Business Cycles

The Theory

Business cycles
What is a BC? What causes the economys ups and downs? Can one explain the reasons for the economys instability? Can the cycles be controlled?

Market Economy
BC is a characteristic feature of market economy. Classical theory believed that the cyclical effects are temporary. There could be no depressions Market mechanisms of price and wages could correct temporary disequilibrium. Economy always self adjusts to deviations from its long term growth. History till 1930 supported the beliefs.

Says Law
Says Law Supply created its own demandsupported the argument . The moment goods are produced it generates income. If it is unsold at a particular price prices would fall and correct the imbalance.

The Depression
The Great Depression was a blow. Effectively destroyed the credibility of Classical economic theory. Keynes developed an alternative view of the macro economy. Calamities would recur if we relied on the market mechanism to self adjust.

The role of Government

To correct instability it required market mechanism Govt can do this pump priming- by buying more output, employing more people, providing more income, providing more income transfers, and making more money available. Similarly when the economy overheats, government must cool it down with higher taxes, spending reductions and less money.

History of some cycles

The Great Depression The asset bubble The East Asian crisis Recession of 2000 The subprime crisis

The Macro Model

To understand the causes and consequences of the cycles one needs to understand the macro model.
Determinants Internal Market forces
External shocks Policy Levers

Outcomes Output
Jobs Prices Growth International Balances

Determinants
Internal Market forces External shocks Policy levers Population, spending behaviour, invention, innovation Wars, natural disasters, terrorist attacks, trade disruptions Interest rates, tax policy, government spending and regulation.

Internal Market forces

Aggregate supply and Aggregate demand Aggregate supply curve slopes upwards Due to the profit effect and cost effect. Aggregate demand sloped downwards due to real balance effect, foreign trade effect, interest rate effect.

Demand factors for instability

Keynes argues that macro instability is largely caused by demand factors Equilibrium rate of output falls short of capacity production. Even if there is an equilibrium between the aggregate demand and supply, this may not be a full employment equilibrium or the equilibrium may not be a permanent one.

Deficiency of spending
It is the deficiency of spending that tends to depress the economy. This deficiency might originate in consumer saving, inadequate business investment or insufficient government spending. Lack of spending leaves the production capacity unused. The AD curve shifts to the left

Aggregate Demand
Components of AD AD = C + I + G + X M Consumption Consumption expenditure constitutes to two third of the total aggregate demand in the US. Therefore a small change in C would alter AD thoroughly.

 Disposable income = C + S To figure out how much consumer spending will add to aggregate demand we need to know how much disposable income will be consumed and how much saved due to change in income. Some statistical measure of consumption

APC = C/Yd MPC = change in C/ change in yd APC in 2008 was seen to be .98 but MPC =0.8 MPS = 1-MPC

The consumption Function

C = a + bY Determinants of Consumption Income and Autonomous consumption Autonomous consumption a. Wealth b. Expectations c. Credit d. Taxes

 Shifts in any of the functions like the C or I or G or E or I shifts the AD curve. Usually a change in consumer expectations sifts the autonomous consumption like for example during the terrorist attack. Investment is a function of rate of interest and Expectations Similarly the government and net export spending shifts the AD Curve. Fall in net exports shifts the AD curve to left.

Leakage and AD
Output not demanded by consumers CF 100 AS

Price Level

50 Real consumer demand at QF

2,350

3,000 QF

Real GDP

Index of Leading indicators

Average workforce Unemployment claims Delivery times Credit Material Prices Equipment orders Stock prices Money supply New orders Building permits Inventories

 Index of leading indicators help the investors and policy makers to foresee what aggregate in the economy is going to be like.

Leakages and injections

Why and How aggregate demand falls short of aggregate supply Leakages in the circular flow

Leakages

Saving

Imports

Household taxes

Business taxes

Business saving

Why
Why would there be too much or too little AD? Some imbalance between AD and AS would happen due to mismatch between leakages and injections

Circular flow
The factor market receives income in the form of wages, rent, interest and profits. For the flow to be continuous all income should be equal to consumer expenditure. But this does not occur since consumer savings, imports, taxes and business savings leak from the circular flow. If this leakage is not offset by other factors some output will remain unsold.

Injections
Business Investments, government purchases of goods and services and exports inject spending into the circular flow adding to aggregate demand. If all income generated in product market went to consumers then the economy may be in full employment.

Imports and taxes

When consumers buy imported goods their spending leaves the domestic circular flow and goes to foreign Income spent on imported goods is not part of aggregate demand for domestic output. Similarly, taxes, gross business savings and corporate taxes go out of the circular flow. But this can be substituted by injections of investment, govt expenditure and exports.

 But the critical issue of macro stability is whether spending injections will actually equal spending leakage at full employment. Classical economists believed that spending injections would always equal spending leakage.

Why it may not?

If consumer savings exceeds business investment unspent income pile up somewhere. Classical economists believed that if interest rates fell business investments would equal the savings. But as Keynes puts it what classical economists ignored is the expectation factor in investment.

 With pessimistic expectations AD is likely to be pushed to the left. Falling prices beyond an extent can lead to deflationary tendencies

Deflation
Deflation would arise from too much supply chasing too little demand. Prices would drop as companies competed for buyers. But lower prices could squeeze corporate profits, hurt the stock market and pressure companies to fire workers and cut wages. Companies and farmers will default on loans which are fixed while the prices they receive fall. Consumers might delay purchases, believing future prices will be lower.

The Multiplier
How spending shortfall leads to worsening situation through the multiplier process. The cycle: Fall in consumption caused due to terrorist attack Consumers cut down their spending This led to unwanted inventories Business investment was cut back and capital goods started piling up. This leads to lack of investment demand

If the economy is in equilibrium at point F

Consumption Investment Govt exp Net exports

2350 billion $ 400 billion 150 billion 100 billion 3000 billion

 Say for example invt demand falls by 100 billion at the existing price level P0. This shifts the AD Curve from ADo to AD1 And immediately moves from F to D. At d however excess inventories prompt firms to reduce prices. As prices fall the economy gravitates towards the new equilibrium GDP at point b. At point b the rate of output Q1 is less than full employment level QF and the price level has fallen from Po to P1.

AD Shift
AS

PRICE LEVEL

$100 billion decline in I F d b AD0 AD1

P0 P1

$2,900

Q1

QF = $3,000

REAL OUTPUT

The Multiplier

 When production is cut back people are laid off. This leads to fall in the income dependent consumption. As a consequence AD will fall further leading to sequence of events. What starts off as a relatively small spending shortfall snowballs into a larger problem.

Multiplier process
1. Consumers cut consumption 2. The $ 100 billion fall in investment 3. Undesirable inventories 4. Cutback in employment and wages 5. Income reduced by $ 100 billion 6. Sales fall by $ 75 billion more (C = 100 + 0.75 Y)

 Unwanted inventories further cut back in employment Income reduced by $ 75 billion more Consumption reduced by 56.25 billion. The multiplier process continues to work until the reduction in income and sales becomes small that no ones market behaviour is significantly effected.

 The ultimate reduction in real spending resulting from the initial drop in investment is not $ 100 billion per year but $ 400 billion. Multiplier = 1/1-MPC Or 1/MPS Here MPC = .75 and MPS = .25 so Multiplier = 1/.25 = 4 So initial reduction in investment of 100 caused the income to decline by 400.