Business Cycle Model
KW 28, 29
AS-AD Framework
• Microeconomists use supply/demand framework
for thinking about markets.
• Macroeconomists use Aggregate Supply/
Aggregate Demand as the central framework for
thinking about business cycles.
• AS/AD framework examines the relationship
between the level of output (real GDP) and the
aggregate price level (GDP deflator).
• We use the AS/AD to show how different events
will affect output & prices in the short run.
Long Run Aggregate Supply
• Central pillar of AS-AD framework is the
assumption that there is no long run relationship
between prices and firms willingness to produce
goods.
• In the long run, a rise in average prices will affect
the price level of outputs and inputs. For any
individual firm, a price rise is no incentive to
produce more if input prices rise also.
• Long-run level of output determined by productivity
and labor force participation is called trend output or
potential output.
Aggregate Demand Curve
P
LRAS
Y
YP
Short Run Aggregate Supply
In the short-run, there is thought to be a positive
relationship between the aggregate price level and firms’
willingness to supply goods.
Why is the Aggregate Supply Curve Upward
Sloping?
• For some firms, some input prices, particularly wages,
will not rise with the general price level.
• If wages are sticky, a rise in the price of goods reduces
the real cost of hiring workers. Firms profit-maximizing
output levels hire more workers, work their existing
employees longer hours and produce more output.
Aggregate Demand Curve
P
LRAS
SRAS
Y
YP
Wage Index
Real Wage Index
P
Mar-06
Sep-05
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
Mar-97
Sticky Wages in HK
Hong Kong's Most Recent Downturn
160
140
120
100
80
60
40
20
0
What causes SRAS to shift?
• To maximize profits, firms will produce up to
the scale that the price level compensates them
for their costs.
• If costs of production drop, output will
increase at any price level
• If costs of production rise, output will
decrease at any price level.
Cost Shifters
1. Commodity & Oil Prices Energy is a
commodity used by all production processes
and is a cost factor.
2. Wage Levels Labor is by far the biggest cost
for most sectors.
3. Productivity New inventions or techniques
may reduce the need for labor and thereby
reduce costs.
Short Run Aggregate Supply Curve
1. Oil Prices Fall
SRAS
2. Wages Decline
P
3. Productivity
Increases
SRAS′
Y
Potential Output
• Potential output is not the maximum output
possible for a country.
• Potential output is the level of production when
supply and demand are in equilibrium in labor
market.
– When output is higher than potential, it is because real
labor costs/real wages are low so there is excess
demand for labor.
• Market forces will push wages up!
– When output is lower than potential, real wages are
high so labor is in excess supply.
• Market forces will push wages down!
Aggregate Supply in Labor Market
P
Excess
Supply in
Labor Market
•Wages Fall
•SRAS Shifts Out
Excess Demand
In
Labor Market
•Wages Rise
•SRAS Shifts In
Y
YP
Aggregate Demand Curve
P
LRAS
SRAS
Y
YP
Aggregate Demand
• There is a negative relationship between the
price of a single good and demand ceteris
parabis. If the price of a good is high
relative to other goods, consumers will find
substitutes.
• Aggregate demand curve is the effect of the
average price (in terms of money) on
demand for all goods.
Aggregate Demand Curve
P
AD
YLR
Y
Why is the AD curve downward sloping?
1. Wealth Effect: increase in prices directly reduces
purchasing power of consumers with savings in
money assets.
2. Interest Rate Effect If prices go up, households &
firms need more liquidity for spending on a
given amount of goods. As consumers shift funds
to cash, interest rate in capital markets will rise
having negative impacts on demand for
investment goods.
Cont.
In HK, monetary policy is to have a fixed exchange
rate with the US dollar. Interest rates are
typically at US dollar levels.
Take exchange rates as given:
3. International Trade Effect An increase in prices
at a fixed exchange rate increases the relative
costs of a countries exports and encourages
domestic consumers to switch to imports.
Demand Matters
• In the short-run, the position of the demand
curve matters for equilibrium output.
• Over time, the economy’s correction
mechanism will restore the economy to a
long-run in which the long-term supply
factors determine output.
Short Run Equilibrium: Output Above Potential
P
SRAS
P*
A
Labor market
displays excess
demand
AD
YP
Y*
Y
Long Run Equilibrium:
SRAS shifts in as wages rise
P
SRAS
B
P*
A
Wages rise and
the profit
maximizing
production level
falls.
