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ch15 CMBA 401

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Business-Finance

Published on April 10, 2008

Author: Alfanso

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Slide1:  Chapter 15 Economic Fluctuations Economic Fluctuations:  Economic Fluctuations Neither output nor employment grows as smoothly and steadily as classical model predicts United States and similar countries have experienced economic fluctuations During recessions, output declines—occasionally sharply During expansions output rises quickly—usually faster than potential output is rising In later stages of expansion, output often exceeds potential output Called a boom Why do economic fluctuations Occur in the first place? Sometimes last so long? Not last forever? Figure 1(a): Potential and Actual Real GDP and Employment, 1960-2001:  Figure 1(a): Potential and Actual Real GDP and Employment, 1960-2001 Figure 1(a): Potential and Actual Real GDP and Employment, 1960-2001:  Figure 1(a): Potential and Actual Real GDP and Employment, 1960-2001 Spending and Economic Fluctuations:  Spending and Economic Fluctuations Why are there booms and recessions? Much of our current understanding is based on the original work of John Maynard Keynes In his 1936 book, The General Theory of Employment, Interest, and Money, Keynes made two arguments A major cause of booms and recessions is fluctuations in private sector spending Accepted by most economists today In order to keep output close to its potential level Government must counteract changes in private sector spending By adjusting either its own spending or taxes A controversial argument Spending And Economic Fluctuations:  Spending And Economic Fluctuations Business firms will not continue producing output that they cannot sell They respond by reducing output and laying off workers Laid-off workers see their incomes decline They will spend less on a variety of consumer goods Other firms cut back on production and lay off workers If the contraction is sharp enough we may enter a recession When total spending suddenly increases firms will produce more output and hire additional workers The result is an economic expansion, and—if the expansion is sharp enough—a boom Thinking About Spending:  Thinking About Spending Before we begin our analysis of spending, we have two choices to make How should we organize our thinking about spending? The most useful approach is to divide spending into four broad aggregates Consumption spending (C) Planned investment spending (IP) Government purchases (G) Net exports (NX) Our second choice in analyzing spending is whether to look at nominal or real spending We care more about real variables because they are more closely related to our economic well-being For this reason, we will think about real variables right from the beginning “Consumption spending” means “real consumption spending” “Investment spending” means “real investment spending” Consumption Spending:  Consumption Spending Household spending on consumer goods is about two-thirds of total spending in the economy What determines the total amount of consumption spending? Disposable Income—the income of the household sector after taxes Disposable income = Total Income – Net Taxes Net taxes are the taxes the government collects minus the transfer payments the government pays out Net Taxes = Tax Revenue – Transfer Payments In macroeconomics, we are interested in the tax dollars that flow from the household sector to the government When we calculate disposable income, we subtract transfer payments from taxes before we subtract the result from total income The Consumption Function:  The Consumption Function The relationship between consumption and disposable income is a positive one A rise in aggregate disposable income causes a rise in aggregate consumption spending Consumption Function A positively sloped relationship between real consumption spending and real disposable income Autonomous Consumption The part of consumption spending that is independent of income Vertical intercept of the consumption function The Consumption Function:  The Consumption Function The marginal propensity to consume (MPC) is Slope of the consumption function Change in consumption divided by the change in disposable income Amount by which consumption spending rises when disposable income rises by one dollar We will always assume that 0 < MPC < 1 Figure 2: U.S. Consumption and Disposable Income, 1985-2002:  Figure 2: U.S. Consumption and Disposable Income, 1985-2002 Figure 3: The Consumption Function:  Figure 3: The Consumption Function Consumption Function 1,000 600 Representing Consumption with an Equation:  Representing Consumption with an Equation Use an equation to represent the straight-line consumption function The most general form of the equation is C = a + b × (Disposable Income) The term a is the vertical intercept of the consumption function Called autonomous consumption spending The other term, b, is the slope of the consumption function Shifts In the Consumption Function:  Shifts In the Consumption Function If disposable income rises, consumption spending will rise with it Other factors influence consumption spending For any given level of disposable income, expect a drop in the interest rate to cause an increase in consumption spending Graphically, this is represented as an upward shift in the consumption function Another determinant of consumption is wealth—the total value of household assets minus total outstanding liabilities For any level of disposable income, a rise in household wealth will cause an upward shift in the consumption function Shifts In the Consumption Function:  Shifts In the Consumption Function Expectations affect consumption spending If households become more optimistic about their job security or expect higher future incomes They are likely to spend more of their income now Shifting the consumption function upward When a change in disposable income causes consumption spending to change, we move along the consumption function When a change in anything else besides disposable income causes consumption spending to change The consumption function will shift Figure 4: A Shift In the Consumption-Income Line:  Figure 4: A Shift In the Consumption-Income Line Investment Spending:  Investment Spending Investment (I) consists of three components Business spending on plant and equipment Purchases of new homes Accumulation of unsold inventories When analyzing total spending in the economy, we define investment spending as Planned plant and equipment purchases by business firms and new home construction Inventory investment is treated as unintentional and undesired Excluded from our definition of investment spending Government Purchases:  Government Purchases Government purchases include all of the goods and services that government agencies buy during the year When analyzing total spending in the economy Government purchases are treated as a given value Determined by forces that are outside of our analysis Net Exports:  Net Exports About 11 