Download Chapter 7: Introduction to Business Cycles

Chapter 7: Introduction to Business Cycles:
Consumption and the Multiplier
J. Bradford DeLong
--Draft 1.0-1999-03-04: 5,990 words
Real GDP in the American economy grows at an average rate of some 2.5
percent per year. The unemployment rate in the American economy
fluctuates around an average level of about 5.5 percent. In recent years the
inflation rate in the U.S. economy has averaged about 2 percent per year.
If chapters 4, 5, and 6 gave a complete picture of how the macroeconomy
behaved, economic growth would be smooth. Real GDP would grow by
2.5 percent per year--the rate of growth of potential GDP--year after year,
not just on average. The unemployment rate would remain steady at its
natural rate of 5.5 percent. Inflation would be steady as well.
And this page would be the last page of this textbook.
But chapters 4, 5, and 6 do not give a complete picture. For growth is not
at all smooth. In 1982 real GDP was not 2.5 percent more but 2.1 percent
less than in 1981. The unemployment rate rose by 4.1 percentage points
between 1979 and 1982--and again by 2.2 percentage points between 1989
and 1992. Inflation reached its post-World War II era high in 1981, when
the GDP deflator grew by 9.4%--and inflation has fallen since, so that in
1999 the GDP deflator grew by only 2.2%.
The U.S. economy undergoes relatively large year-by-year fluctuations--in
unemployment, in production, and in prices--about its long run growth
trend. For more than one hundred years economists have called these
fluctuations business cycles.
Economists divide business cycles into two parts. Economic expansions
are the times when output and employment are rising (and the
unemployment rate is usually falling). Recessions are the times when
production and employment are falling--and the unemployment rate is
rising. An especially steep recession is called a "depression." Politicians in
office don't want to speak the word "recession"--so they often speak in
euphemisms: periods of "adjustment," "slow growth," and so on. An
expansion and the subsequent recession make up a complete business
cycle.
Sticky short-run prices
Models in which prices are "sticky".
Two key differences.
There are two key differences between the analysis of chapter 6--in which
GDP was always equal to potential output, and in which there were no
business cycle fluctuations--and the analysis of the rest of the book. First,
in chapter six prices were flexible. Any changes in supply and demand
conditions produced shifts in prices that restored the balance of supply
and demand. That was what allowed us to start our analyses by noting
that GDP was and would remain equal to potential output.
The rest of this textbook is a sticky-price textbook.
From this point in the textbook on, prices are "sticky": they don't move
freely and instantaneously in response to changes in demand and supply.
Instead, businesses first expand or contract production in response to
changes in demand and cost, while prices remain fixed at predetermined
levels.
Such "sticky prices" make a big difference.
What happens when prices are sticky?
For a preview of this difference, consider a situation like that at the very
end of chapter 6, in which a fall in central bank monetary policy leads to a
significant decline in the economy's money stock--in the amount of wealth
held in the form of readily-spendable purchasing power.
In the full-employment model.
In the full-employment model of chapter 6, such a change has no impact
on the level of real GDP: prices will shift to keep demand for the factors of
production equal to their supplies, and so real GDP will remain equal to
potential output:
Y  0
What impact will such a fall in the economy's money stock have on prices?
According to chapter 6, the quantity equation:
P
MV
Y
will continue to hold, so:
P 
V 
M
Y 
We can describe in words the process by which such a change in monetary
conditions--a reduction in the economy's nominal money supply, its
nominal stock of assets that can be easily used to purchase commodities-leads to no change in the level of production but to a decline in the price
level. As the nominal supply of money falls, consumers and investors find
themselves illiquid, short of cash. They cut back on their spending as they
try to devote a share of their incomes to building-up their liquid cash
reserves.
As firms see spending on their products fall, they cut their nominal prices-and they cut the nominal wages that they can afford to pay workers. The
workers don't care because they realize that the decline in nominal wages
is not a decline in real wages--that falling prices mean that their lower
(nominal) wages buy the same commodities as before. The business
managers don't care because they realize that the decline in nominal prices
for their products is matched by an equal decline in the wages and other
costs they must pay.
