on the economy.
Sorrrce. Depannrcnt <f()nrnrercc, )iatnrrr.rl hrconrc al(l Pr(xhcl Acc(\rnL$, :r!rilablc ar rnrr.t'-yr4 and cstimates t4
irrtho6. I hc dates are year and qrrartcr. I l(,'rcc. lgJ''l):3 is thi. lhr d q u' t(.r ol 1950.

spending, while cautous consumers and businesses, along

AreWars Necessary for Full Employmentl


Historicall economic expansions were
the constant companions of war. As can
b seen n Table 7-4, major wars in the
past were often accompanied by large increases in military spending. In World War ll, for example, defense outlays rose by almost l0 percent of total GDP before Pearl
Harbor was bombed in December 1941. Indeed, many
scholars believe that the United States emerged from the
Great Depression largely because of the buildup forWorld
War ll. Similar but smaller military buldups accompanied
economic expansions in the Korean andVietnam Wars.
By contrast, the Persian Gulf War of the early 1990s
trtgered a recession.The reason for this anomaly was that
ther was but a small increase n mlitary spending and psycholoScal

hctors triggered by the war more than oftet

the ncrese n

C.

What were these psychological hctorsl After haq


invaded Kuwait in August 1990, consumers and investors
became frightened and reduced spending. Additonally, ol

prices shot up, lowering real incomes.These factors then


reversed after the U.S. victory in February | 99 | .
What was the impact of the war in haq in early 20031
This war resembled the Persian Gulf War more than it

did maior wars. There was linle increase n

defense

with high oil

prices, produced a stFong headwind that


slowed the economy.
The role of wanime spending in economic expansions
is one of the most diect and persuasive examples of the
funcioning of the multiplier model. Make sure you understand the underlynt mechanism as well as why the sizes
of the economic expansions shown in Table 7-4 vary so
much.

lmpoct of Taxes
Taxes also have an impact upon equilibriurn GDP,
although the size of tax multipliers is smaller than

that of expenditure multipliers. Consider the follnwing example: Srrppose the economv is at is potcrrtial GDP and the nation rises defense spending by
$200 billion. Such sudden increases have occurrcd
at many points in the history of the United Statesin the early 1940s for World \4hr II, in l9l-r I for tl'rc
Korean wa in the mid-1960s for the Viefnam war,
and in the earl), 1980s clrrring the Reagan adrninistration's military builrlup. Furthermorc, say that ccG
nomic planners wish to raise taxes just crrorrgh to
offset the effect on GDP of the $200 billion incrcasc
in G. I{ow much wolrld taxes have to bc raiscd?

CHAPTER 7 .

146

\{'e are in for a srrrprise. Ti offset the $200 billion


incrcasc in (i ll'e need to increase nx collections by
rnorc than $200 billion. In otr ntmeric:rl example, we
can fincl thc cxact sizc of tlre tax, or 'il increase from Fig-

'flrat figrrre shows that a $300 billion increse

ru-c 7-$.
in 7'r-cduccs rlisposable income by.just enough to prc>
cltcc a constunptinn decline of $2ff) billion rvhen the
l]\)isr/t. Put differcntl1', a tax increase of $30O billion

rvill shili tlc (ll, cun'e doran by $200 billion. Ilence,


whilc a $ I billiorr increse in defense spending shifs

+I+

G line b1' $l billion, a $l billion trx


s tlorvn thc (l + 1+ C line bv only $% billion (when the .&lP(.'is 7r). I'hus olTsctting an increase
in go\rnment purcltues tc<ttircs arl itrcrca-sc in 7larger than rhc increast' in (J.

up tlrc

(,'

incrc:rsc shif

Tlrr cltattgcs ttc u -rorvctlrtl \!cal)()Ir irr aflcctirtg


otrtptrt. BLrt thc t:rx rnrrltiplicl is snrallcr- than llre
expencliture rntrltiplicr l.r'a lat tol ctrr:rl to thc ,llPfi:
Tax nrultiplier'

\,Il'O x cxrctttlittttt rlrLrlti;licr'

