National Income Determination Flashcards
Business Cycles
They are economic-wide fluctuations in total national output, income, and employment usually lasting for a period of 2 to 10 years marked by widespread expansion or contraction in most sectors of the economy.
Two main phases of business cycles
- Prosperity
2. Depression
All the phases of the business cycle
- Expansion
- Peak
- Recession
- Trough
- Recovery
Expansion
There’s an increase in various economic factors such as production, employment, output, wages, profit, demand and supply of products, and sales.
Peak
Increase in growth rate of business cycle achieves its maximum limit
Recession
Is a recurring period of decline in total output, income, and employment lasting usually from 6 months to a year and marked by widespread contractions in many sectors of the economy.
Trough
Economic activities of a country decline below the normal level. Growth rate becomes negative and there is a rapid decline in national income and expenditure.
Characteristics of recession
- Sharp contraction in consumer spending
- Fall in labour demand
- Fall in inflation rate
- sharp falls in business profits
Two main theories of business cycles
- Exogenous
2. Internal.
Exogenous sources of business cycles
They’re factors outside the economic system that lead to economic fluctuations, eg. Elections, pandemic, oil price shocks, wars
Internal sources of business cycles
They’re the factors within the economic system that generate expansions and contractions
[T/F] Business cycles may also be induced by aggregate demand or aggregate supply
True
[T/F] Demand-induced business cycles result from fluctuations in aggregate demand
True
[T /F] Supply-induced business cycles result from shocks to production that leads to fluctuations in economic activity.
True
Aggregate demand
Total quantities of goods and services demanded by households, firms, governments, and the external sector at various price levels
Mathematically, Aggregate demand is
AD = C^d + I^d + G + NX
where C^d = desired consumption
I^d= desired investment
Main determinants of consumption
- Current income
- Future income
- Wealth
- Interest rate
- Taxes
The Keynesian Consumption Function
Expresses consumption as a function of current disposable income
C= a + BY^d
Y^d is disposable income
a is autonomous consumption
B is marginal propensity to consume
Autonomous consumption
It is the level of consumption that does not depend of income
Marginal Propensity to Consume
Measures the change in consumption per unit change in income.
Properties of the Keynesian Consumption Function
- MPC is constant
2. Average Propensity to Consume decreases with income. [see notes]
Factors that determine investment
- The user cost of capital (real interest rate)
- Business expectation about the future prospects of the economy
- Taxes
- Investment tax credit
The Keynesian Savings Function
[- a + (1 - B) Y^d]
-a is autonomous dissaving
(1 - B) is marginal propensity to save.
Investment tax credit
An amount that businesses are allowed by law to deduct from their taxes, reflecting an amount they reinvest in themselves
Net exports depends on
- Domestic income
- Foreign income
- Real exchange rate
The real exchange rate
The real exchange rate measures the price of foreign goods relative to the price of domestic goods.
Mathematically, real exchange rate is
The ratio of a foreign price level and the domestic price level, multiplied by the nominal exchange rate.
Fiscal policy
Refers to the changes in the level of government spending and/or taxes meant to influence the level of economic activity.
Types of fiscal policy
- Expansionary policy (fiscal loosening)
2. Contractionary policy (fiscal tightening)
Expansionary policy (fiscal loosening)
refers to increases in government spending or reduction taxes
Contractionary policy (fiscal tightening)
Refers to increases in government taxes and/or reduction in government spending. Fiscal austerity
Austerity
A set of economic policies a government implements to control public sector debt.
Output (GDP) Gap
The difference between what the economy could have produced and what actually is produced thus, potential output minus actual output
If output gap is positive i.e potential GDP is greater than actual GDP
We have recessionary gap
If output gap is negative i.e potential GDP is less than Actual GDP
We have inflation gap
If output gap is zero i.e potential GDP is equal to actual GDP
We have full employment
Major goal of fiscal policy
Is to stabilize actual output close to the potential output
[T /F] If actual output is greater than potential output (inflationary gap), contractionary fiscal policy can be used to reduce output to potential output
True
[T /F] If actual output is less than potential output (recessionary gap), expansionary fiscal policy can be used to increase output to the full employment output
True
Automatic stabilizers
In-built fiscal mechanisms within an economy that dampens effects of fluctuations in aggregate demand on actual output. Example, unemployment insurance
Crowding out
Refers to offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduce investment spending.
