Income, Spending, and Business Cycles

The economy experiences both boom periods and recessions; periods when output expands and contracts. During an expansionary phase unemployment rates fall. During a contraction unemployment rates rise. What explains the business cycle?

In this unit we look at short-run changes in output. Unlike long-run analysis, where the capital stock determines output, short-run analysis shows that the level of spending in an economy is important. During Recessions, spending falls.

After saying a few words about the business cycle, we'll look at aggregate demand. Then, we'll combine demand with aggregate supply which will allow us to answer questions about output, unemployment, and inflation.

Recession

Recession is defined as two consecutive quarters of falling GDP (gross domestic product). GDP is a measure of the total goods and services produced in the economy. In the short run, fewer inputs are required to produce less GDP. Thus, when the economy produces less, fewer worker are hired. That is why a recession is accompanied by an increase in the unemployment rate.

The natural rate of unemployment, u_n, is the unemployment rate that exists if only frictional and structural unemployment exists. There is no cyclical unemployment at the natural rate. Full employment output, Y_f, is the output (GDP) that would be produced if the unemployment rate was the natural rate. It's a guess by economists (not measured directly). If the economy is below Y_f, economists are worried about high unemployment.

Circular Flow

Whenever a purchase is made, that expenditure goes to income for someone else. If Joe buys an apple that Mary has harvested from her orchard, Joe's expenditure on the apple becomes income for Mary. In more realistic examples, purchases go to income for owners of firms, workers, and the suppliers. Thus, we think of demand as the same thing as income.

Who is doing the spending in an economy? First, households consume goods. Firms invest in new factories. The government spends money as well. Foreigners buy our goods too. Thus, total demand (aggregate demand) in an economy is the sum of these types of spending:

Aggregate Demand=Consumption + Investment + Government
Expenditures + Exports - Imports

AD= C + I + G + E - IM

(The reason we subtract the value of imports is because some portion of consumption measures spending on foreign goods, which should not be considered demand for domestic goods).

If any component of expenditures (say exports) increases, income and output will increase.

The Multiplier

If I decide to spend $100 dollars, total income in the economy will increase by more than $100. As an example, say I buy $100 tennis racquet. The store owner (let's simplify things and say the owner gets all the income. In reality, workers at the store and the tennis racquet manufacturer get income as well) will get $100 income. She will likely spend a portion of this on, say, an nice meal at a fancy restaurant. Now, the restaurant owner gets, say, $80, which he spends a portion of to repair his car. The mechanic will get the income, and, in turn, spend. The basic idea is that my original $100 expenditure will turn into more than $100 total expenditures, and thus more than $100 in income. GDP will go up by more than $100 when I decide to buy my tennis racquet!

If you are they government, you want to know how much GDP will increase by if, say, you buy a new jet fighter plane. If the plane costs $1bil, how much will total GDP go up by if it's bought?

We have a formula that relates the change in GDP or income (DY) to the original change in expenditure (DY). It will all depend on how much people spend of an extra (marginal) dollar that they get. The Marginal Propensity to Consume (MPC) is the portion of an extra dollar that people spend. For instance, if people tend to spend 80 cents of every extra dollar, the MPC is 0.80. In this case, people save the other 20 cents.

The Multiplier is defines as the inverse of one minus the MPC:

Multiplier = 1 / (1-MPC)

In the above example, if the MPC is 0.80, the Multiplier is 5 (=1/(1-.8) ).

The Multiplier is how much an extra dollar of spending is "multiplied" into extra income (GDP). The formula is:

DY = 1/(1-MPC) * DExpenditure

Continuing our example, if the MPC=0.80, and if the government bought a billion dollar plane, total income (GDP) would increase by $5bil (=1/(1-0.80) * $1bil).

Aggregate Demand

In addition to asking questions about output and unemployment, we might also want to ask when do prices rise (inflation)? In this section, we ask how are total expenditures related to price, and in the next we ask how is total output of the firm related to price. The two together will allow us to fix the price level and output level in the economy.

What happens to expenditures as prices rise? In some sense, we might expect nothing, since expenditures are simply income. Thus, if the prices of all goods rise, it costs more to buy goods. However, from the circular flow we know that expenditures eventually become income for someone. Thus, incomes will increase with prices. So, when prices rise, people earn higher incomes to pay for the more expensive goods. Thus, we might expect no change in total amount of goods purchased.

However, people spend money not based just on current income (ask any student!) but also based on wealth. If Bill Gates had a bad year and actually earned no income, I'm sure he would still spend more than me because he has much more money in the bank. If the price level rises, the value of money in the bank falls, since it takes more money to buy goods (that is what inflation means). Thus, people feel less wealthy when the price level increases. This Wealth Effect tells us that expenditures in the economy are negatively related to the price level.

The Aggregate Demand Curve (AD)shows all possible combinations of price level and income (GDP) level where what people are buying is equal to the income that is earned:

Shifts in Aggregate Demand

The AD curve shifts to the right whenever any component of expenditures increases. For instance, if investment or consumption increases, if we export more, if the government spends more, or if we import less, AD will shift to the right:

AD curve shifts to the left if any component of aggregate demand falls.

Aggregate Supply

The AD curve gives us all possible price level and output levels for the economy. But where does the economy actually locate? We need to look at how much total GDP is supplied by firms when the general price level rises. This is the supply side of the economy.

If there is an increase in demand, how does a firm respond? The firm can either raise prices or raise output. More likely, the firm does both. At the economy wide level, we believe that firms will increase prices and increase output at the same time. Thus, the price level and GDP are positively related. This implies that the Aggregate Supply curve is sloped upwards. The Aggregate Supply (AS) curve shows all combinations of price level and output where firms are willing to supply:

Shifts in AS curve

The AS curve increases (shifts to the right) if costs for firms fall. Costs include wages, energy costs, raw materials, etc. AS will also increase (shifts to the right) if technology gets better (and firms can make the same output using fewer inputs):

AD and AS together

Together, AD curve and AS curve set the price level and output level (GDP) in the economy. This is an extremely useful model for answering basic questions about the economy. For instance, let's say exports to Asia fall because those economies cannot afford our goods after their currency depreciated. What do we expect to happen to the price level, output, and the unemployment rate? First, we need to ask which curve shifts. If exports fall, AD will shift to the left. There is no mention of changes to firms' costs or technology changing, so AS is assumed to stay fixed. As AD falls, the price level should drop, and output will fall:

Since unemployment is inversely related to output (a firm will reduce the number of employees if it cuts back on production), we expect the unemployment rate to increase. Thus, the current troubles of Asian countries can be expected to exert downward pressure on U.S. prices, lower GDP, and raise the unemployment rate.

Can We Prevent Recessions?

What can economic policy makers do if unemployment is too high and output is too low? In the short run, low output is the result of a deficiency in demand. That is, people are not buying enough. In order increase demand, the government can try to spend more itself, or stimulate others to spend more.

Two types of economic policy exist. Fiscal policy is determined by the President and Congress when they agree on a budget. The two tools are government expenditures and taxes. To expand the economy (and push rightward the AD curve) the government would have to increase expenditures or decrease taxes (so that consumers could increase spending). The second policy is monetary policy, administered by the Federal Reserve system. By increasing the money supply, the Fed can give banks the ability to loan more, which will raise investment and consumption, and shift the AD curve to the right.

Economy at a Glance

Click here to see major economic indicators published by the Bureau of Labor Statistics. Visit the Index of Economic Activity of Humboldt Country (constructed by Professor Hackett in School of Business and Economics).