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Economics
THIRD EDITION
By John B. Taylor
Stanford University
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
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Chapter 23 (Macro 10)
The Nature and
Causes of Economic
Fluctuations
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Overview
This chapter develops an initial explanation of
economic fluctuations that is based on changes in
aggregate demand. To illustrate the concept that
changes in aggregate demand lead to short-run
fluctuations in real GDP, a description of how real
GDP is forecast is included. Unconditional and
conditional forecasts are used to introduce the
aggregate expenditures' dependence, via the
consumption function, on income. The spending
balance is carefully developed in both graphical
and tabular form.
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Teaching Objectives
• Introduce an explanation of how and why
economic fluctuations occur.
• Introduce the simple consumption function and
discuss its properties.
• Develop an Aggregate Expenditures (AE) -income
spending balance relationship in which only
consumption depends on income.
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1. Changes in Aggregate Demand First Lead to Changes in Output
1a. Figure 23.1 places the problem of
economic fluctuations in the familiar setting
of the previous chapters. In Figure 23.2 the
distinction between potential GDP and real
GDP at a point in the business cycle is used
to emphasize that changes in aggregate
demand explain economic fluctuations.
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Figure 23.1
(Macro 10)
Narrowing the Focus on
Economic Fluctuations
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Figure 23.2
(Macro 10)
The First Step of an Economic Fluctuation
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1. Changes in Aggregate Demand…. (cont.)
1b. The decisions of individual firms depend on
capacity utilization. Firms generally increase or
decrease production, not prices, in the short run or
over the business cycle.
Firms have the ability to vary production over a
range of utilization, for example, between 70 and 90
percent. High utilization rates in factories and
unemployment below the natural rate occur during
booms, while the opposite occurs in recessions.
Firms respond to changes in demand through
changes in production in all areas, not just in
manufacturing. For example, construction
employment is quite sensitive to changes in demand.
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1. Changes in Aggregate Demand…. (cont.)
• 1c. The explanation of why changes in demand
result in changes in production relies on two
factors.
• 1c.1 Firms operate with limited information,
uncertain about whether an increase in demand is
permanent or temporary. Firms are often reluctant
to raise prices because of uncertainty and an
implicit contract with customers. Similar
arrangements with workers lead to nominal wage
rigidities.
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1. Changes in Aggregate Demand…. (cont.)
• 1c.2 The response of the typical firm is
illustrated in Figure 23.3. Demand is
uncertain: It can be high, medium, or low.
The flexible price assumption views the
firm as adjusting price; under the sticky
price assumption, the firm adjusts quantity.
If demand becomes certain or is viewed as
permanent, a firm is more likely to adjust
price than quantity.
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Figure 23.3 (Macro 10)
Alternative Short-Run Responses of a Typical Firm to a Change in Demand
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1. Changes in Aggregate Demand…. (cont.)
• 1d. Another explanation of economic fluctuations
is the real business cycle theory. Under this
explanation, the source of economic fluctuations is
found in frequent shifts in potential GDP. This
would mean that the determinants of aggregate
supply (labor, capital, and technology) must shift
frequently. However, these determinants tend to
change slowly over time.
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2. Forecasting Real GDP
• 2a. The case for viewing shifts in aggregate
demand as the source of economic
fluctuations can be seen as a forecasting
problem. To forecast real GDP, a forecast of
each component is made and then added
together using the GDP identity: Y = C + I +
G + X . As the underlying factors for each
spending component change, the value in
the forecast changes.
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2. Forecasting Real GDP (cont.)
• 2b. Another approach is to make a
conditional forecast, one in which
alternative assumptions about the value of
an underlying factor or the value of one of
the spending components is made. This
approach to forecasting real GDP makes
clear that it is changes in the spending
components, or aggregate demand, that are
responsible for economic fluctuations
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3. The Response of Consumption to Income
• 3a. The consumption function describes
how consumption depends on income. This
relationship is illustrated by Table 25.1.
From this data we are able to determine the
marginal propensity to consume (MPC).
Figure 23.4 graphs the consumption-income
relation.
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Figure 23.4
(Macro 10)
The Consumption Function
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3. The Response of Consumption to Income
• 3a.1 The measure of income used, whether
real GDP, income, or disposable income,
depends in part on the purpose of the
analysis. However, because taxes and
transfer payments tend to be a constant
proportion of income, the measures bear
essentially the same relation to
consumption, as in Figure 23.5.
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Figure 23.5
(Macro 10)
Consumption versus Aggregate
Income
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3. The Response of Consumption to Income (cont.)
• 3b. Other influences, such as the interest
rate and wealth, are less important in the
short run and so are ignored in the initial
explanation.
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4. Finding Real GDP When Consumption and Income
Move Together
• 4a. There are now two income-related parts to the
determination of aggregate demand or spending:
the GDP identity and the consumption function.
Taken together they determine GDP for a given
forecast change.
4b. The 45-degree line in Figure 23.6 is used to
determine the income-spending equality.
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Figure 23.6
(Macro 10)
The 45-Degree Line
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4. Finding Real GDP… (cont.)
• 4c. The aggregate expenditure ( AE ) line
results from adding up the spending
components successively, as in Figure 23.7.
• 4c.1 The slope of the AE line depends at this
point on the consumption-income relation
and is the MPC.
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Figure 23.7 (Macro 10)
The Expenditure Line
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4. Finding Real GDP… (cont.)
• 4c.2 Changes in any autonomous spending
component shift the AE line. For example,
an increase in I will shift the AE line up, as
in Figure 23.8.
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Figure 23.8
(Macro 10)
Shifts in the Expenditure Line
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4. Finding Real GDP… (cont.)
• 4d. The level of real GDP is determined
through the spending balance between AE
and income using the 45-degree line, as in
Figure 23.9 and Table 23.2. These examples
illustrate a temporary equilibrium for actual
GDP, not necessarily potential GDP.
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Figure 23.9 (Macro 10)
Spending Balance
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4. Finding Real GDP… (cont.)
• 4e. The AE -spending balance approach
gives a different conditional forecast for the
proposed $100 billion decline in G
discussed as an example, as in Figure 23.10.
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Figure 23.10 (Macro 10)
From One Point of Spending Balance to Another
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5. Spending Balance and Departures of Real GDP from
Potential GDP
• Figure 23.2 was used to illustrate the type of
departure from potential GDP that is characteristic
of economic fluctuations. In Figure 23.11 we
return to this setting to show how changes in AE
explain departures from potential GDP. Although
the departures are short-run balance points, they
are first steps in a process that brings GDP back to
potential GDP.
• Successive downward shifts in AE are a key
reason for the Great Depression.
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Figure 23.11
(Macro 10)
Spending Balance and Departures of Real GDP from Potential GDP
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