5- Business Cycles and Aggregate Spending Flashcards
Peak definition
The top of the cycle ñ productive capacity fully utilised shortages may start to develop.
Recession definition
- Is a downturn in activity - a recession is defined as a fall in real GDP for two successive quarters.
- Typically incomes and employment levels fall. Profits may also decline as some firms experience financial difficulties.
- A recession that is deep and long lasting is called a depression.
Trough definition
Characterised by high unemployment and low demand in relation to the capacity to produce. Business confidence is low.
Recovery definition
Characterised by rising incomes, employment and consumption.
Business expectations become more optimistic and new investment projects are begun.
J.A. Hobson description on cause of recession
The cause as over-production due to savings being too high and consumption too low (due to the unequal distribution of incomes, as the rich spent less than
the poor).
Who came up with the short run general theory?
Keynes
Macroeconomics short run definition
A period in which the economy maintains a deviation from potential output, or a GDP gap. Often associated with the existence of spare capacity or unemployment (output gaps).
Macroeconomics long run definition
A period sufficient to allow time for the automatic adjustment mechanisms to return economic activity to our model’s assumed equilibrium after it has been disturbed by an exogenous shock.
Desired spending definition
Refers to what people want to spend out of the resources that are at their command.
Aggregate spending (AE) definition
Total desired spending on domestically produced goods.
AE= C + I + G + (X-M)
What does national accounts measure?
Actual spending in each of the 4 categories: C + I + G + (X-M)
Autonomous/ exogenous spending definition
Components of aggregate spending that do not depend on current domestic incomes.
It can change but not in response to changes in income.
Induced/ endogenous spending definition
Components of aggregate spending that do change in response to changes in income.
The Consumption Function
C = α + bY
α = autonomous consumption
b= marginal propensity to consume
Y= income
What is consumption spending mainly affected by?
Disposable income
Average propensity to consume (APC)
Total consumption spending divided by total disposable income.
APC= C/Y(d)
Relationship between APC and disposable income
APC falls as disposable income rises.
Marginal Propensity to Consume (MPC)
Relates the change in consumption to the change in disposable income that brought it about.
MPC= Change in consumption/ change in disposable income
MPC in Keynesian consumption function
Constant
Summary of short-term properties of consumption function
- There is a break-even level of income at which APC equals unity. Below this level, consumption exceeds income, so households use savings or borrow. When APC>1- there are positive savings.
- MPC between 0 and 1.
The role of the 45 degree line
- To help locate the breakeven level at which consumption spending = disposable income on desired consumption against real disposable income curve.
- To locate equilibrium of AE and GDP.
Savings Function
S = Y -C
S= -α + (1-b)Y
α = autonomous saving
(1-b)= MPS
Average propensity to save (APS)
The proportion of disposable income that households want to save.
APS = S/Y(d)
Marginal propensity to save (MPS)
Relates the change in total desired saving to the change in disposable income that brought it about.
MPS= change in S/ change in Y(d)
Sum of APC and APS
APC + APS =1
Sum of MPC and MPS
MPC + MPS =1
Where is the breakeven level of income on consumption function
Desired consumption equals disposable income, desired saving is zero.
Wealth and the consumption function
- Higher levels of wealth= higher consumption
- Less disposable income needs to be saved for the future.
- Increases the incentive to save.
- Shifts consumption function upwards.
Interest rate and consumption function
- Higher interest rate= less spending
- High rates encourages saving, discourages borrowing.
- Mortgage payments will increase for those on variable mortgage rates.
- Lower assets values- less wealth- less consumption.
- Higher interest rate lowers autonomous consumption.
3 major forms of investment
- Investment in inventories
- Investment in residential housing construction
- Investment in business fixed capital
At this stage, how do we treat investment?
As exogenous
Investment volatility?
Most volatile part of GDP
Aggregate spending function
- Relates the level of desired real spending to the level of real GDP.
- AE (agg. spending) = C + I
The Propensity to Spend out of GDP
- The fraction of any increment to GDP that will be spent on purchasing domestic output.
- Symbol of c.
- = change in aggregate spending/ change in income
Slope of AE function
The propensity to spend out of GDP
The marginal propensity not to spend
- The fraction of any increment to GDP that doesn’t add to the desired aggregate spending.
- Denoted as (1-c)
What does the marginal propensity to spend and the marginal propensity not to spend equal in a simple model?
MPC = c
MPS = (1-c)
Where is GDP equilibrium
Where aggregate desired spending (AE) equals national output.
What happens when AE>Y?
- Firms incentivised to increase current output and therefore GDP rises.
What happens when AE<Y?
- Firms incentivised to cut current output and therefore GDP falls.
Effect of AE=GDP
- Purchasers can fufill their spending plans without causing inventories to change.
- There’s incentive for firms to alter output.
- Everyone wishes to purchase an equal amount to what is being produced.
When is there equilibrium GDP graphically?
- Where AE curve meet 45 degree line
- Where S=I
How to graphically (AE) show changes in GDP?
Shifts in AE
2 types of shifts of AE
1) Parallel shift- same addition to spending occurs at all levels of income.
2) AE slope change- if there is a change in the propensity to spend out of GDP.