This process continues until the total nominal flow of spending is once
again proportioned to the economy's supply of liquid assets, with the
price level lower but with the level of real GDP unchanged, equal to
potential output.
In a sticky-price model.
But things are very different if prices are "sticky." As the nominal supply
of money falls, consumers and investors find themselves illiquid, short of
cash. They cut back on their spending as they try to devote a share of their
incomes to building-up their liquid cash reserves.
As firms see spending on their products fall, they do not cut their nominal
prices--remember, prices are sticky. Instead, they respond to falls in
demand by reducing their production in order to avoid uncontrollable
rises in unsold inventory. Thus in the short run, to a first approximation,
as long as the velocity of money reamins constant (which it may well not
be), the effect of a change in monetary policy that reduces the money
supply will be no change in the "sticky" level of prices:
P  0
But a significant fall in real GDP:
Y 
V 
M
P 
We will develop the argument of the paragraphs above--in words,
diagrams, and algebra--at extended length over the next several chapters.
Understanding the difference between full-employment and sticky-price models.
Price stickiness causes problems only if inflation expectations are not accurate.
Note that stickiness of prices not a serious problem if expectations of the
change of prices--expectations of inflation--turn out to be equal to actual
inflation. If people accurately foresee changes in the overall level of prices,
then even "sticky" prices will not keep the market system from producing
a level of real GDP equal to potential output. Prices and wages are sticky,
but not that sticky: with sufficient advance notice unions and businesses
can strike wage bargains, and businesses can adjust their selling prices, so
that they can match their productive capacity to demand and will not
have to cut back on production and fire workers in order to keep unsold
inventory from exploding.
Both stickiness of prices in the short run and a failure to accurately foresee
future changes in the overall price level are needed to create the shortterm year-by-year fluctuations in production and unemployment we call
"business cycles."
Sources of price stickiness.
Note that prices could be "sticky" for any of a number of reasons. Why
don't prices adjust quickly and smoothly to maintain production at full
employment? Why do businesses respond to fluctuations in demand first
by hiring (or firing) workers and accelerating (or shutting down)
production lines? Why don't they response first by raising or lowering
prices.
There are a number of possible reasons that have been sketched out by
economists. But there is great uncertainty about which reasons are truly
important.
First, businesses and workers can find that changing their prices or the
wages they demand is costly. Hence they will prefer to keep their prices
and wages unchanged as long as the shocks affecting the economy are
relatively small, or rather as long as the change that they would wish to
make in their prices and wages (if it was costelss to change them) is small.
Such "menu costs" can themselves arise for a large number of reasons:
perhaps people wish to stabilize commercial relationships by signing
long-term contracts, perhaps it is expensive to reprint a catalog, perhaps
your customers find frequent price changes annoying, perhaps other firms
are not changing their prices and what matters most to your firm is your
price relative to the price of your competitors.
Second, businesses and workers can lack complete information about the
state of the economy. They can be unsure whether a change in the flow of
spending on their products reflects a change in overall aggregate demand,
or a change in demand for their particular product which they should
respond to by changing how much they produce.
Third, workers might simply not be the flinty-eyed rational economic
maximizers of our theories. First, work effort and work intensity depends
on whether employees believe that they are being treated fairly. And for
your boss to cut your nominal wages is almost universally perceived as
"unfair." Wages depend on social norms that usually evolve slowly. Thus
wages are sticky by nature. And if wages are sticky, firms will find that it
is best for them to respond to shifts in demand by hiring and firing
workers rather than by changing prices and trying to pass those changes
in prices through to what they pay workers.
Fourth--and this is another theory in which workers are not the flintyeyed rational economic maximizers of economists' theories--a significant
body of evidence suggests that workers, consumers, and managers can
confuse changes in nominal prices with changes in real (that is, inflationadjusted) prices. Firms may react to higher (nominal) prices by thinking
(falsely) that it is more profitable to produce more, even though it isn't
because their costs have risen in proportion. Workers may react to higher
(nominal) wages by searching more intensively for jobs and working more
overtime hours, even though rises in prices have erased any increase in
the real purchasing power of the wage paid for an hour's work.
