AGREGATE DEMAND AND
BUSINESS CYCLES
dr. Aleksandar Kešeljević
Faculty of Economics
University of Ljubljana
Assistant professor
THREE MAIN TOPICS
A. AD, CONSUMPTION AND INVESTMENT
(Ch. 21)
B. BUSINESS CYCLES AND AGGREGATE
DEMAND (Ch. 22)
C. TODAY’S CRISIS
A. AGREGATE DEMAND
1. CONSUMPTION (C)
2. INVESTMENT (I)
3. GOVERNMENT EXPENDITURES (G)
4. NET EXPORTS (NX)
1. CONSUMPTION
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AD= C+I+G+NX
Y= C + S → C = f (Y)
C = 55% GDP
Family budget expenditures (P)
Consumption function (P)
Marginal propensity to consume (MPC) (P)
MPC + MPS = 1
Hypothesis (classical, Friedman, Modigliani)
Determinants of consumption (DI, weath, live cycle,…)
P: Family budget expenditures
P: Consumption function
P: Consumption function
P: MPC
P: MPC
Saving
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Y= C + S
The saving function (P4)
MPS = 1 – MPC
Paradoks of saving
(S↑→C↓→AD↓→Y↓→S↓)
• S = f (Y, i, T, social security system, financial
markets, inflation…..)
P: The saving function
2. INVESTMENT
• Double role of I (AD= C+I+G+NX; AS)
• The investment demand curve (P)
• Determinants of investments (revenues,
costs, expectations) (P)
• Investments and saving S= I
P: The investment demand curve
P: The investment demand curve
P: Determinants of ivestments
3. GOVERNMENT EXPENDITURES
• AD= C + I + G + NX
• Comparasion: G/BDP, T/BDP (P7)
• G<T, G=T, G>T
P: Governement spending
P: Governement taxation
• Functions of the governement (improving
economic efficiency, reducing economic
inequality, stabilizing through macroeconomic
policies, international economic policy)
• Social state and governement expenditures →
no such a thing as a free lunch!
• Governement expenditures (state, local)
• Today’s crisis and the role of the government
4. NET EXPORTS
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AD= C + I + G +NX
EX- IM =NX
X = f (Y , e)
M = f (Y , e)
e = exchange rate (mechanism,…)
F
D
P: AD = C + I + G + NX
B. BUSINESS CYCLES AND AGGREGATE
DEMAND
1. BUSINESS CYCLES
2. ANTICYCLICAL POLICY
3. THE MULTIPLIER MODEL
1. BUSINESS CYCLES
• Business cycles are fluctuations in output, income,
employment, inventiries usually lasting 2 to 10
years
• Four phases (peak, contraction or recession,
trough, expansion) (P)
• Recession occurs when real GDP has declined for
two consecutive calendar quaters
P: Four phases of business cycle
P: Business activity since 1919
• Internal theories (multiplicator theory,
monetary theory, political theories, real
cycle theory,….)
• External reasons (wars, oil shocks,
revolutions, elections, gold expeditions,
migrations, new world,.....)
2. ANTICYCLICAL POLICY
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Business cycles forecasting
Discretionary policy versus rules
Anti-cyclical policy
Automatic (or built in) stabilizers
EU, EMU
3. THE MULTIPLIER MODEL
• How output is determined in the short run?
