ECON 2133 Class Outline 5
Chap. 9 – Economic Fluctuations; Chap. 10 – The Short-run (Keynesian) Model
Chap. 9 – Economic Fluctuations
Economic fluctuations (“business cycles”) are periodic ups and downs in an
economy’s real output (Yr).
Terminology: Expansion
Peak (turning point)
Contraction / Recession
Trough (turning point)
Contraction / Recession: A period during which an economy’s real GDP (Yr)
__________
During a recession

Yr falls below its “__________” (i.e., full employment) level

Employment decreases (____________ increases)
See Fig. 1, pg. 231 – 7 recessions since 1960 (shaded on graph)
With each, the U rate increased sharply (Fig. 2, pg. 232)
Even after a recession “officially” ends, it may take some time for

Yr to return to its “potential” level

The empl. / unempl. levels to return to a “full empl.” condition
(See Fig. 1 (top) and Fig. 2)
Usually, recessions are relatively brief (months), but the potential aftereffects make
any recession a serious economic event (rf. pg. 230)
Key focus of chapter
The Classical model does not recognize or explain econ. fluctuations, especially
those that are long or have lasting effects on Yr and employment
(pg. 231, 235)
So what causes econ. fluctuations?
Answer: ___________ changes (or econ. “shocks”)
(see pg. 2364 – 239; Table 1, pg. 238)
So we need a model that explains the short run effects of “spending shocks”
This short run macro model (a.k.a. the Keynesian model) is introduced in Chap. 10
Chap. 10 – The Short-run (Keynesian) Model
This model is based on
Output
vs.
Y = C + I + G + NX
Aggregate Expenditures
AE = C + Ip + G + NX
If AE ≠ Y, then Ip will ≠ I
And it is these inequalities that trigger a ____________ or ____________
phase of a business cycle.
The short run (Keynesian) model focuses on
1. What determines AE?
2. What happens when AE ≠ Y?
The components of AE
1. Consumption spending ( C ) is affected by

Disposable income (Yd)

Interest rates

Wealth

Expectations
(pg. 242 – 243)
Yd is the most important of these for modeling
3 key relationships
(1) Yd = Y – T
(2) Yd = C + S
(3) C = Co + mYd
C is ________ consumption spending
Co is “__________” C spending
m is the “marginal propensity to consume”
(a.k.a. the “mpc”)
See pg. 243 – 247; Fig. 2, pg. 245
The C function relating C to Yd is the basis of the Keynesian model, but it is more
useful to relate C to total Y (rather than Yd)
This is called the
consumption – income (C – Y) line
Fig. 3, pg. 248
Note that on the C – Y graph
(1)
Y (tot. income, or GDP) is on the horiz. axis
(2)
Slope of the C – Y line = mpc
(3)
Co(y) = Co(d) – mpc*T
(See pg. 248)
On Fig. 2, Co(d) = 2000
mpc = 0.6 and T = 2000
So on Fig. 3, Co(y) = 2000 – 0.6*(2000) = 800
Note also that in this model

A ∆Y will cause a movement ________ the C – Y line (e.g., A to B on Fig. 3)

While a ∆ in any other determinant of C ________ the C – Y line (either up
or down)
(See pg. 249 – 250; Table 3, pg. 251
2. Investment: In the AE model, I __________ ∆s in inventories
i.e., Ip is __________ capital and new housing investment, with inventories
__________
In other words, Ip is assumed to have a given (constant) value in the model
(pg. 251)
3. G and NX are also assumed to have given (constant) values
(pg. 252 – 253)
So the complete AE model is
AE = C + Ip + G + NX
See Fig. 5, pg. 257
Notes on Fig. 5

The AE line (top line on graph) has the same slope as the C – Y line (slope =
mpc)

The vert. intercept of the AE line = Co + Ip + G + NX (the Ip, G, and NX
values are stacked on top of the C – Y line)
(Co + Ip + G + NX)
is called “autonomous spending”)
Interpreting the AE – Y graph
1. ____________ is where the AE and 45° lines intersect
At $8 tril. (Fig. 7, pg. 259)
i.e., Y = $6 tril. and AE = $6 tril.
so that __________ = ____________
But what if Y ≠ $8 tril.???
1) Suppose Y = $12 tril.
Then AE = $10.4 tril. (see Table 4, pg. 254)
So AE < Y
What happens to the output (Y) that is produced but not bought
(AE)?
Ans.: Unsold output accumulates as __________
i.e., when Y > AE, then inventories __________
This increase in inventories is ____________ investment so that, when
Y > AE, ________ I is > __________ I !
When this happens, what will business owners / managers do???
They will __________ __________ to reduce excess inventories
Bottom line: If Y > AE, then future Y will __________
2) Suppose Y = $4 tril.
Then AE = $5.6 tril.
AE > Y
(Table 4, pg. 254)
and inventories will __________
i.e., I < Ip
so that businesses will __________ output to restore inventories to desired
levels
Bottom line: If Y < AE, then future Y will __________
Summary
Let INVe mean equilibrium (optimal) inventory level
INVa mean actual inventory level

If Y < AE, then INVa < INVe
(I < Ip)
and Y will increase ---- ____________

If Y > AE, then INVa > INVe
(I > Ip)
and Y will decrease ---- ____________

If Y = AE, then INVa = INVe
(I = Ip)
and Y will not change ---- ____________
Study pg. 254 – 260
Other points re. the Keynesian model
1. Employment

In the classical model, equilibrium is always at full employment

In the Keynesian model, AE – Y equilibrium can occur either below
or above full employment
(pg. 260 – 263)
2. How changes in Co, Ip, G, or NX affect the economy
E.g., with equilib. At AE = Y = $8 tril.
If Ip increases by $1 tril., then AE and Y could increase by much
more (pg. 263 – 265)
How / why? Because increased spending creates increased incomes, which
generates more spending,
. . . .
I.e., there is a __________ __________ of the initial change in spending
How much? The potential total effect of a change in Ip is
Y = Ip * [ 1 / (1 – mpc) ]
pg. 266
the “expenditures multiplier” (EM) = [ 1 / (1 – mpc) ]
pg. 265
If mpc = 0.6 and Ip = $1 tril.

EM = [ 1 / (1 - .6) ] = 2.5

Y = $1 tril * 2.5 = $2.5 tril.
And a change in Co, G, or NX have the same potential effects as a change in
Ip
pg. 267
Note that a decrease in Co, Ip, G, or NX will __________ AE and Y by a
multiple of the initial change in spending
(pg. 266)
Multiplier effects in the real world
For the U.S. economy, the mpc ≈ 0.9
So the EM = [ 1 / (1 – 0.9) ] = 10
But the actual mult. effect of a change in Co, Ip, G or Nx is only ≈ 1.5
“Automatic stabilizers”
Why?
As Y increases
Taxes __________, so that Yd and C do not increase in proportion to the
increase in Y
Transfer payments __________, so that G decreases
Interest rates __________, so that Ip (and C) decrease
Net exports __________ because more is imported with higher Y and AE
levels (IM increases, EX may remain constant or decrease)
“Forward looking behavior” (also called “Consumption averaging”) may
occur -- C may not rise as much as expected for a given increase in Y (the
mpc decreases)
See pg. 269 – 270
We will consider the role of fiscal policy (pp. 271 – 276) in counteracting
undesirable business cycle movements later.
XXX Chap. 10