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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 MV 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: GG 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.