All these are potential powerful sources of price stickiness. Your course
lecturer--and your section leader--may have strong views as to which of
these is most likely to be correct. I think that our knowledge is more
limited--I at least am not sure that the evidence is strong enough to
provide clear and convincing support for the position that any particular
one of these sources of price and wage stickiness is the most important.
How to reconcile chapter 6 with the rest of the book.
How are we to reconcile the analyses of the rest of the book--in which
changes in government policy and the economic environment have effects
not only on the composition but the level of real GDP--with the analysis of
chapter 6, in which changes in government policy and in the economic
environment affect the composition but not the level of real GDP?
The conventional way is to say that the analyses of chapter 7 forward are
"short run" analyses and that the analysis of chapter 6 (and 5, and 4) are
"long run" analyses. In the short run prices are sticky, and so shifts in
policy or the environment that affect the total flow of nominal spending
affect the level of output (but not the level of prices)--in the short run. In
the long run prices are flexible, and so shifts in policy or the environment
that affect the total flow of nominal spending affect the level of prices (but
not the level of production)--in the long run.
But when does the "long run" arrive? Do we change from living in the
short run of chapters 7 forward to the long run of chapter 6 on June 19,
2005? Clearly not. The long run is an analytical construct. A change is
"long run" if people see it coming far enough in advance, or have had long
enough to adjust to it to renegotiate all their contracts and change their
standard operating procedures. And if those changes in contracts and
standard operating procedures are also foreseen that those affected by
them have had time to adapt and adjust as well.
If expectations of inflation rates and the economic environment are
accurate, then even in the month-by-month or quarter-by-quarter context
the world works as if we were in the full-employment model of chapter 6.
The long run is now. And if expectations of inflation and of the economic
environment are not accurate, then the world may not work as if we were
in the full-employment model of chapter 6 even if the shock or change to
the economy took place five or ten years ago.
How fast it takes the long-run to arrive thus depends on how expectations
of inflation and other variables in the economy are formed. Economists
consider three benchmark types of processes for forming expectations that
fall along a spectrum. Expectations can be static, expectations can be
adaptive, or expectations can be rational. The closer the processes for
forming expectations are to the front end of the spectrum, the less relevant
is the full-employment model of chapter 6 to understanding the economy.
The closer the processes for forming expectations are to the back end of
the spectrum, the more relevant is the full-employment model of chapter
6.
These issues will be dealt with at length in chapter __.
The income-expenditure diagram
Higher aggregate demand boosts national product, which boosts
employment and incomes. Higher incomes give a further boost to
consumption, which in turn boosts aggregate demand. A shift in
aggregate demand leads to an amplified shift in national product because
of the induced shift in consumption.
John Maynard Keynes was one of the first to stress the importance of this
multiplier process. In booms it induces an upward spiral in production
(although also an acceleration of inflation). In bad times it is a source of
misery: a downward shock is amplified as those thrown out of work cut
back on their consumption spending. The multiplier is quantitatively
important because--as we saw above--consumption spending is more
than two-thirds of aggregate demand. Hence any positive-feedback
process by which higher spending leads to higher production which leads
to higher incomes which leads to higher consumption spending has the
potential to be quantitatively important.
The rest of this chapter sets out how the level of aggregate demand is
determined in the sticky-price context. The approach is a bottom-up
approach: build up planned expenditure on domestic products E out of
the determinants of each of its components, consumption spending C,
investment spending I, government purchases G, and net exports NX:
E  C  I  G  NX
Building up planned expenditure.
The consumption function.
Consumption: spending by households on services such as haircuts,
nondurable goods such as food, and durable goods such as washing
machines. As incomes rise, consumption spending rises--thus increasing
demand, and setting the multiplier process in motion. But as we saw in
chapter 6 consumption rises less than dollar-for-dollar with total incomes.