AD
Y
YP
Short Run Equilibrium: Output Below Potential
P
SRAS
P*
Labor market
displays excess
supply
A
AD
Y*
Y
YP
Long Run Equilibrium:
SRAS shifts in as wages rise
P Wages fall and the
profit maximizing
production level
rises.
SRAS
SRAS ′
A
P*
B
AD
Y
YP
Business Cycles
• Economy has a self correcting mechanism, the labor
market, that automatically returns the economy to
the level of potential output in the long-run.
• Demand is subject to fluctuations caused by external
events.
• Business cycles are the time between when a shock
hits and when the self-correcting mechanism returns
the economy to the long run.
• The labor market is imperfect. Contracts and wages
are renegotiated infrequently and matching between
employers and employees is time-consuming.
Keynesian View of Business Cycles
• Mainstream economic view is that shocks
that affect the demand curve are the main
driver of business cycles.
• Demand is a positive feedback system and
thus can be volatile.
• In business cycles driven by demand
shocks, prices rise during expansions and
fall during recessions.
Demand Driven Boom
SRAS′
P
SRAS
2. Demand shifts
out
3
P*
2
1
AD
YP
1. Economy in LT
equilibrium
Y*
3. Rising wages
leads to return
to equilibrium
AD
Y
Demand Driven Recession
P
SRAS
1
2. Demand shifts
in
2
P*
1. Economy in LT
equilibrium
3
3. Falling wages
leads to return
to equilibrium
AD
AD′
SRAS′
Y*
YP
Y
What causes the demand curve to
shift?
• Shifts in Household Consumption
– 1) Wealth effect; 2) optimism about future;
• Shifts in Corporate Investment Spending
– 1) Interest Rates; 2) optimism about future
• Shifts in Trade Balance
– 1) Exchange Rates; 2) Foreign business cycles.
Income and Expenditure
KW Chapter 28
Income and Expenditure
•
Two components of expenditure may
depend strongly on income levels
1. Consumption
2. Imports
–
Net Exports = Exports – Imports: the trade balance
is negatively impacted by domestic income.
•To simplify, assume a zero trade balance
and no government spending, NX = 0, G
=0
Consumption Function
• Consumption is in the form
C  A  mpc  YD
• Where
• A = Autonomous Consumption not directly
dependent on current income
• mpc = marginal propensity to consume the
fraction of extra income that will go to spending
• YD = Disposable Income
What causes the Consumption Function
to shift?
The determinants of autonomous income:
• Real wealth – Stock or property market prices
changes will shift A.
• Expectations of Future Income –
Optimism and pessimism of the household sector
affects spending patterns.
Consumption Function
Real Consumption
ΔC
ΔYD
mpc  C
YD
A
Disposable
Income
Consumption Function HK 1986-997
C 525000
475000
425000
375000
mpc≈.78
325000
275000
225000
400000
450000
500000
550000
600000
650000
700000
750000
800000
YD
Shift Up in Consumption Function
Real Consumption
A'
A
Disposable
Income
In Recent Years, the consumption
function in HK has shifted down!
Consumption Function HK 1998-2004
C
650000
1998
600000
550000
500000
450000
400000
350000
300000
500000 550000 600000 650000 700000 750000 800000 850000 900000 950000
YD
Investment
•
We can divide investment into two
categories:
1. Planned Fixed Investment: Building P&E for
future production
2. Unplanned Inventory Investment
I  IUnplanned  I Planned
What causes Planned Investment to shift?
•
Changes in the Foreign Interest Rate – Real
interest rate affects corporate investment spending,
residential investment spending, consumer
durables etc.
• Expected Returns to Capital– Optimism and
pessimism of the business sector affects spending
patterns.
• Capital Overhang – If firms have built up too
much plant & equipment in a previous
investment bubble, investment spending will
decline.
Expenditure Curve
Planned Expenditure
C+IPlanned
mpc
A+IPlanned
Income
Q: Why is demand so volatile?
A: Demand is multiple feedback loop
• Total Expenditure is an increasing function
of aggregate income.
Expenditure = C+I
– Consumers will spend more if they have greater
income.
• But Expenditure creates production
• Production creates income….