• How changes in spending (AD) get translated
into changes in output and employment? ∆
GDP = m * ∆ AD
• Three approaches: AS-AD, I=S, Keynesian cross
• Advantages/disadavantages
Multiplier:
I↑ → GDP↑
AS-AD APPROACH: AD↓→ GDP↓
KEYNESIAN CROSS APPROACH
NUMERICAL ANALYSIS
• ∆ GDP = m * ∆ AD
• GDP = C +I+G+NX; I, G, NX=0 → ∆GDP=∆C
• ∆Y=1000 (Y=C+S)
• 1000+666+444+296+……= 3000
• 1 + r + r2 + ...= 1 ∕ (1-r) = 1 ∕ (1- MNP)= 1∕MPS
• ∆GDP = 1 ∕ (1-MPC) * ∆ AD = (1 / MPS) * ∆ AD
MULTIPLIERS
• Investment multiplier
• Government expenditures
multiplier
• Tax multiplier
Investment and government expenditures
multipliers
• ∆ GDP = 1/MPS * ∆I
investment multiplier
• ∆ GDP = 1/MPS * ∆G
government expenditure multiplier
Tax multiplier
• T↑ → AD↓ → GDP↓
• T↓ → AD↑ → GDP↑
• ∆ GDP = MPC/MPS * ∆T
tax multiplier
Tax multiplier
FISCAL POLICY IN THE MULTIPLIER MODEL
• ∆ GDP = 1/MPS * ∆G r
• ∆ GDP = MPC/MPS * ∆T
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mt = mg * MPC
mt < mg
Tax mupliplier= MPC * expenditure multiplier
Consequences for fiscal policy and its affect on
output
AD vs. AS
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Supply side economics
AS (not AD) in the center of interest
Laffer curve
Privatization, deregulation, liberalisation
USA, GB in the 1980’s
Effect of moving AS curve
C. TODAY’S CRISIS
• Crisis is like pretty woman: Hard to define but
recognizable when encountered (Goldsmith)
• Crisis: financial, economic, social, political,
sistemic aspect
Main reasons
• too expansive monetary policy
• fast liberalization of capital markets
and inovative financial instruments
• booms and baloons
• bad regulation in the financial sector
(grey banking)
• structural reasons (w/GDB↓)
• bad corporate governance
WALL STREET-MAIN STREET (“We are 99”)
SOLUTIONS AND COSTS
• Screenplay for the movie Apokalipsa
• Restoring the confidence and trust among
population and banks (government guarantees of
bank deposits, recapitalization of banks,…)
• Coordinated action of CB (↓i, liquidity trap, QE3)
• Fiscal policy stimulus packages
• Fiscal measures: government debt guarantees,
injection of capital, purchases of assets, take-overs
by the government (state ownership),
• Funding: IMF, WB, the role of rising China
• ESFS, EFSM (2013), ESM (2013→)
• Fiscal deficits and public debt (P)
P: Public debt/GDP (%)
2007
2011
Germany
64,9
82,4
Irland
25,0
112,0
France
63,9
84,7
Italy
103,6
120,3
Belgium
84,2
97,0
Greece
105,4
158
Spain
36,1
68,1
Slovenia
23,1
42,8
Czech Republik
29,0
41,3
Croatia
33,2
40,4
EMU-17
66,2
87,8
EU27
59,0
82,3
• Not every country in the same position (crisis
on crisis, free rider)
• Different approaches: In EU not enough
manoeuvring space for economic policy, EU is
not a federal state as USA, EU27 more modest
(3% GDP) than USA (different ES), differences
regarding FED and ECB
• American elections (Obama, Romney)
Dilemmas
• Dilemma 1: to much from taxpayers viewpoint
or to little to solve the problem (P)
• Dilemma 2: moral solution and deep recession
or vice versa
• Dilemma 3: exit or relying on others (PIGS)
• Dilemma 4: market or the state
• Dilema 5: socialist instruments or more
market
• Dilemma 6: austerity measures or higher
spending. Are austerity measures effective?
Implications for the Capitalism?
• Is capitalism dead, We are 99
• Enormous creation of well being until today by
capitalism (1980-2008 GDP↑ 145%, 3,4% annually)
• Is socialism an alternative? (not hamper the
markets, not all regulation will be wise)
• Capitalism will not be the same afterwards → today
market the only game and enemy in town
• Regulation: Institutional reforms, corporate
responsibility, business ethics, corporate
governance, living within the personal limits,…
Better days
• It is not as bad, as it sounds… (M. Twain)
Gini Coefficient World 2011
HDI World in 2011