Chapter 15
Economic Fluctuations
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 15 / ECONOMIC FLUCTUATIONS
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
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?
Lieberman & Hall; Introduction to Economics, 2005
2
Actual and Potential Real GDP
(Billions of 1996 Dollars)
Figure 1(a): Potential and Actual Real
GDP and Employment, 1960-2001
9,000
8,000
The orange line shows fullemployment or potential output.
7,000
6,000
The green line shows
actual output.
5,000
4,000
3,000
During recessions,
output declines.
During expansions, output
rises—sometimes rapidly.
2,000
Lieberman & Hall; Introduction to Economics, 2005
3
Figure 1(a): Potential and Actual Real
GDP and Employment, 1960-2001
140
Employment
(Millions)
Employment falls in recessions . . .
120
100
80
and rises in expansions.
60
Lieberman & Hall; Introduction to Economics, 2005
4
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
Lieberman & Hall; Introduction to Economics, 2005
5
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
Lieberman & Hall; Introduction to Economics, 2005
6
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”
Lieberman & Hall; Introduction to Economics, 2005
7
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
Lieberman & Hall; Introduction to Economics, 2005
8
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
slope 
Lieberman & Hall; Introduction to Economics, 2005
ΔConsumpti on
ΔDisposable Income
9
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
Lieberman & Hall; Introduction to Economics, 2005
10
Figure 2: U.S. Consumption and
Disposable Income, 1985-2002
Real Consumption Spending
($ Billions)
7,000
2000
6,000
1995
5,000
1990
1985
4,000
3,000
3,000
4,000
5,000
6,000
7,000
Real Disposable Income ($ Billions)
Lieberman & Hall; Introduction to Economics, 2005
11
Real Consumption Spending
($ Billions)
Figure 3: The Consumption Function
8,000
7,000
The consumption function shows the (linear)
relationship between real consumption
spending and real disposable income
Consumption
Function
6,000
5,000
600
4,000
1,000
3,000
2,000
1,000
The vertical intercept ($2,000
billion) is autonomous
consumption spending . . .
and the slope of the line
(0.6) is the marginal
propensity to consume.
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Real Disposable Income ($ Billions)
Lieberman & Hall; Introduction to Economics, 2005
12
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

Lieberman & Hall; Introduction to Economics, 2005
13
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
Lieberman & Hall; Introduction to Economics, 2005
14
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
Lieberman & Hall; Introduction to Economics, 2005
15
Figure 4: A Shift In the ConsumptionIncome Line
Real 8,000
Consumption
Spending ($ 7,000
Billions) 6,000
Consumption-Income Line
When Net Taxes = 500
5,000
4,000
3,000
Consumption-Income Line
When Net Taxes = 2,000
2,000
1,000
2,000
Lieberman & Hall; Introduction to Economics, 2005
4,000
6,000
8,000
Real Income ($ Billions)
16
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
Lieberman & Hall; Introduction to Economics, 2005
17
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
Lieberman & Hall; Introduction to Economics, 2005
18
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
Lieberman & Hall; Introduction to Economics, 2005
19
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
Lieberman & Hall; Introduction to Economics, 2005
20
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
Lieberman & Hall; Introduction to Economics, 2005
21
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?

MPC is 0.6

When households spend an additional $60 billion
 Household tax payments do not change at all with their additional income
 Households will save the remaining $40 billion
 Firms that produce consumption goods and services will produce and sell an
additional $60 billion in output

An increase in investment spending will set off a chain reaction
 Leading to successive rounds of increased spending and income
Lieberman & Hall; Introduction to Economics, 2005
22
Figure 5: The Effect of A Change in
Investment Spending
100.0
Increase in
Spending
Each Round
($Billions)
60.0
36.0
21.6
13.0
1
2
3
Lieberman & Hall; Introduction to Economics, 2005
4
5
7.8
6
4.7 2.8 1.7
7
8
9
Time Periods
23
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


1
P
GDP  


I

 (1 - MPC) 
Lieberman & Hall; Introduction to Economics, 2005
24
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
Lieberman & Hall; Introduction to Economics, 2005
25
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
Lieberman & Hall; Introduction to Economics, 2005
26
Other Spending Shocks
Lieberman & Hall; Introduction to Economics, 2005
27
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
Lieberman & Hall; Introduction to Economics, 2005
28
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
Lieberman & Hall; Introduction to Economics, 2005
29
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

In the long run, our multiplier has a value of zero

 The passage of time
 No matter what the change in spending or taxes, output will return to full employment
• so the change in equilibrium GDP will be zero
Lieberman & Hall; Introduction to Economics, 2005
30
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
Lieberman & Hall; Introduction to Economics, 2005
31
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
Lieberman & Hall; Introduction to Economics, 2005
32
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 10year tax cut that went into effect in June of 2001
Lieberman & Hall; Introduction to Economics, 2005
33