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Chapter Nine: Aggregate Demand and Economic Fluctuations
27

Chapter Nine: Aggregate Demand and Economic Fluctuations.

Jan 16, 2016

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Garry Summers
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Page 1: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Chapter Nine:

Aggregate Demand and

Economic Fluctuations

Page 2: Chapter Nine: Aggregate Demand and Economic Fluctuations.

The Business Cycle

Page 3: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Figure 9.1: U.S. Real GDP and Recessions

Source: BEA quarterly data 1985–2012, and NBER

Page 4: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Figure 9.2: U.S. Unemployment Rate and Recessions

Page 5: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Figure 9.3: U.S. Inflation Rate and Recessions

Source: “Economic Report of the President” 1985–2005; rate is calculated as a three-month moving average of the CPI; NBER.

Page 6: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Year

Trough

Contraction ExpansionG

DP

Y*

Peak Peak

Figure 9.4: A Stylized Business Cycle

Page 7: Chapter Nine: Aggregate Demand and Economic Fluctuations.

  1929 1933(a) Real Standard and Poor’s Stock Index 100.0 45.7(b) Unemployment rate (official) 3.2% 24.9%(c) Price level (CPI) 100.0 75.4(d) Real gross domestic product 865.2 billion 635.5 billion(e) Real personal consumption

expenditures 661.4 billion 541.0 billion(f) Real gross private domestic

investment 91.3 billion 17 billion(g) Real private debt 88.9 billion 102.0 billion(h) Bankruptcy cases 56,867 67,031(i) Non-farm real estate foreclosures 134,900 252,400(j) Food energy per capita per day

(calories)3460 3280

Table 9.1: The Early Years of the Great Depression in the United States

Sources: (a) from Historical Statistics of the United States, p. 1004, series X495.; (b)-(c) from Dornbusch, Fischer, & Startz (2001);( d)-(f) from http://www.bea.doc.gov/bea/dn/nipaweb/TableView.asp#Mid; (g) from Historical Statistics of the United States, p. 989, series X399.; (h) from Bradley Hansen and Mary Eschenbach Hansen, The Transformation of Bankruptcy in the United States (http://academic2.american.edu/~mhansen/transform.pdf ); (i) from Historical Statistics of the United States, p. 651, series N301; (j) from Ibid., p. 328, series 851; (d) and (e) are inflation-corrected using (b)

Page 8: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Macroeconomic Modeling and Aggregate Demand

Page 9: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Output

(Y )

Income

(Y )

Spending

(Aggregate Demand or AD )

Spending stimulates firms to produce

Production generates incomes

Incomes give actors the ability to spend

Figure 9.5: The Output-Income-Spending Flow of an Economy in Equilibrium

Page 10: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Production generates income to households

Saving (S )

leakage

Intended Investment ( II )

injection

firms decide how much to invest

households decide how much to consume and save

Output (Y )

Spending (AD )

Income (Y )

Consumption (C )?Sufficient to sustain output at a steady level

Figure 9.6: The Output-Income-Spending Flow with Leakages and Injections

Page 11: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Quantity of funds borrowed and lent

Inte

rest

rat

e

140

5%

Supply of Loanable Funds

Demand for Loanable Funds

E1

Figure 9.7: The Classical Model of the Market for Loanable Funds

Page 12: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Quantity of funds borrowed and lent

Inte

rest

rat

e

140

5%

Supply of Loanable Funds

Original Demand

E1

New Demand

60

3%

E0

Figure 9.8: Adjustment to a Reduction in Intended Investment in the Classical Model

Page 13: Chapter Nine: Aggregate Demand and Economic Fluctuations.

leakage

injection

Production generates income

Spending stimulates firms to produce

Saving (S )

Equilibrium in the market for loanable funds

Intended Investment (II ) is equal to S

Output (Y* )

Consumption (C )

Income (Y* )

Spending sufficient to sustain full

employment

AD = Y*

Figure 9.9: Macroeconomic Equilibrium at Full Employment in the Classical Model

Page 14: Chapter Nine: Aggregate Demand and Economic Fluctuations.

The Keynesian Model

Page 15: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Table 9.2: The Consumption Schedule (and Saving)

Page 16: Chapter Nine: Aggregate Demand and Economic Fluctuations.

