ECON FINAL STUDY GUIDE CHAPTERS 10 13 10 Economic Fluctuations Employment rate begins to drop at the onset of each recession and below normal employment is a slump Shift from a strong expansion to a serious recession can occur very suddenly Can the classical model explain economic fluctuations In reality preferences tend to change very slowly and not rapidly enough to explain recessions Because sudden shifts of labor supply are unlikely to occur classic model cannot explain fluctuations through labor supply shifts A recession may be causes by a leftward shift of the labor demand curve Most say no Sticky wages or downward wage rigidity wage rate does not fall to market clearing level right away even when so many are searching for jobs possibly because firms reluctant to decrease wages due to negative effects on worker morale and productivity Labor demand curve may shift left is workers have become less productive and therefore less valuable to the firms This can explain the shift in the labor demand curve but doesn t happen rapidly enough to explain real world economic fluctuations Classical model assumes that total spending will equal whatever level of output firms are producing so if total spending declines total income and total spending will fall too CLASSICAL MODEL DOES NOT EXPLAIN ECONOMIC FLUCTUATIONS So what is the trigger Millions of qualified people want to work in a recession but are not being hired managers want to hire but not enough output is being sold In a boom firms desperate to hire are less careful about who they hire and accounts for frictional unemployment Firms compete for who they hire and wage rates are driven up raising production costs and forms must raise prices A recession or rapid expansion was caused by a large change in production but can also begin with a change in spending If people believe a recession is likely in the future they will save income by spending less and businesses will have to reduce their spending and lay people off People lose jobs because they were afraid of losing them People hope that others will still spend while they continue to save as much as possible Spending changes by any economic sector can have these effects Assumption that interest rate adjusts until saving is equal to business and government borrowing only holds in the classical long run model Over shorter periods of time we cannot be sure that loanable funds market will do their jobs When households spend less by saving more and do not supply their savings to the loanable funds market by instead keeping it to themselves total spending will drop below total income Financial intermediaries institutions that collect funds from savers and then lend them to borrowers bank When financial intermediaries do not lend out all of the additional saving by the households total spending will also drop below total income Interest rate changes even by themselves can cause economic fluctuations A rise will encourage people to save more and spend less This will also decrease business spending on plant and equipment The opposite change in interest rate will have opposite effects and planned investment will rise Recessions caused by military cutbacks Federal Reserve causing sudden increases in interest rates oil prices bursting of the housing bubble Strong expansions caused by military buildups falling oil prices that stimulate consumption spending and bursts of planned investment spending Higher spending leads to greater production higher employment and still more spending which leads to a boom Most recent recession 2008 09 Caused by rise in oil prices housing bubble burst and financial crisis Spending on cars new homes and capital equipment decreased CLASSICAL MODEL Spending can be safely ignored Say s Law SHORT RUN actual or even anticipated changes in spending that begin in one or more specific sectors will affect production of the economy 11 The Short Run Macro Model In the short run spending depends on income and income depends on spending Largest component of spending is household spending on consumption goods more than 2 3 of total spending in economy Disposable Income kept after deducting any taxes you have to pay Disposable Income Income Net Taxes or Income Taxes Transfers With no other change a rise in disposable income causes a rise in consumption spending Consumption spending also influenced by Wealth where a rise in wealth with no other change will also cause a rise A rise in the interest rate will cause a decrease in consumption spending Optimism about the future causes an increase as well The relationship between disposable income and consumption is roughly linear and this is illustrated by the consumption function Autonomous consumption spending is the vertical intercept and how much consumption spending will be in the economy if disposable income is equal to zero It represents the influence by everything other than disposable income Changes in autonomous consumption spending shift the line up or down Slope of the consumption function is change in consumption change in disposable income also known as the Marginal Propensity to Consume MPC and is always between 0 and 1 Consumption spending a b disposable income The relationship between consumption and income is the consumption income line Net taxes have lowered the consumption income line compared to the consumption function It dropped by MPC x T and that is how much it shifted down by Due to taxes the intercept is a MPC x T The slope however is unaffected by net taxes When income increases disposable income increases and consumption spending increases Movement rightward along the consumption income line When taxes decrease disposable income at each income level increases therefore consumption at each income level increases Upward Shift of the consumption income line Not only net taxes but all other influences on consumption spending besides income will shift the consumption income line but by changing the value of autonomous consumption When autonomous consumption increases consumption at each level of disposable income increases consumption spending at each level of income increases and the line shifts upward Assuming that all three of these types of spending planned investment spending government purchases and net exports are fixed values for now Investment spending does not include changes in inventories Aggregate expenditure is the sum of spending by households businesses the government and the foreign sector on
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