Thc rerson the ta-x rrrultiplicl is snrallcr than lhe


expenditure multiplier is straigh tlirrward. Whcrr government spends $l on q that $l ges spcrrt dilcctlv
on GDP. On the other hartd, whett govcrtlllcllt cttts
urxes by a dollar, onlv part ol that tlollar is spcrlt on (,.
while a fraction o[that $l tax cut is savcd.'l'hc tlill-crcnce in the responses to a dollar of (, and to a tlollar
of T is e nough [o lowcr the tax rnultiplicl bclow thc
expenditure multiplier.s

The Multiplier Model ond


the Eusiness Cycle
The multiplier model is the simplest model of
the husiness cvcle. It can show how changes in

' lor

sirrrplicrty. we trkc thc absolutc riltc ()f lhe lax mulripli<'r (sirr<c thc rnultiplicr is actrrlly rrcgative). Tltc difTerent
mukipliers can he sccn rrsing thc dc!icr'ol the "expcnditttrc
rourrds- shown on pagc | 39. l,ct thc M/{, bc r. Then if (i goes
up bl' I unit. the tourl ircrerse in spcnding is the sttrn ofseconclary rcs'nding rottrttls:

I * * :'+'*...=:

I
l-

No$, il taxes are leduced by $I, consurneNsave ( I )olthe


increased disposable income and sx'nd r dollan ()n th(' finit
ound. WiLh the [u ther r oul<Ls, the t(ttal spending is thus

-I'lrus

|-

! | r t

'= L,
_

rhc rL\ mrrlriplier is rimes rhe


multiplier
"*p"n.ti,u..
wltcrc rrs lhc,l'fP(L

ItI.:SINI:SS (Y(:I,F],S AND A(}(;RF](;ATE DETTIAND

to innovation or pessimism, or
spcnding dte to war,
irt
gr-rvcrnrncnt
fluctuati<-xls

invcstn)crrl duc

can lead to sharp changes in outpr,rl. Strpposc tlrat

war breaks out and the countrv incrcascs nrilitar), spending (as illustratcd b;- thc tnany cascs in
Table 7-4). G increases, arrd this lcads to a mtrltiplied increase in out-rut, as sccn in F'igure 7-l l.
lf vou lotk back at Figurc 7-2 on pagc 128, yorr
cln see horv large wars rvcrc accotnpanicd by large

in

or,rtput rclativc to Potcntial otltPrt.


Similarll', suppose that a bulst ol'innovation lcads
to rapid growth in investrnent, as occurrccl with
the new-economy boom of the 1990s. This would
lead to an rprvard shift in the C + I + G curve and
to higher outplt. Again, you can see the results in
Figrrre 7-2. Make sure you can graph each of these
exampfes rrsing the C + I + G apparatus. Als<-r,
make srre you can explain rvhy a revolution in a
colrnrrv that led to sharp decline in investment
rnight leacl to a recession.
increases

Economists often combine the multiplier


model with the accelerator principle of investmenl as an internal theory of the business cycle. In
tlris approach, every expansion breeds recession
and contraction, and every contraction breeds
revival and expansion-in a quasi-regular, repeatir.rg chairr. According to the accelerator principle,
rapid output growth stimulates investment, which
is amplified by the multiplier on investment.
High invcstment, in turn, stimlllates more output
growth, and thc process continlres until the capacity of'thc cconorny is reached, at rvhich point the
ccrnonric growth rate slows. The slower growth,
in trrn, rcduces investment spending, and this,
wor-king through thc multiplier, tencls to send
the cconorny inlo a rcccssiotr. The process then
works irr rcversc rntil thc trorrgh is reached, and
the econorny thcn stabilizcs and trtrns tlP again.
This iutcrnal thcoly of thc brrsiness cvcle shows a
rncchanism. likc thc risc and fall of the tides in
which an exogcnous shock tcnds to propagate
isclt thr<-rugh thc cconolnv in a cvclical fashion.
(Sec <rrestion I I at thc cnd of thc chapter for a
nurnerical cxarnplc.

