PSCI 1500: Introduction to

Economics

Business Cycle & Causes of Economic Fluctuations

Business cycle refers to wave-like fluctuations in aggregate economic activities i.e. national income, employment and output.

It is composed of periods of good trade with rising prices and low unemployment percentages and followed by periods of bad trade with falling prices and high unemployment percentages.

BUSINESS CYCLE

What is a business cycle?

BUSINESS CYCLE

PEAK OR BOOM Maximum output, business activity at maximum

level. Lowest unemployment rate, full or nearly full

employment Price level likely to rise

Real GDP

Year

PEAK

RECESSION

TROUGH

RECO

VERY

PEAK

RECESSION Contractionary phase – decline in the GDP,

total output, income, trade volume and price level

Unemployment rate increases, a deep and long recession is known as depression.

TROUGH The period where the GDP and

output is at the minimum level. Unemployment rate is its

maximum. RECOVERY Expansionary phase - GDP

output and price level increase.

Unemployment rate decline.

PHASES OF BUSINESS CYCLE

Example :Cyclical Behavior of the U.S. Economy

Economic Activity (1900–1984)

CHANGES IN MACROECONOMIC ACTIVITY

(continued)Economic Activity (1900–1984)

Example :Cyclical Behavior of the U.S. Economy

CHANGES IN MACROECONOMIC ACTIVITY

SPENDING & MACROECONOMIC ACTIVITY

RELATIONSHIP BETWEEN TOTAL SPENDING & BUSINESS CYCLE

Total /aggregate spending refers to total of combined spending by all units in the economy (households, businesses, government, foreign sectors) for new goods & services

Total Spending and the Level of Economic Activity

SPENDING & MACROECONOMIC ACTIVITY

HOUSEHOLD SECTOR

Household Sector & the Circular FlowIncome-Determined Spending - Household spending on new goods and services using income earned from providing resources to producers. Flow (1) and (2).

Household Spending, Borrowing, Transfers, Saving, and Taxes

HOUSEHOLD SECTOR

• Personal Consumption Expenditures

Household spending on new goods and services.

• Transfer Payments

Money from the government for which no direct work is performed in return.

• Non income-Determined Spending

Spending that is not generated from household earned income.

HOUSEHOLD SECTOR

• Injections into the Spending Stream

Spending that comes from a source other than household earned income.

• Leakages from the Spending Stream

Uses for earned income other than spending, such as taxes and saving.

BUSINESS SECTOR

Business Sector & the Circular Flow

Business Investment Spending, Saving, and Taxes

• Investment Spending - Flow (1)Also considered non income-determined spending. Business spending on new goods, such as machinery, equipment, buildings, and inventories.

• Retained Earnings/ Business Savings - Flow (2)Portion of a business’s accumulated profits that has been retained for investment or other purposes.

• Business Taxes - Flow (3)Paid to the government *

BUSINESS SECTOR

Saving-Borrowing RelationshipRelationship between the amount saved by households & businesses, and the amount returned to the spending stream through households & businesses borrowing.

• Financial Institution** Important for the investment borrowing and business savings for holding of the deposits

BUSINESS & HOUSEHOLD SECTOR

Saving, Investing, and Borrowing by Households and Businesses

BUSINESS & HOUSEHOLD SECTOR

Saving-Borrowing RelationshipFunds saved by households and businesses are

the leakages from the spending streamFinancial institutions change the leakages into

injection through giving of borrowingAmount saved may not equal to amount borrowed

Saving = Borrowing leakages = injectionSaving > Borrowing decrease total spending, economic downturn (output & employment decrease)

Saving < Borrowing increase total spending, economic rebound (output & employment increase)

BUSINESS & HOUSEHOLD SECTOR

GOVERNMENT SECTOR

Government Sector & the Circular Flow• Government Purchases of Goods & Services

Also considered non income-determined spending.

Government spending on new goods and services.

GOVERNMENT SECTOR

Government Sector & the Circular Flow

The Government Sector and the Circular Flow

Government Tax-Spending Relationship

Government tax leads to leakages in the spending stream

Government spending is the injection to the spending stream

Tax received < Government spending Upswing/grow

Tax received > Government spending Downswing

Tax received = Government spending No change

GOVERNMENT SECTOR

FOREIGN SECTOR

Foreign Sector & the Circular Flow• Exports (X) - Goods and services that are sold

abroad.

• Imports (M) - Goods and services purchased from abroad.

• Net Exports (X- M) - Exports minus imports.

FOREIGN SECTOR

Foreign Sector & the Circular Flow

The Foreign Sector and the Circular flow

FOREIGN SECTOR

Foreign Expenditures Injections by foreign country that buy local products i.e. Export (X)

Also considered as the non income determined spending

Local ExpendituresLeakages from local country that buy foreign products i.e. Import (M)

Import – Export Relationship : If X > M increase spending, economic grow If X < M reduce spending, economic shrink

SUMMARY OF TOTAL SPENDING & ECONOMIC ACTIVITY

• Total Spending drives the economy’s production, employment, and income levels.

MULTIPLIER EFFECTMultiplier Effect

A change in total output & income that is generated by a change in non-income determined spending, becomes larger than, or a multiple of, the initial change in the spending itself.

MULTIPLIER EFFECT

Calculating the Multiplier Effect

Initial change in non-income determined spending divided by the percentage of additional income not spent will yield the total change in output and income.

Assuming 20% due to $2,000,000 (what was not spent) from $10,000,000 initial injection Thus, $10,000,000 / 0.20 = $50,000,000

MULTIPLIER EFFECT

Effect on Total Output and Income from a Non-income-Determined Spending Injection of $10,000,000

How does non-income determined spending and multiplier effect affect the economic activity?

An initial injection of non-income determined spending provides income to those who own the resources used to produce the goods and services.

Those who own the resources then spend part of their income on new goods and services, which again, provides income to the owners of resources used to produce goods and services.

Those who own the resources, then again, spend part of their newly received income to purchase goods and services.

MULTIPLIER EFFECT

(Cont’d) How does non-income determined spending and multiplier effect affect the economic activity?

Thus, the multiplier effect occurs because non-income determined spending injected into the economy is spent again and again.

This process will be continuously repeated, leading to the non-income determined spending later on becomes larger than, or a multiple of the initial injection as the process repeat itself in the circular flow of income stream.

Large injection will therefore stimulate the economic activity.

MULTIPLIER EFFECT

REVIEW

1. Explain each phase of macroeconomic activities using a business cycle.

2. Describe the sources for “non-income determined spending” in a four –sector macroeconomic model.

3. Discuss the injection - leakages relationship within a three sector macroeconomic model.