percent of American goods and services are sold to foreign consumers, business, and government These are exports and they must be included in our measure of total spending International trade in goods and services also requires us to make an adjustment to the other components of spending This means we will be deducting total imports from our measure of total spending Net Exports = total exports – total imports Summing Up: Total Spending:  Summing Up: Total Spending Total spending is the sum of spending by households, businesses, the government, and the foreign sector on final goods and services produced in the United States Total Spending = C + IP + G + NX Total spending plays a key role in explaining economic fluctuations Over time business firms tend to respond to changes in total spending by changing their level of output Total Spending And Equilibrium GDP:  Total Spending And Equilibrium GDP When total spending is less than GDP, firms will decrease production and GDP will drop When total spending is greater than GDP, firms will increase production, and GDP will rise When total spending is equal to GDP, firms will continue producing at the same rate, and GDP will remain unchanged Equilibrium GDP is the level of GDP that tends to remain unchanged—that is, the level of GDP at which total spending and total output in the economy are equal C + IP + G + NX > GDP  GDP↑ C + IP + G + NX < GDP  GDP↓ C + IP + G + NX = GDP  No ΔGDP Note that the economy’s equilibrium output need not be its potential output A Change in Investment Spending:  A Change in Investment Spending Business firms decide to increase yearly investment purchases by $100 billion above the original level The $100 billion in additional output will become $100 billion in additional income What will households do with their $100 billion in additional income? Household tax payments do not change at all with their additional income MPC is 0.6 Households will save the remaining $40 billion When households spend an additional $60 billion Firms that produce consumption goods and services will produce and sell an additional $60 billion in output An increase in investment spending will set off a chain reaction Leading to successive rounds of increased spending and income The Spending Multiplier:  The Spending Multiplier ΔGDP = 2.5 × ΔIP The spending multiplier is the number by which a change in spending must be multiplied to get the change in equilibrium GDP The value of the spending multiplier depends on the value of the MPC Simple formula we can use to determine the multiplier for any value of the MPC For any value of the MPC, the formula for the spending multiplier is 1/(1-MPC) Using the general formula for the spending multiplier, we can restate what happens when investment spending increases The Multiplier In Reverse:  The Multiplier In Reverse Just as increases in investment spending cause GDP to rise by a multiple of the change in spending Decreases in investment spending cause GDP to fall by a multiple of the change in spending The multipler formula we’ve already established will work whether the initial change in spending is positive or negative Other Spending Shocks:  Other Spending Shocks Shocks to the economy come from other sources besides investment spending Changes in investment, government purchases, autonomous consumption, or net exports lead to a multiplier effect on GDP The spending multiplier—1/(1-MPC)—is what we multiply the initial change in spending by in order to get the change in equilibrium GDP The following equations summarize how we use the spending multiplier to determine the effects of the four different types of spending shocks Other Spending Shocks:  Other Spending Shocks Changes In Net Taxes:  Changes In Net Taxes There is one additional factor that can change total spending and lead to a multiplier effect on output Net Taxes Changes in net taxes lead to a multiplier effect on GDP Although the multiplier for tax changes is smaller than for other spending changes A cut in net taxes causes GDP to rise, while a rise in net taxes causes GDP to fall Spending Shocks In Recent History:  Spending Shocks In Recent History Economy is constantly buffeted by shocks, and they often cause full-fledged macroeconomic fluctuations Increases in oil prices Military cutbacks Increases in interest rates Military buildups Falling oil prices Etc. In addition to these identifiable spending shocks, the economy is buffeted by other shocks whose origins are harder to spot Each shock has momentum Booms and recessions do not last forever Automatic Stabilizers:  Automatic Stabilizers Automatic stabilizers reduce the size of the multiplier and therefore reduce the impact of spending shocks on the economy With milder booms and recessions, the economy is more stable Real-world automatic stabilizers Taxes Transfer Payments Interest Rates Imports Forward-looking Behavior Due to automatic stabilizers, spending shocks have much weaker impacts on the economy than our simple multiplier formulas would suggest There is one more automatic stabilizer you should know The passage of time In the long run, our multiplier has a value of zero No matter what the change in spending or taxes, output will return to full employment so the change in equilibrium GDP will be zero Countercyclical Fiscal Policy:  Countercyclical Fiscal Policy What you’ve learned about the multiplier process not only helps to explain what causes economic fluctuations It also suggests a method of preventing them Countercyclical fiscal policy Any change in government purchases or net taxes designed to counteract spending shocks and keep the economy close to potential output Why do economists recommend against using countercyclical fiscal policy, and why does Washington mostly follow their advice? Timing Problems Irreversibility The Reaction of the Federal Reserve Using The Theory: The Recession of 2001:  Using The Theory: The Recession of 2001 Our most recent recession lasted from March 2001 to November 2001 Investment spending and real GDP fell sharply during the second quarter of 2001 and continued to fall throughout the year What caused these successive decreases in investment spending? Businesses rushed to incorporate the internet into their business practices But as 2000 ended and 2001 began, firms had begun to catch up to the new technology The rush ended and investment began to fall The internet and other new technologies made the public very optimistic about the future profits of American businesses Using The Theory: The Recession of 2001:  Using The Theory: The Recession of 2001 In late 2000 and early 2001, reality set in Optimism shifted to pessimism The final reason for the investment shock was the infamous terrorist attacks on the World Trade Center and the Pentagon on September 11, 2001 One abnormal feature of the recession of 2001 was the behavior of consumption spending Consumption spending actually rose during every quarter of 2001 Part of the reason for the upward shift was a 10-year tax cut that went into effect in June of 2001

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