'l'hc rntrltiplicr rtrotlcl, *ot'kiug togcthel rritir th<'


drlarnics of irlvcstrnclrt, slton's Itorv altt'rttatitrg bottts
()l illvcstrncnt optirnisrn ancl ;cssitnistn, alortu rtith
tharrt's irr otlrcl c\()gcnolrs cxrctrrlitttrt's. calt lcarl
to tlrc Ilrrctratiorrs tllat rvt'call busilress crr'lt's.

t47

SU ItI I'A RY

The Muttipler Model in Perspective


We havc conrpletetl r.rrr introdrct<ry sun'ey of the
Keynesian mrrltiplier model. It will be rrseful to put
all rhis in perspective irnd see horr' the mrrltiplier
m<ldel firs into a broader'ew of the rnacroeconomy'.
Orrr goal is to undernd s'hat determines rhe level
of rational output in r countr),. In the long nrn, a
corlntrv's prodrrction and living standards are largel't,
deternrined by its potential outprt. Rrrt in the short
rrn, brrsincss conditions lvill prrsh thc cconorny
abovc or bclolv its lorrg-tcrm trend. lt is this dcviation
of outpr.rt anrl cnrplovnrcnt fl'onr thc long-tcrrn tlcncl
tlrat wc analvzc with thc multiplicr rnoclcl.

'['ltc rnultiplicr rnodcl has lccn

eno-nrtuslv

rcst tl the world. Finalll', the model omits the srrpply


sidc of the economy:u represented by the interaction of spending n'ith aggregate supply and prices.
All of these shortcomings will be remedied in latcr
chapters, and it is rrselil to keep in nrirrrl that this
first rnodel is sirnplv a stepping stone on tlrc path to
rrndersunding the economy in all its complcxitr'.
The mrrltiplier :rn:rlvsis focuscs trirnalily on
spencling changes as tlrc factors lrchind sh<rt--ulr
output nrovcrncrrts. ln this aprroach, tiscal policv is
often rrscd as a totl to stabilizc lhc cconorrry. But the
govcl'nnrcnt lrrs arrothcr- cqually powcrfirl weapon
iu rrronctarl policr,. Although rnonctary policv works

quitc difll'r'crr

tl1',

it

has nrarry advantagcs as a means

influcntial in business-cyclc theory over the last


half<entury. However, it gives an oversimplified pic-

of' cornbating unemplolment rnd inflation.


The next trvo chapters srlrvev one of the most fir,+

tnre of the economv. One of the most signicirnt ornissions is tlre inrpact of nancial markets and moneurn'

cinating pars of all economics: monev and finarcial


marke6. Once rve understand horv the central bank
helps deterrrrine interest rates and credit conditions,
we lrill have a fuller apprcciation of how govern-

policy on the economl'. Changes in output tend to


affect interest rates, which in turn affect the economy.
Additionally, the simplest multiplier model orrirs the
interactions betrveen the donrestic economy and the

menls cin tame the business cycles that have rurr

ld

throrrgh mrrch of the histon, of capitalism.

SUIrIMARY
A. What are Business Cycles?
l. Business cyclcs <>r fluctuations arc sngs

a. Aggregate Demand and Business Cycles

in

tourl
national <lrrtprrt, irrc<me, and empklvment, merrked bv
widespread exrarrsion or crnt:rction in rnan sr.rtors

.{,ncient s<cicties strffered wherr hrrcst failures pr<>


dtced frmines. l he nrodeln rlarket econonry carr

rl tll<'t't<rrrv. Tht:y rx-r'rrr ir ll arlvnctrl rnarkct


r'<rrronrit's. \4t' rlistirrgrrislr tlrt' rlrasts of cxransion,

a[$ra'Hat(' <k'lnarrrl l<arls t rk'tcrioratirrg lrrsirrcss


c<rrrlitiorrs arrd high unernploymcnt. At othrr timts,
excessive fI()\Krnment spending and reliance on the

reak, rcc<'ssion, and trorrgh.


Most brsincss cy-cles occur rrhen shift^s

in

A rltr lint' irr aggrcgatt' <k'rrarrrl k:arls


tr rt't cssi<ns or cvt'rr rlclrcssi()ns. An llplurn n ec(>
nomic actiriry can lcad to inflatron.
llrrsincss-cycle theories difler in thcir crnphmis on
('x()fac'Ious and intcrnal f:rctors. lmpornrrcc is <ften
:rturched to fluctrrti()ns in such exogenors lactors as
t(r'hrrology, ek:ctiolts, uars, <:xcharrgr'.ralr. rov('nl(:nls,
arrrl oil-pricc slrttks. Most thcories rrnplrasize that
thesc exogenous shr>cks interact with inrernrl mechirnisms, such r-s financial marker bubblcs and brsts.

