AGREGATE DEMAND AND BUSINESS CYCLES

dr. Aleksandar KešeljevićFaculty of Economics

University of LjubljanaAssistant professor

THREE MAIN TOPICS

A. AD, CONSUMPTION AND INVESTMENT (Ch. 21)

B. BUSINESS CYCLES AND AGGREGATE DEMAND (Ch. 22)

C. TODAY’S CRISIS

A. AGREGATE DEMAND

1. CONSUMPTION (C)2. INVESTMENT (I)

3. GOVERNMENT EXPENDITURES (G)4. NET EXPORTS (NX)

1. CONSUMPTION

• AD= C+I+G+NX• Y= C + S → C = f (Y)• C = 55% GDP• Family budget expenditures (P)• Consumption function (P)• Marginal propensity to consume (MPC) (P)• MPC + MPS = 1• Hypothesis (classical, Friedman, Modigliani)• Determinants of consumption (DI, weath, live cycle,…)

P: Family budget expenditures

P: Consumption function

P: Consumption function

P: MPC

P: MPC

Saving

• Y= C + S • The saving function (P4)• MPS = 1 – MPC• Paradoks of saving

(S↑→C↓→AD↓→Y↓→S↓)• S = f (Y, i, T, social security system, financial

markets, inflation…..)

P: The saving function

2. INVESTMENT

• Double role of I (AD= C+I+G+NX; AS)• The investment demand curve (P)• Determinants of investments (revenues,

costs, expectations) (P)• Investments and saving S= I

P: The investment demand curve

P: The investment demand curve

P: Determinants of ivestments

3. GOVERNMENT EXPENDITURES

• AD= C + I + G + NX• Comparasion: G/BDP, T/BDP (P7)• G<T, G=T, G>T

P: Governement spending

P: Governement taxation

• Functions of the governement (improving economic efficiency, reducing economic inequality, stabilizing through macroeconomic policies, international economic policy)

• Social state and governement expenditures → no such a thing as a free lunch!

• Governement expenditures (state, local)• Today’s crisis and the role of the government

4. NET EXPORTS

• AD= C + I + G +NX • EX- IM =NX• X = f (YF, e)• M = f (YD, e)• e = exchange rate (mechanism,…)

P: AD = C + I + G + NX

B. BUSINESS CYCLES AND AGGREGATE DEMAND

1. BUSINESS CYCLES 2. ANTICYCLICAL POLICY3. THE MULTIPLIER MODEL

1. BUSINESS CYCLES

• Business cycles are fluctuations in output, income, employment, inventiries usually lasting 2 to 10 years

• Four phases (peak, contraction or recession, trough, expansion) (P)

• Recession occurs when real GDP has declined for two consecutive calendar quaters

P: Four phases of business cycle

P: Business activity since 1919

• Internal theories (multiplicator theory, monetary theory, political theories, real cycle theory,….)

• External reasons (wars, oil shocks, revolutions, elections, gold expeditions, migrations, new world,.....)

2. ANTICYCLICAL POLICY

• Business cycles forecasting • Discretionary policy versus rules• Anti-cyclical policy • Automatic (or built in) stabilizers• EU, EMU

3. THE MULTIPLIER MODEL• How output is determined in the short run?

• How changes in spending (AD) get translated into changes in output and employment? ∆ GDP = m * ∆ AD

• Three approaches: AS-AD, I=S, Keynesian cross

• Advantages/disadavantages

Multiplier: I↑ → GDP↑

AS-AD APPROACH: AD↓→ GDP↓

KEYNESIAN CROSS APPROACH

NUMERICAL ANALYSIS• ∆ GDP = m * ∆ AD

• GDP = C +I+G+NX; I, G, NX=0 → ∆GDP=∆C

• ∆Y=1000 (Y=C+S)

• 1000+666+444+296+……= 3000• 1 + r + r2 + ...= 1 ∕ (1-r) = 1 ∕ (1- MNP)= 1∕MPS

• ∆GDP = 1 ∕ (1-MPC) * ∆ AD = (1 / MPS) * ∆ AD

MULTIPLIERS

• Investment multiplier• Government expenditures

multiplier• Tax multiplier

Investment and government expenditures multipliers

• ∆ GDP = 1/MPS * ∆I investment multiplier

• ∆ GDP = 1/MPS * ∆G government expenditure multiplier

Tax multiplier

• T↑ → AD↓ → GDP↓• T↓ → AD↑ → GDP↑

• ∆ GDP = MPC/MPS * ∆T tax multiplier

Tax multiplier

FISCAL POLICY IN THE MULTIPLIER MODEL

• ∆ GDP = 1/MPS * ∆G r• ∆ GDP = MPC/MPS * ∆T

• mt = mg * MPC• mt < mg • Tax mupliplier= MPC * expenditure multiplier • Consequences for fiscal policy and its affect on

output

AD vs. AS

- Supply side economics- AS (not AD) in the center of interest- Laffer curve- Privatization, deregulation, liberalisation - USA, GB in the 1980’s- Effect of moving AS curve

C. TODAY’S CRISIS

• Crisis is like pretty woman: Hard to define but recognizable when encountered (Goldsmith)

• Crisis: financial, economic, social, political, sistemic aspect

Main reasons

• too expansive monetary policy• fast liberalization of capital markets

and inovative financial instruments • booms and baloons • bad regulation in the financial sector

(grey banking)• structural reasons (w/GDB↓)• bad corporate governance

WALL STREET-MAIN STREET (“We are 99”)

SOLUTIONS AND COSTS• Screenplay for the movie Apokalipsa • Restoring the confidence and trust among population

and banks (government guarantees of bank deposits, recapitalization of banks,…)

• Coordinated action of CB (↓i, liquidity trap, QE3)• Fiscal policy stimulus packages• Fiscal measures: government debt guarantees,

injection of capital, purchases of assets, take-overs by the government (state ownership),

• Funding: IMF, WB, the role of rising China• ESFS, EFSM (2013), ESM (2013→)• Fiscal deficits and public debt (P)

P: Public debt/GDP (%)2007 2011

Germany 64,9 82,4

Irland 25,0 112,0

France 63,9 84,7

Italy 103,6 120,3

Belgium 84,2 97,0

Greece 105,4 158

Spain 36,1 68,1

Slovenia 23,1 42,8

Czech Republik 29,0 41,3

Croatia 33,2 40,4

EMU-17 66,2 87,8

EU27 59,0 82,3

• Not every country in the same position (crisis on crisis, free rider)

• Different approaches: In EU not enough manoeuvring space for economic policy, EU is not a federal state as USA, EU27 more modest (3% GDP) than USA (different ES), differences regarding FED and ECB

• American elections (Obama, Romney)

Dilemmas

• Dilemma 1: to much from taxpayers viewpoint or to little to solve the problem (P)

• Dilemma 2: moral solution and deep recession or vice versa

• Dilemma 3: exit or relying on others (PIGS)• Dilemma 4: market or the state • Dilema 5: socialist instruments or more

market• Dilemma 6: austerity measures or higher

spending. Are austerity measures effective?

Implications for the Capitalism?

• Is capitalism dead, We are 99• Enormous creation of well being until today by

capitalism (1980-2008 GDP↑ 145%, 3,4% annually)• Is socialism an alternative? (not hamper the

markets, not all regulation will be wise)• Capitalism will not be the same afterwards → today

market the only game and enemy in town• Regulation: Institutional reforms, corporate

responsibility, business ethics, corporate governance, living within the personal limits,…

Better days

• It is not as bad, as it sounds… (M. Twain)

Gini Coefficient World 2011

HDI World in 2011