Business Cycles

Fall 2013

US Real GDP (Quarterly series)

Real GDP Turkey

1998Q1

1998Q3

1999Q1

1999Q3

2000Q1

2000Q3

2001Q1

2001Q3

2002Q1

2002Q3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2008Q3

2009Q1

2009Q3

2010Q1

2010Q3

2011Q1

2011Q3

2012Q1

2012Q30.00

5000000.00

10000000.00

15000000.00

20000000.00

25000000.00

30000000.00

35000000.00

Real GDP (100=1998)

Real GDP (100=1998)

Real GDP in Turkey

1998Q1

1998Q3

1999Q1

1999Q3

2000Q1

2000Q3

2001Q1

2001Q3

2002Q1

2002Q3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2008Q3

2009Q1

2009Q3

2010Q1

2010Q3

2011Q1

2011Q3

2012Q1

2012Q30.00

5000000.00

10000000.00

15000000.00

20000000.00

25000000.00

30000000.00

35000000.00

0

5000000

10000000

15000000

20000000

25000000

30000000

35000000

40000000

Series1 Real GDP (100=1998)

Growth rate of Real GDP in Turkey

1998Q2

1998Q4

1999Q2

1999Q4

2000Q2

2000Q4

2001Q2

2001Q4

2002Q2

2002Q4

2003Q2

2003Q4

2004Q2

2004Q4

2005Q2

2005Q4

2006Q2

2006Q4

2007Q2

2007Q4

2008Q2

2008Q4

2009Q2

2009Q4

2010Q2

2010Q4

2011Q2

2011Q4

2012Q2

2012Q4

-6

-4

-2

0

2

4

6

8

10

Series1

Why? What to do about it?

• Alternative 1:Do nothing; it will come to back to Potential Output, (long run level of output)

• Alternative 2:Do economic policy to correct the business cycles.

Why? What to do about it?‘Schools of Thought’

Historical Perspective• Classical View (until 1930s Great Depression)

(Start of Macroecononomics)

• Keynesian View (recovery of Great Depression)

Recent Perspective• New Keynesians• Monetarist Model• The New Classical Model• Real Business Cycles

Keynesian View

• Flow of demand for goods and services vs.

• Flow of supply of goods and services

in GOODS AND SERVICES MARKET

Keynesian Macroeconomics

• Aggregate Expenditure (aggregate demand)vs.

• Aggregate Supply

‘Desired’ Aggregate Expenditures

• Buyers in the Goods Market:1. Desired Consumption Expenditures,2. Desired Investment Expenditures,3. Desired Government Expenditures,4. Desired Net Exports

WHY ‘DESIRED’ EXPENDITURES?

WHY ‘DESIRED’ EXPENDITURES?

• Agents may want to purchase, plan to buy but

Are there enough goods there?If not ? What happens? How does the

adjustment occur?What happened at the end of 2008 in Turkey?

Equilibrium in a Macroeconomy

Keynesian Model: (emphasizes the demand side)

• 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.

Equilibrium in a Macroeconomy• 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 )

What determines the desired AE?

• AEd= Cd + Id + Gd + Xd – Md

• Household: Cd depends on Disposable Income.• Firms: Id depends on cost of borrowing.• External Sector: Xd and Md depends on

exchange rate and Income.• Government: determines its own expenditure

level Gd (it is a policy tool).

A Model for Desired Aggregate Expenditures

• Desired Consumption Expenditures: Cd

– What is Disposable Income? YD

•Therefore desired consumption expenditures are an increasing function of Y.

A Model for Desired Aggregate Expenditures

• Desired Investment Expenditures: Id

• Therefore we can write as:

•

A Model for Desired Aggregate Expenditures

• Desired Government Expenditures: Gd

• Therefore we can write as:

•

A Model for Desired Aggregate Expenditures

• Desired Net Exports: NXd

(in the simple model)

• Therefore we can write as:

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= Y3. Solve for Y, which will be the level of output

which is equal to the level of AEd.

Example…

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:

• (Graphically all of these are vertical (upward) shift of the AE function)

How does the Equilibrium Income change?

Example: If Investment increases from to (where )

Then

How does Eq. Income respond to a change in AEd?

• What is the change in equilibrium income if Id increases?

• ( )

• Multiplier:

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 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.

How does the multiplier work?

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.

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.

Potential OutputIdeal 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.).

Output Gap = Y – Y

• Graphically Output Gap•

AE

Y

AEd

45o

YE

AEd=Y

YE NEW

AEd new

Δ Id

Δ YE

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?

???