irrsrfIir-iclrt

nronetiirv printing press cirn lcad to runan':r,v inflation. Undenturnding the fi>rces that allect aggregate

lrggrcgutc

demand crrrse clranges in output. employmelt, ;rrd


prices. Aggregate demard shills rchen ch:rnges in
sperrrling by consumers, brsilt<'sscs, or f{( )r'cnl nl(:t t-s
( lang(' l(tal sx:rrrlirrg rclativ<' lo thc r'<rrrronry's
rrr>
<lrrt tiv<' r arar itv.

srtlli:r lrort rovt'r'ty antirlst rk'rrty rvlrt'rr

demrnd, incltrcling g()vernrnent liscal ancl monetarf


policir:s, carr hclp rx'orronrists and xrlicyrnakr:rs
srnrx)lh out tlt' r'v< k' tl lrrxrrn an<l llrst.

5.

Aggrt'gatc dcrrrarrrl r clrcst'rrts thc total ruarr tity of orrtput willnf{h,bought at a given price levrl, othcr things
hcld c<nstant. OclmponenLs of spenclirrg inclrrde
(n) cr>nsrrmption, which clepends primaril- rrpon dis
posable income; () investment, which depends rrpon
present and expectcd lirtrrre output and upotr interest
-at<'s and taxr:s; (r') g()v('tnnt(:nt trrr<lras<'s of grxxls
and senices: and (/) net cxports, wlriclr deprntl upon

fbreign and d<nrcstic outputs and priccs and upon


lirreign excharrge rates.

CHAPTER 7 . I}LISI\ESS (:Y(:T-IIS A\D AC(iRliGAI'H D[:MANI)

t48

10. lnvestment hs t nulliplird 4led on outprrt. \4tlen


investment changes, output will initially rise bv an
equal amount. But that output increase is also an
inconre increase ltr- consrrrers. As consumers spend
a rart ()f tlrcir a<klitirxral irrt onrr:, this sct.s in rrolirn a
whole chain of additional consumpdon spending and

6, Aggregate demand curves differ from demand cuwes


in nricroecononric irnalysis. I he Al) cunes relate
ovcmll srt:nding orr all conrrrnerrLs ol otrtput to the
ovcrall rrirc lcv<1, rvitlr xrli<-v arrrl cxogcrtorrs variables held constant. The aggrcgatc cltntatttl crtrvr'is
ruscd

7.

downward-sloping because a higher price level reduces


real incorre and real wealtl'.
Factors that change aggregate demand inclrrde (n)
rna< nx'r orrorri<- rolicit's, srtch s f iscal ard rnone tary
policics, and () cxogcttorts varialrlt's, stt<:lt as firrt:itr
economic acdry, technological advnces, and shifts irt
asset markels. When these variables change, the,v shift
the A,l) curve.

employment.
I

spend cf each extrdollarof income


on consunrption, the totirl of e multiplier chain will be

I =
I
: I
IPC I'fP.l
l-
|
multiplier is numerically equal t<r

I + r+ I + ...=
'I'he

simplest

t/(r -

C. The l'lultiplier ilodel


8. Tht: rrrrrltirlicr'nork'l rrrrvirk:s a sirnrk'way to un(lcr'stand the inrpact of aggrcg.rtc tlcrnand on tlrt lcv<'l

MPot.

12. K<:y poinLs to (:rrcnrl)c'r'ar<: (a) thc basic rnultiplier


rrxxl<'l crnrhasizcs th<'introltarrcr: <l sltifi-s in aggrr:gatc dernarrd irr affccting orrtrut an<l irrcorrrc ancl () it
is primarilv applicable for situations with uncmploed

of ontput. In the simplest approach, household constmption is a [unction of disposable income, while
invesnent is lixcd. People's desire to consume and
thc willingness of brrsiresses to irrvest are brought into
balanct: by a(liustIn('nts rr r)rrtput. Tlrt: t'rrrilibrirtnt
lcvcl ofnaliorral olt[)ut r( ( u r'i wlr(:n rlanrrrrl sx'rr<lirr4
cqrrals planned outpr.rt. LIsinH the expen(litrrrc<)lrtput
approach, equilibrium output comes at the intersection o[ the total expenditrrre ( 7)fi) consumption-plusinYestment schedule:rnd thc 45' line.

9. ll output is tenrpomrilv above its equilibriunr

l. lf people:rlwa;rs

resotrces.

