Output, growth
and business cycles
Econ 102
GDP Growth
Countries:
 High savings rate have
higher GDP/ cap.
 high population growth
rates have low GDP/ cap.
Solow model:
GDP and Per capita GDP
Output grows over time:
SR and LR Aggregate Supply
LR Aggregate Supply
SR Aggregate Supply
Very long run Aggregate Supply
Potential Output
Ideal level of income
 What is an ideal level of Real GDP?
POTENTIAL INCOME
(Full employment level of income)
 The income level that corresponds to the output that will
be produced if all resources are employed at a ‘normal’
rate.
 Here, the output level at the Natural Rate of
Unemployment,
(U% is equal to only frictional + structural U% rate, and cyclical
U% is zero.).
SR and LR Aggregate Supply
 There are constraints on Price changes and Output
changes.
 Very long run: capacity is growing, shifts in the LRAS
curve.
 Long run AS: capacity of production is constant, an
increase in demand increases prices but not quantity.
 Short run AS : price pressures are less, there are
unemployed resources and if demand increases
output increase without price increase.
Which output level is produced:
Demand and Supply
Aggregate Demand and Aggregate Supply
Business Cycles
Boom
Y potential
Recession
Depression
Trough
AS and AD Equilibrium at different Y
levels
 Business Cycles: Cyclical fluctuations in real GDP,
 Contractionary period: output is declines, unemployment rises,
price pressures are low, pessimistic outlook, investment is
declining
 Recession (depression): Output is low, Unemployment is high,
wages are low, prices are not increasing, interest rates are low.
 Expansionary period: Output is increasing, unemployment is
declining, wages and prices are increasing, optimistic outlook,
investment is increasing,
 Boom: Prices are high, interest rates are high, unemployment
is low, (good times but not clear how long this will last...)
Aggregate Demand
 Total of desired aggregate expenditures
 Which type expenditures?




Desired Consumption Expenditures:
Desired Investment Expenditures:
Government Expenditures:
Net Exports:
WHY ‘DESIRED’ EXPENDITURES?
WHY ‘DESIRED’ EXPENDITURES?
 Agents may want to purchase, may plan to buy but
Are there enough goods there?
If not ? What happens?
What type adjustment occur will
happen?
‘Desired’ Aggregate Expenditures
 Buyers in the Goods and Services Market:
Desired Consumption Expenditures
+
Desired Investment Expenditures
+
Desired Government Expenditures
+
Desired Net Exports
___________________________________________________
Desired Aggregate Expenditures (AEd)
Closer look at the components of
desired AE?
 AEd= Cd + Id + Gd + Xd – Md
 Household: Cd depends on Disposable Income, after
tax income.
 Firms: Id depends on cost of borrowing; interest rate.
 External Sector: Xd and Md depends on exchange rate
and Income of domestic and foreign income.
 Government: determines its own expenditure level Gd
(it is a policy tool).
When will there be an equilibrium?
 When aggregate desired expenditures are equal to total
output produced
AEd = Y (Equilibrium)
 If Aggregate Expenditure is less than output
AEd < Y, stocks of unsold good will pile up.
 If Aggregate Expenditure is more than output
AEd > Y stocks of unsold good will decline.
Equilibrium in a Macroeconomy
(Keynesian Model)
 Graphical Presentation and Equilibrium:
Disequilibrium adjustment
 If the economy starts at a point where AE≠Y;
what happens?
The forces in the economy will bring the economy
to the equilibrium output level. (Stable equilibrium)
If for example AE<Y…
then inventories will pile up, the firms will cancel
orders, firms will cut back production, fire workers,
employment and production will decline until AE=Y.
(Reverse is also true for AE>Y )
Equilibrium in a Macroeconomy
Keynesian Model: (emphasizes the demand side, assumes
constant prices and unemployed resources)
 If AEd > Y , then there is unplanned decline in the
inventory levels of the firms, firms start to increase
production.
 If AEd = Y , then there is no unplanned change in
inventory levels, no change in production (Equilibrium).
 If AEd < Y , then there is unplanned increase in the
inventory levels of the firms, firms start to decrease
production.
More of a closer look at the components
of Aggregate Expenditures
 Desired Consumption
Expenditures: Cd
C d = C + mpcYD
 What is Disposable Income?
DI
DI =Y -T +TR