The share of an extra dollar of income that is added to consumption
spending is the marginal propensity to consume, or MPC, denoted in
equations by the letter lower-case c. For reasonably long-lasting shifts in
the level of income, the MPC it is roughly about 0.6. That is, 60 cents of
every extra income dollar shows up as higher consumption.
The consumption function is the mathematical relationship that describes
the dependence of consumption spending on economy-wide after-tax
incomes, equal to one minus the tax rate times the level of real GDP, (1-t) x
Y:
C  C((1  t)Y)  c0  c(1  t)Y
Consumption C has two parts: a baseline level of autonomous
consumption (c0) which is independent of the current level of national
income; and additional consumption that does depend on the level of
national income and is equal to the product of after-tax incomes ((1-t) x Y)
and the marginal propensity to consume (c).
Other components of planned expenditure.
The determinants of the other components of planned expenditure on
domestic products are familiar form chapter six. The amount of
investment spending that firms, home builders, and others plan on
undertaking is:
I  I(r)  I0  r
The amount of government purchases is set by the Congress and the
President:
GG
Net exports are a function of the real exchange rate , and the levels of real
GDP or national income, both domestic Y and foreign Yf.
NX  X( ,Y f )  IM(Y)  X 0  xY f    Y
And we can substitute out the exchange rate by using the interest-rate
equation for the determination of the exchange rate as a function of the
gap between the home real interest rate r and the foreign real interest rate
rf:
   0  (r  r f )
Into the equation determining the level of net exports:
NX  X( 0 ,(r  r f ),Y f )  IM(Y )  X0  xY f   0   (r  r f ) Y
We can substitute the determinants of each component of planned
expenditure on domestic products for each component:
E  c0  c(1  t)Y  I0   r  G  X 0  xY f   0   (r  r f ) Y
And then regroup in order to classify things that might affect planned
expenditure on domestic products into four groups: (i) the level of real
GDP or national income, (ii) the level of the domestic real interest rate, (iii)
conditions abroad, and (iv) others--consumers' and investors' optimism,
government purchases, foreign-exchange speculators' views, and still
more:
E  c(1  t)  Y   r  r   xY f   r f  c0  I0  G  X0   0 
Planned expenditure and national income.
The income-expenditure diagram.
The most straightforward way to draw out the implications of this
bottom-up approach to understanding planned expenditure on domestic
products is to draw a diagram, the income-expenditure diagram,
sometimes called the Keynesian cross. On the vertical axis we plot the value
of planned expenditure. On the horizontal axis we plot the value of
national income (or real GDP: at this level of aggregation we neglect the
NIPA differences between the two).
[Figure: the income-expenditure diagram]
The planned expenditure line.
On this income-expenditure diagram plot planned expenditure on
domestic products as a function of the level of national income. This
planned expenditure line intercepts the y-axis at a positive value that
depends on the parameters of the model, and on the values of other
variables--r, G, rf, and so forth--other than the level of national income, or
real GDP. Changes in the values of these other variables, or in most of the
parameters of the model, will shift this planned expenditure line up or
down.
[Figure: income-expenditure diagram, the planned expenditure line]
The higher national income, the higher aggregate demand. This planned
expenditure line has a positive slope, but a slope less than one. In fact, the
slope of the planned expenditure line, the marginal propensity to spend
[MPS] is:
Each one dollar increase in national income Y carries with it an increase in
planned expenditure of c* = c(1-t) - . A one dollar increase in national
income or real GDP carries with it an increase in imports of --which
reduces planned expenditure on domestic products by reducing net
exports--but also an increase in consumption spending: a one-dollar
increase in national income increases after tax incomes by (1-t) dollars, one
minus the tax rate, and leads to an increase in consumption spending by
(1-t) x c, by the increase in after-tax incomes times the marginal propensity
to consume.
The larger the marginal propensity to consume, the steeper the slope of
this planned expenditure line. The higher the tax rate, the shallower the
slope of this planned expenditure line. And the higher the marginal
propensity to import , the shallower the slope of this planned
expenditure on domestic products line.