D. Fiscal Policy in the l.lultpler l.lodel


13. Tlr' alallris o[fix al x rlicv clalxrat<'s tllr: Kt'yn<si:m rrtultillit'r nrrxlcl. lt slrowr that arr ill< rcas<' in gov('nrrrx'nl
prrrch:rses-urken by isclf, rlith taxes arrtl irrvcstrncnt
unchanged-has an expansionary effect on nation
orrtput much like at of investment. The torl expndi-

turc 77, : (: + I + (; schedr.rle shilts uprrnrcl to a higher


<:rrrilibrirrnr intcnscctior with tlrc 4l'' line.
14. A rk' K.sr: in {ax(:ri-tak(:n bv it-\(.lf , widr in\r'suucnt and

level,

find orrtput highcr tharr sales, widr irrvr:rrtorit's rilirr ur irrvolrrrr tarily irrrrl rrrrfit.s rlrrnlnct irt3.
Finrrs lhcrcf<rt: cllt pnxlu( tion anrl r:rrr lk rlrnt'n t back
toward the rquilibrium levcl. The onl,v srrstainablc
level of output comes when buvers desire to prrchase
brrsin<'ss<:s

l{()v('rrrnr('lrt rrrrchax's rrntharrgrrl-rais(:s thc c(luilil>


rirrn lcvcl <f national outpr.rt. TII(' (,l, v'hcdulc of <rrrrstrmption plolted against (]DP is shifted up$"ard and
lefward by a urx cr.rt. Brrr since the extra dollars of dispnsable income go pardy into s:uing, the dollar increiue
ilr consrrnrplion will not be quite:rs great a^s the increase
in ncw disrosllblc incrmc. Tlcrt f<rrc, thc tax nrultiplit'r
is smaller than thc govemmentrxpe ndittrre multiplier.

exactly :rs much as businesses desire to produce. Thus,


for the simplilied Keynesian mrrltiplier moclel, investrnr:nl talls th(' llrn(' an<l <<rstrrr|lrti('n (lan((s t() th('
mtsic.

COHCEPTS FOR REVIEW


Business Fluctuatons or Cycles

Aggregate Demand

business cycle tr businers flrctuati<>n


business-cycle phases: peak, trough,

aggreg-te demand shifrs and busrness

('xpansl()n,

(:()n t ra(:l

t(

)rl

rcccssion

exogenous and internal cycle theories

lactors underhing and shifng the A.l)

flucluations
agHr('K.rl(' rk'rnan<1, ,4/) < rrrlr'
major c()mponcnts of agHrcgatc

demand:

O,

I,

G,

downwarcl-sloping,{-D cun'e

ltrv('

The Basic Multiplier Hodel

'l'L- (:+ /* (i schedule


outpul an(l sr<:rrding: plarrned
actual lcrr'ls
nrLrltiJrlicr cflu t of iuv('slrr('nf

vs.

449

QL'ESTIONS FOR DtS(:t SSl0N

multiplier

multiplicr cffccts of government


purchases (C) ancl taxes (7')

Government Purchases and


Taraton

=t+MPC+(,!l/{j)r+...
_l_l
I - IIIP(: ML'S

(,'* 1* (i

fiscal rolicy:
G efl'ect on e quilibritrnr CIDP
7'cffect on (;C and on GDP

curve

FURTHER READING AND INTERNET WEBSITES


Further Reading
Tlrc trrotaf iorr lirnl ()kun is Arthur M. Okur, 'l hc Political
fionom of Pro4mit (Nortorr, Ncw Vr'k, lf)7{)), pp. 33 ll.
This is a fascinating book on lllc cc()Ir()tr)i( ltistory of tlrt'
1960s

rritten

Thc classic

by one of America's great macrcecontntisls.

ofbusincss cvclcs by leaclirrg scholars at the


National Burear of F.corr<rrric Rcst'arclr (NRF.R) is Althru'
F. Brrrns and \4'esley Clair Mitchell, Measuring Busine.ss
(,-rclr.s (Columbia Unilersitv Press, New York, 1946). This
is available liom the NIJ[.R at uur.nbt org/boohs/burn4(> L
Thc nrrrltiplier nrodel was developed b.v.John Maynard
Kt'vrrcs in

stu<ly.'