Expenditure =Income = GDP
Planned
Expenditure
Planned
Expenditure =
IUnplanned
C+IPlanned
Actual
Expenditure
-IUnplanned
45º
Income = Y =
Expenditure
Expenditure =Income = GDP
Planned
Expenditure
•Output below
expenditure
•Inventories
declining
•Firms increase
production
•Increasing
income.
C+I+G+NX
•Output above expenditure
•Inventories increasing
•Firms cut back on production
•Reducing income levels.
45º
Y*
Income
US Business Cycles begin with
accumulation of inventories
Autonomous Expenditure Increases
Expenditure
C+I
A,I↑
Extra Expenditure Increases
Output which increases
income which increases
expenditure which increases
output which increases income
… Multiplier effect
Output
45º
GDP
Income
Autonomous Expenditure Increases by 100
mpc = .8
ΔA
ΔC
ΔGDP
Stage 1
100
100
100
Stage 2
0
80
80
Stage 3
0
64
64
Stage 4
0
51.2
51.2
Stage 5
0
40.96
40.96
Multiplier Effect
Firms
mpc
Savings
Workers
Spenders
Multiplier Effect
Central Bank
Firms
mpc
Workers
Savings
Spenders
Multiplier Effect
Firms
Savings
mpc
Workers
Spenders
Multiplier
• Expenditure
= IPlanned+ A + mpc∙Income
• GDP = IPlanned+ A + mpc∙GDP
• (1-mpc)∙GDP = IPlanned+ A
• GDP = [1/(1-mpc)] ∙ IPlanned+ A
• Expenditure Multiplier = [1/(1-mpc)]
Open Economy Multiplier
• The greater is the fraction of spending that
is done on imports, the less income is
recycled into extra spending on consumer
goods.
• mpc should be lower for very open
economies (like HK)
• Multiplier should be lower for very open
economy.
Multiplier Effect
Government
Firms
mpc
Savings
Workers
Spenders
Imports
Multiplier Effect
Central Bank
Firms
mpc
Workers
Savings
Spenders
Imports
Multiplier Effect
Government
Firms
Savings
mpc
Workers
Imports
Spenders
Open Economy Multiplier
• When we think about the fraction of income that is
re-circulated into demand, we are concerned with
the fraction that is
• Define marginal propensity to import, mpim, as
the percentage of income
• Open economy mpc mpc  mpc  mpim is
marginal propensity to consume domestic goods.
1
• Open economy multiplier
1  mpc
What causes the trade balance to shift?
Net Exports
•
Changes in the Exchange Rate – At any given
domestic currency price level, a change in the
exchange rate will change the relative prices of
domestic and foreign goods.
• Overseas Business Cycles – Demand in
trading partners economy affects demand for our
exports.
Is Inflation Pro-cyclical or Countercyclical?
• During a demand driven expansion, prices
are rising and inflation tends to accelerate.
• During a supply driven expansion, prices
are dropping and we experience
disinflation.
• A supply driven recession is often referred
to as Stagflation with low output and high
inflation.
Supply Driven Boom
P
1. Economy in LT
equilibrium
SRAS
1
SRAS′
3
3. Rising wages
leads to return
to equilibrium
P*
2
AD
YP
Y*
2. Supply shifts out
AD
Y
How Long does the adjustment
process take?
• In USA, organization called National
Bureau for Economic Research has
committee to date business cycles.
• During post war period, average time from
trough-to-peak is 10 months, average time
from peak-to-trough is 52 months.
• In the United States during the 1930’s or
Japan more recently, we may experience
long periods of contraction.
GDP
Trend
Mar-01
Mar-99
Mar-97
Mar-95
Mar-93
Mar-91
Mar-89
Mar-87
Mar-85
Mar-83
Mar-81
Mar-79
Mar-77
Mar-75
Billion Yen
Japan Recession
Japan GDP
700000
600000
500000
400000
300000
200000
100000
0
Japan Stock Market
JP: Index: TSE 1st Section Composite
04/01/1968=100
3000
2500
2000
1500
1000
500
0
Jul-1973
Jul-1977
Jul-1981
Jul-1985
Jul-1989
Jul-1993
Jul-1997
Jul-2001
Jul-2005
Students Should be able to
• Characterize potential output and distinguish fluctuations
in output due to demand shocks and supply shocks.
• Identify the sources of business cycle shocks.
• Describe the self-correcting mechanism of the economy.
• Describe the multiplier effect and calculate the size of the
simple multiplier in a closed economy with no
government.