Therefore desired consumption
expenditures are increasing
function of DI and hence Y.
A Model for Desired Aggregate
Expenditures
d Desired Investment

I =Expenditures:
f (cost of borrowing)
Id
The model assumes interest
rates to be constant, hence
wed can write:

I =I
A Model for Desired Aggregate
Expenditures
 Desired Government
Expenditures: Gd
G = Government's Policy Tool
d
 Therefore we can write
as:
G =G
d
A Model for Desired Aggregate
Expenditures
= constant
Net Exports
 NX
Desired
Net Exports:
NXd
d
In the simple model
the exchange rate and
foreign income are held
constant, hence we can
write: NX d = NX
Mathematical Example
Steps to find the Equilibrium Income (Output):
1. Find Desired Aggregate Expenditure
Function as a function of Y.
2. Use equilibrium condition: AEd= Y
3. Solve for Y, which will be the level of output
which is equal to the level of AEd.
Example…
Economic Models
 Economic models are the use of simple (often
mathematical) relationships in order to represent the
complex of economic processes.
 We make assumptions and use the necessary variables we
are interested in. We domnot explicitly mention the other
factors that might have relatively less important effect on
the outcome.
Example: Consumption Function
and
d
C  C  mpcYD
YD =Y -T +TR
Why does the Equilibrium Income
change?
 If any of the autonomous spending increase then
equilibrium income will increase from YE to YE NEW.
 Possible causes of autonomous income increase are:
C, I , G, NX
(Graphically all of these are vertical (upward)
shift of the AE function)
How does the Equilibrium Income
change?
I =I
d
I <I
I =I
d
Example: If Investment increases from
to
(where
AEd=Y
Then
AE
)
AEd new
AEd
Δ Id
45o
YE
YE NEW
Δ YE
Y
How does Eq. Income respond to a
change in AEd?
 What is the change in equilibrium income if Id
increases?
 Multiplier:
DY E
1
=
d
DI
1- slope of AE function
Numeric example…
Why is there a ‘multiplier effect’?
 Initial increase in autonomous spending sets off a
series of increase in AE and in real GDP.
 First
increases, which means firms want to
purchase more new machines, the AE in the economy
increases, the factories which makes these machines
will hire workers. This will increase their salary
payments, the workers will increase their desired
consumption and hence the economy will move to a
higher Y level along the new AE function.
I
How does the multiplier work?
Change in
Autonomous
Expenditure
Round 1
Round 2
Round 3
Round 4
Round ∞
200
0
0
0
.
.
0
Change in Induced Expenditure
0
(0.7)* 200
(0.7)*140= (0.7)2*200
(07)*98=(0.7)3*200
.
.
(0.7) ∞*200
200
140
98
68.6
0
DY E = (1+ 0.71 + 0.72 + 0.73 +... + 0.7¥ )DI
æ 1 ö
E
DY = ç
÷ DI
è 1- 0.7 ø
Change in Aggregate
Expenditure= Change
in Real GDP
200
340
438
506.6
.
.
666.67
Multiplier
 For one unit increase in the autonomous desired
expenditures the equilibrium income increases by a multiple
amount.
 The formula for the multiplier:
 The steeper the slope of AE function, the larger will be the
multiplier.
DY E
1
=
d
DI
1- slope of AE function
Why do we need the multiplier
information?
 If Desired Government Expenditure increase by 1 billion TL,
we can tell what will be the change in the equilibrium
income. (Multiplier x 1 billion TL)
 Hence we will be able to tell how much increase in desired
government expenditure is necessary to bring the economy
to Potential Real GDP level.
Output Gap = Y – Y
 Graphically Output Gap
AEd=Y

AE
AEd new
AEd
Δ Id
45o
YE
YE NEW
Δ YE
Y
Necessary change in G to close the
Output Gap
 ∆Y= multiplier*∆G
 Hence you may compute the necessary change in change
in G from the above equation, as
 ∆G= ∆Y/ multiplier
What if the government increases
taxes by 1 Billion TL
 Is the effect on Real GDP ( Equilibrium income)
expansionary or contractionary?
???
 How much will be the change in Real GDP?
???