7-h

(hntrtl'l'lmnl

oJ

I',nlt,!Tu'nl, In"r?sl en.l Mone,t

(Harcourt, Ncw Y<rrk, firrt rublislrt'rl irr lf)35). Alvart< r:d


treanenr can be f<und in rhe intcrmcdiatc tcxthxrks
listed in the Further Reading section in Ohapter.l. One of
Kt--vnes's most

influential

l<><ks. 'l he

liconomie ()msenurnts

of the Peru e (1\ll\l), rlr:dictt.rl with rrrrcanny accru acy that tht.
Trcatr' of \e naillcs worlt'l lcd to disastrors consequences
for Europe.

Websites

consortium

of

macroeconomists participates

in

the

NBER program on economic fluctuations and growth. You


can sample the rrriungs and data at uau.nhexorg/Wgrans/
eJg/eJg.htnL 'I'he NBER also dares business cycles lbr the
llnitcrl Statcs. Vrr < al s<'r: lhr: rcc<:ssirrs alrd exoansions
afrrrrg witlr a <f iscrrssirrrr at nrunt.nhr.ugl/cyrlz,i. htmL

Business<ple data and discussion can be found at the


ol Eccr'romic Analysis, totau.bea.gou. 'I'he
first [t'w ragr:s of tlrr' .Sznrry o[ (htrrtnl lirirzrr, availabl<' at
unuu.bea.gou/bea/zs. frn, corrtain a discussion of rcccnt

sitr: of thr: Brrreau

business<vcle del'el<omens.

QUESTTONS FOR DTSCUSSTON


l. Dcfinc cart'firlll tlrc rlifli'rcn<r' lx'tw('('r

nr(v(:nrent.s

4.

along e,{1)crrn'e and shifts of thc r1l)crrrve. F.xrlairr


wh,v an increase in potential output would shift out the
A.\ cun'e and lead to a movement along the AI) curve.
F.xrlairr rvlr,v a tax cut would shili the A/)cun'e outwrd
(increasc aggrcgatc dcnrarrrl ).

Constnrct a table parallt'l t< Tablc 7-1. listirrg t'vcrrt.s


that wotrld lead to a drwn^se in aggregatc de manrl.
(Your nble should prode different examples rather
an simplv changing the direction of the factoru mentioned ir 'l'able 7-l.)
3. Ir r'('(('rrl !'(:a, a n('$ tlrtrny ol rr:al btnitress cycles
(or RB(is ) lras lrt'r'n rrorr>srrl (this arproach is fittther analyzed in Chapter l7) . RBO theory suggcsts tltat
business fluctuatitns are cattsed by shocks to productivit,v, rvhich d)err propatrte thr()ugh the econonr'.
a. Show thc RBO tlrcory irr tlr<' ,4.T-,1/) liarrrcwrrk.
b, Discrrss whethcr thc RBC thcory t'arr t'xrlairr tlrt'
customirry charircteristics of business flrtcttations
describecl on pages 128-129.

5.

ln the sinrple mulplier model, assume that investrrt.rl is alwavs zt.r'o. Shrw that cquilibrium output in
this special casc worrkl corn( at thc blr:ak<'vcn xrint
of the consumpon function. l4hy would equilibrium
outprr come aboae the break-even point when investrrcnt is positive?
l)t'lirrr: t ax:lirlly w'lrat is nreant

b,v

equilibrium in the

nrultirlicr rnrxk:|. For cat h ol th<: fblkrwing, state why


the sitrratitn is zol arr t'<rrililrrirrn. Also rlt:sr:ribc how
the econonry rvould react to each of the sitrratiors to
restore equilibrium.
a. In -lhble 7-2, GI)P is $3300 billion.
b, ln l'igtrre 7-7, actrral investment is z-ero and output
is at ,[f
c, (hr dealrrs fintl that thcir invclttorics of nt'w cars
are rising unexpectedly.
6. Reconstnrct 'lhble 7-2 assunring that planned inlestrrrcnl is crrr:rl t() () $3(X) billion and () $400 billion.
\A'hat is tlrt' rcsrrlting rlifli'rcncr: in (;l)P? ls this dillerence grerfer or smallcr than thc changc irr 1? Why?

t50

7.

cHAPTER

When .l drops from $200 billion ro $100 billion, how


much must GDP drop-
Give (n) the cornmor sense, () rhe ar-ithrnetic, and
(.) tlrc gconretrT ol th<: rnultirli<'r'. W|rt arr: lrt.rrrltirlicrs f<rr hIPO = O.9? 0.8? 0.5?
arr<l usirrg thc notioll of cxpenditure rounds rvhy the ux multiplier is smaller than the

8. Fix;lain in wortls

expenditure multplier.

