Download Lecture29(Ch25)

What are recessions?
What causes them?
Why do they end?
A role for government?
BILLIONS OF
1992 DOLLARS
6,750
6,500
Real GDP
6,250
6,000
Potential GDP
5,750
1988
BILLIONS OF
1992 DOLLARS
1989
1990
1991
8,000
7,000
6,000
5,000
4,000
Real GDP
3,000
Potential GDP
1960
1965
1970
1975
1980
1985
1990
1995
1992
1993
This morning’s headlines
First key idea of the theory of
economic fluctuations
• Recessions and “booms” are departures of
real GDP from potential GDP
25_02
TRILLIONS
OF 1992
DOLLARS
TRILLIONS
OF 1992
DOLLARS
6.25
e
Real GDP
(purple line)
6.25
c
Potential GDP
(black line)
b
6.00
b
6.00
Potential GDP
(black line)
d
a
c
Real GDP
(purple line)
a
5.75
5.75
Year 1
Year 2
Recession
Year 3
d
5
4
Year 1
a, b
3
e
2 1
0
1
2
3
4
Percentage deviation of
real GDP from potential GDP
5
Year 2
Boom
Year 3
Second key idea of the theory of
economic fluctuations.
• The departures are due to changes in
demand (aggregate demand). But why?
What about fluctuations in
potential GDP?
• These are usually too smooth to explain
recessions.
• Rarely is there a huge decline in labor,
capital, or technology at the time of a
recession
• Exceptions are important and have huge
effects, but not the typical recession
– AIDS epidemic in Africa
– Hurricane Mitch in central America
Using the Key Ideas
• Aggregate demand can be obtained by
adding up spending: C + I + G + X
• Example: forecast real GDP for 1999
• Y=C+I + G + X
– BUT WATCH OUT: C depends on Y, because
Y is income too: example C = 1000 + .6Y
Y
=C+I+G+X
– To see the implications of this dependence, put
I and X on the backburner for now
A consumption function:
Algebra example: C = 1000 + .6Y
or in numerical form:
25_01T
Consumption
Income
1,600
1,000
2,200
2,000
2,800
3,000
3,400
4,000
4,000
5,000
4,600
6,000
5,200
7,000
5,800
8,000
6,400
9,000
7,000
10,000
7,600
11,000
8,200
12,000
8,800
13,000
9,400
14,000
Or the same consumption
function in graphical form:
25_04
CONSUMPTION
(BILLIONS OF DOLLARS)
Consumption
function
5,000
4,000
3,000
Slope equals marginal
propensity to
consume.
Change in consumption
2,000
Change
in
income
1,000
1,000
2,000
3,000
4,000
5,000
6,000
INCOME (BILLIONS OF DOLLARS)
Making sure both relationships
are satisfied
• Income (which equals spending) depends on
consumption
– Or in equation form, Y = C + I + G + X
– this is the income-spending identity
• Consumption depends on income
– Or in equation from, C = 1000 + .6Y
– this is the consumption function
Economists fool around with
the second relationship (the
consumption function) a little bit
• They add investment (I), government
purchases (G), and net exports (X) to the
consumption function
– They get a total sum which shows how
C + I + G + X depends on income
• They call this “total sum” the aggregate
expenditure line
The aggregate expenditure (AE) line
25_07
C+I+G+X
SPENDING
C+I+G
Aggregate expenditure line
C+I
s
t
Ne
ort
p
x
e
nt p
e
rnm
e
v
Go
nt
e
m
est
v
n
I
C
ses
a
h
urc
Consumption function
C = Consumption
I = Investment
G = Government
purchases
X = Net exports
INCOME OR REAL GDP
Note that the AE line shifts up
and down if G or I or X change
(question: what is the effect of the Asian
financial crisis on AE in the United States?)
Now let’s remind ourselves that
spending equals income; graphically
this gives the 45-degree line
25_06
SPENDING
45-degree line
B
A
45°
A
B
INCOME OR REAL GDP
Put the AE line and the 45 degree
line together to get spending balance
25_09
SPENDING
45-degree line
AE line
Point of spending balance
Level of real GDP at
spending balance
INCOME OR REAL GDP
Sometimes numerical examples help
one see spending balance better
25_02T
Income or
Real GDP
6,000
7,000
8,000
9,000
10,000
11,000
12,000
13,000
14,000
Aggregate
Expenditure
7,600
8,200
8,800
9,400
10,000
10,600
11,200
11,800
12,400
Consumption
4,600
5,200
5,800
6,400
7,000
7,000
8,200
8,800
9,400
Investment
900
900
900
900
900
900
900
900
900
Government Net
Purchases Exports
2,000
2,000
2,000
2,000
2,000
2,000
2,000
2,000
2,000
100
100
100
100
100
100
100
100
100
Finally, let’s imagine that the AE
line shifts down, perhaps because
of the Asian financial crisis
25_10
SPENDING
45-degree line
Original point
of spending
balance
Original AE line
New AE line
G falls by this
amount
($100 billion).
New point of spending balance
Income or real GDP falls by this amount
(more than $100 billion).
New
income
level
Original
income
level
INCOME OR REAL GDP
In general, when the AE line shifts,
real GDP falls (d) or rises (e)
25_11A
SPENDING
(TRILLIONS
OF 1992 DOLLARS)
45 line
6.50
e
Boom
AE line
6.25
Normal
AE line
c
6.00
Recession
AE line
d
5.75
5.75
6.00
6.25
6.50
INCOME OR REAL GDP
(TRILLIONS OF1992 DOLLARS)
Three
possible
lines for
year 3
It is hard to imagine the AE line shifting.
Can you show how this works with
animated graphics or just a blackboard?
These falls or rises take real GDP
away from potential GDP
• They are the
first steps
toward
recession (d) or
boom (e)
25_11B
SPENDING
(TRILLIONS
OF 1992 DOLLARS
6.50
(Boom)
e
6.25
c
b
6.00
(Real GDP=
potential GDP)
d
(Recession)
a
5.75
Year 1
Year 2
Year 3
But they are not the final steps
• To see what happens next (and ultimately to
see why the economy recovers from
recession), we need to look at the forces of
adjustment in the economy
• These forces are the subject of the next
lecture
END
OF
LECTURE