45

Consumption (C )

(= + mpc Y)

Income (Y )

Co

nsu

mp

tio

n

(C )

Consumption = Income Line

400

Saving (S)

100

C

500

400

300

200

100

0

= 20

340

C

Slope = mpc

Figure 9.10: The Keynesian Consumption Function

Page 17: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Income (Y )

Inte

nded

Inv

estm

ent

(= I

I )

Intended Investment (II )

(= II )II = 60

Figure 9.11: The Keynesian Investment Function

Page 18: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Consumption (C )

Income (Y )

Con

sum

ptio

n, I

nves

tmen

t, a

nd

Agg

rega

te D

eman

d

400

400

Aggregate Demand(AD ) = C + II

Intended Investment (II )340

80C +II =

Figure 9.12: Aggregate Demand

Page 19: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Table 9.3: Deriving Aggregate Demand from the Consumption Function and Investment

(1)Income

(Y)

(2)Consumption

(C)

(3)Intended

Investment(II)

(4)Aggregate Demand

AD = C + II= column (2) + column (3)

0 20 60 80300 260 60 320400 340 60 400500 420 60 480600 500 60 560700 580 60 640800 660 60 720

Page 20: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Table 9.4: Aggregate Demand with Higher Intended Investment

(1)Income

(Y)

(2)Consumption

(C)

(3)Intended Investment

(II)

(4)Aggregate Demand

(AD)

0 20 140 160

300 260 140 400

400 340 140 480

500 420 140 560

600 500 140 640

700 580 140 720

800 660 140 800

Page 21: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Income (Y )

Agg

rega

te D

eman

d

400100

1000

800

700

600

500

400

300

200

100

0

AD (II = 140)

800

AD (II = 60)

480

160

80

Figure 9.13: Aggregate Demand with a Higher Level of Intended Investment

IIC IIC

==

Page 22: Chapter Nine: Aggregate Demand and Economic Fluctuations.

(1)Income

(Y)

(2)Aggregate Demand

(AD)

(3)Excess Inventory

Accumulation (+) or Depletion (-)= column(1)-

column(2)

(4)Intended

Investment(II)

(5)Investment

(I)= column(3)+ column(4)

(6)Check that the

macroeconomic identity still holds:

Y = C+I

300   320   -20   60   40   300  400   400   0   60   60   400  500   480   20   60   80   500  600   560   40   60   100   600  700   640   60   60   120   700  800   720   80   60   140   800  

Table 9.5: The Possibility of Excess Inventory Accumulation or Depletion

Page 23: Chapter Nine: Aggregate Demand and Economic Fluctuations.

45

Income (Y )

Agg

rega

te D

eman

d an

d O

utpu

t

Output = Income Line

400100

1000

800

700

600

500

400

300

200

100

0

Aggregate Demand (AD )

800

E

unintended investment (build up of inventories)

80

720

Figure 9.14: Unintended Investment in the Keynesian Model

Page 24: Chapter Nine: Aggregate Demand and Economic Fluctuations.

45

Income (Y )

Agg

rega

te D

eman

d an

d O

utpu

t

400100

1000

800

700

600

500

400

300

200

100

0

AD0 (II = 140)

800

E0

Full Employment

Y*

160

Figure 9.15: Full Employment Equilibrium with High Intended Investment

Page 25: Chapter Nine: Aggregate Demand and Economic Fluctuations.

45

Income (Y )

Agg

rega

te D

eman

d an

d O

utpu

t

400100

1000

800

700

600

500

400

300

200

100

0

AD0 (II = 140)

800

E1

E0

Full Employment

AD1 (II = 60)

Persistent unemployment equilibrium

Y*

80

160

Figure 9.16: A Keynesian Unemployment Equilibrium

Page 26: Chapter Nine: Aggregate Demand and Economic Fluctuations.

Income (Y* )

Insufficient Spending

AD < Y*

Production generates income

Income goes to households

If leakages are larger than injections…

Lower Income

Lower Spending

AD = lower YLower Output

Output (Y* )

Figure 9.17: Movement to an Unemployment Equilibrium

Page 27: Chapter Nine: Aggregate Demand and Economic Fluctuations.

(1)Change in Intended Investment

(2)Change in Aggregate Demand

(as C or II change)and in Output and Income

(as firms respond to changes in AD)

(3)Change in Consumption

ΔC = mpc Δ Y= .8 Column (2)

1. Investors lose confidence.Δ II = 80

2. Reduced investment spending leads directly to Δ AD = 80.Producers respond to reduced demand for their goods by cutting back on production.Δ Y = 80

3. Less production means less income. With income reduced by 80, households cut consumptionby mpc Δ Y= .8 80ΔC = 64

 

4. Lowered consumption spending means lowered ADΔ AD = 64Producers respond.Δ Y = 64

5. Households cut consumptionby mpc Δ Y= .8 4ΔC = 51.2

6. Δ Y = 51.2 7. mpc Δ Y = .8 51.2ΔC = 40.96

8. Δ Y = 40.96 9. ΔC = 32.77

10. Δ Y = 32.77 11. ΔC = 26.21

etc. etc.

Sum of changes in Y= 80 + 64 + 51.2 + 40.96 + 32.77 +. . . .= 400

 

Table 9.6: The Multiplier at Work