Changes in Macroeconomic Activity The Business Cycle The phases of the business cycle are: Recovery or Expansion, Peak or Boom (shaded green) Recession.

Changes in Macroeconomic

Activity

The Business Cycle• The phases of the business cycle are:

• Recovery or Expansion,• Peak or Boom (shaded green)• Recession or Contraction• trough or Depression (blue shaded areas).

Time

Real GDP

Business peak

Depressionor trough

Recession Rec

over

y

Business peak

Depression or trough

Trend line

• Ups and downs characterize business activity.• There has been an upward trend in real GDP in the

United States and other industrial nations.

The Business Cycle• Cycles are irregular

•Source: Economic Report of the President, various issues.

•Annual growth rate of real GDP

•6

•8

•4

•2

•0

•- 2

•1960 •1965 •1970 •1975 •1980 •1985 •1990 •1995 •2000 •2005

•Long-run growth rate(approx. 3%)

•2009

Changes in Total (Aggregate) Spending in

the Economy, cause changes in total

(aggregate) production and employment

1. Households2. Businesses3. The Government4. Foreigners

HouseholdsBusinesses

Goods and Services Markets

Resource Markets Resources

Payments $$

•Simple Case: all output is purchased by the household

•Nothing left for businesses, government or foreigners

1. Spend their earned income2. Biggest spenders

(7.1 of 10.2 trillion)3. Expansion

a. Increased spending

b. larger output

c. increased employment

d. more income

4. Contractiona. Decreased

spending

b. smaller output

c. decreased employment

d. less income

•Next Case: households save some of their income, output is left over

•Businesses purchase left over output, government or

foreigners still get none

AnotherCircular

Flow

1. Investment spending2. Borrow to buy capital

replace old and new machinery3. Reasons to buy or

investa. expected profits

b. economic activity

c. lower interest rates

•Next Case: not all output is purchased by the household or businesses

•something left for government or foreigners

1. Second largest spender

2. Purchases goods and services

3. provides transfers

No goods or services received

AnotherCircular

Flow

•Final Case: all output is not purchased domestically

•Something left for foreigners

1. Exports

Foreign purchases of US goods and services

2. Imports

US purchases of Foreign goods and services

AnotherCircular

Flow

From the Circular Flow:

1. Savings – consumers not spending

2. Taxes - money not able to spend3. Imports - money sent abroad

From the Circular Flow:1. Investments –spending from

Business

2. Government transfers - money not earned by Households

3. Exports - money from abroad

The Multiplier• The Multiplier:

A change in an injection (e.g. investment) leads to an even larger change in output and employment.

• An injection comes from outside of the circular flow. (non-household)

• Once it enters, the dollars are spent over and over.

• The multiplier is the number by which the change in spending is multiplied to obtain the total increase. • The size of the multiplier depends on

how much is spent of each increase. • The greater this %, the greater the effect

The Multiplier• Remember:

• injections will increase the size of the multiplier;

• leakages will decrease the size of the multiplier,

effectively, $4 million is spent in the economy.

• Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until …

Expenditure stage

Additional income(dollars)

Marginal propensity to consume

Additional consumption(dollars)

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

1,000,000 750,000

562,500

421,875

316,406

949,219

750,000 562,500

421,875

316,406

237,305

711,914

Round 1

Round 2

Round 3

Round 4

Round 5

Total 4,000,000 3,000,000

All others

3/4 3/4

3/4

3/4

3/4

3/4

3/4

The Multiplier Principle

• The multiplier concept is based upon the proportion of additional income that households choose to spend (here assumed to be 75% = 3/4).

Assume the people will spend .8 (80%) of a change in their income and the change in business investment is $10 (billion). Complete the table below. How much will they save? ______

change in income

change in consumptio

n

change in savings

increase in invest-ment of $10 billion

+ $10 8 2

2nd round 8 6.4 1.6

3rd round 6.4 5.1 1.3

4th round 5.1 4.1 1

5th round 4.1 3.3 .8

all other rounds

16.38 13.10 3.28

Totals 50 40 10

MPCSize of

multiplier

9/10 4/5 3/4 2/3 1/2 1/3

10.0 5.0 4.0 3.0 2.0 1.5

M = 1

1 - %spent

Higher SpendingMeans a Larger Multiplier

• As the spending % increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.).

• The effect is that for higher spending, higher multipliers result, specifically the relationship follows this equation:

Change in investment % saved multiplier effect

$10 20% ________

$10 10% ________

$10 25% ________

$20 20% ________

Calculating the effect of the multiplier:

change in the injection % not spent (saved)

•The phase of the business cycle where real GDP, or output, reaches its maximum is the:•a. limit •b. trough•c. peak•d. expansion•Money received by a household from the government for which there is no work directly performed in return is:•a. a surtax•b. a payment-in-kind.•c. a transfer payment.•d. an income tax refund.•Which of the following is a leakage from the spending stream by households?•a. saving•b. a decrease in earned income.•c. the receipt of transfer payments.•d. borrowing from financial institutions.

•A decrease in interest rates would•a. have no effect on investment decisions•b. make investment projects less attractive.•c. make more investment projects attractive•d. make investment spending as stable as personal consumption expenditures.The 2 main categories of government expenditures are:a. defense expenditures and tax refundsb. purchases of goods and purchases of servicesc. purchases of goods and services and transfer paymentsd. income determined and non-income-determined spending.The multiplier effect is the change in:a. income-determined spending generated by a change in total output.b. total output generated by a change in income-determined spending.c. total output generated by a change in non-income-determined

spending.d. non-income-determined spending generated by a change in total output