9. "Even if the government spends billions on w.stelil


militarl arrnaments. this acton can cr('at(: jobs irr a
rct cssitr.- f)iscuss.

of nations depends
cnrcially on saling and investment. furd from youth

10. Advaced problem: The growth


we are taught that

thrift

is

impornnt and that "a pennv

saved is a penny earned." But rvill higher-savirrg nec-

essarily benelit the econorny?

ln a slriking argur('nt

/r lruru nx of lnf, Kcvncs xrirrt<'<l orrt thal


whcn pcoplc attempt to save more. this will not necessarilv result in more saring for the nation as a rvhole.
To see this point, assume that people decide to
save nore. Higher desired savirrg nrcans lowcl rlcsilcrl
conslunl)ton, rr'a <lrwrrrvarrl shift irr the consrtnption
frtrction. lustratc horv an increase in desirecl saving
shifs down the 7E curve in the mrrltiplier model of
Figrrre 7-7. Explain whv this will dcrrsr ouryut tltith
no inoeasc in saving! Pr<lride the inruitiotr here rhat if
people tn to increase their s.rling and lower their colrsumption fbr a giverr level of busirrcss irrvr:strn<:nt, sl<'s

called

will fall and

tlsirrt'ss<'s

will < ut back on pnxlrrctiorr.

7 .

C)nc sequence rhrrs obutined nns 7, 4, 10, 3, 7, I I,


I, 10,. . . The avenrges were (7 * 4 + l0+3+
7)/5 : 6.2:(ll + 7 + 2 + 9 + l0)/l- = T,andsofbr-th.
Why rloes t}is lurk likr: a brrsirrt'*s cyck.?
I Hint: Thc ranrlorn lunrbcrs generated by the
dice arc like exogenous shocks of investment or wars.
The moving average is like the economic system's (or

7,2,

a rocking chair's) internal multiplier or smoothing


mechar.isnr. 'Ihken togethr:r; thrv producc rrhal kxrks

likc a o'r'lc.l
12. Dafa problem: Sorrrc ccorromisls preler an objective,
qrantitative definition of a recession to the more subjectire approach tsed bv the NBER. These economiss
define a recession as any period during which leal
C}DP declined lbr at least two qrrarlcrs ir a rrw. Notc
liorn lhc tcxl that this is zr,/ thc way the NBER defines
A recetslon.

a.

b.

l.

Advanced problem 57ting e multiplier-accelerator mechanism: Find two dice and use the following
technique to see if you can generate something that

Get quarterly daa on real GDP for lhe United


States for the period since l9.1tl. 'l'his car.r be
obtained h'om the wetxite of- the Bureau of Eco
n<rrnic :\nalysis, untqL'.het,gtv. Pr thc data il a
<rlrnrr rf a srrcarlslrt'<'t, akrrrg witlr tlrc cr>rrcsronrling datc in anothcr colLrmn.
flalctlare in a spreadsheet rhe percent growth rate

o[ real GDP for each quarter at an annual rate.


'l'his

is the paradox
tlrrif t: When the conlnruniry desiles to savc nl()r'(.. tlrr: <'lli'ct nra,, at lrrallv lx.
a lorvcring rf irrrorrc antl rtrrtlrt with no increase <tf
savi n g.

ANIr A(i(;RF,(;AI t t)UMANt)

looks like a business c-ycle: Record e rumbers from


20 or nrore rolls ol the dice. 'Ike Iire-period moving
avel-ages ol tht' srcccssivr: lrnrlx:rs. Thcrr rl<lt (lrcse
a\('r'ag('s. Tlrcy will l<xrk vcry nrrrch likc movements in
(]DP, rncmJlo,vlnent, or in flation.

F.xplain how far output will fall.

Ilere then

Rt_TStNESS TiYCLF.S

c.

is

calcrrlated as lbllows:

&:400 "

-';

Under this alternar,e delinition, which periods


would vou idenfy as rcccssions? Fol wlriclr ycarr
dot:s tlis altcrnativc obicctive :rocedure reach a
corrclrrsion different from that of the NBER?

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