Samuelson and Nordhaus

Chapter 22
Business Cycles and Aggregate Demand
Prepared by Joshua Gapay
Outline
A. Business Cycles
B. Aggregate Demand and Business Cycles
C. The Multiplier Model
D. Fiscal Policy in the Multiplier Model
A. Business Cycles
A. Business Cycles
• Business cycles are economy wide fluctuations in
total national output, income, and employment,
usually lasting for a period of 2 to 10 years, marked
by widespread expansion or contraction in most
sectors of the economy.
• Two main phases of the business cycle: recession
and expansion
• Recession is the downturn of a business cycle
• A recession that is large in both scale and duration
is called a depression
A. Business Cycles
A. Business Cycles
Different business cycle theories can be classified
into two categories:
1. Exogenous Theories
2. Internal Theories
A. Business Cycles
Exogenous Theories find the sources of the business
cycle in the fluctuations of factors outside the
economic system…
• in wars, revolutions, and elections;
• in oil prices, gold discoveries, and population migrations;
• in discoveries of new lands and resources;
• in scientifc breakthroughs and technological
innovations;
• even in sunspots, climate change, and the weather
A. Business Cycles
Internal Theories look for mechanisms within the
economic system itself.
In this approach,
• every expansion breeds recession and contraction, and
• every contraction breeds revival and expansion
These theories are the reason why monetary and
financial economics exist
B. Aggregate Demand
B. Aggregate Demand
Aggregate demand is the
total planned or desired
spending in the economy
during a given period.
It is determined by the
aggregate price level and
influenced by domestic
investment, net exports,
government spending, the
consumption function, and
the money supply
B. Aggregate Demand
Why is it downward-sloping?
• Answer: When the price level goes up, the real
disposable income falls, leading to a decline in real
consumption expenditures
B. Aggregate Demand
Shifts in Aggregate Demand
Two Sets:
• Policy Variables. These are under government
control (fiscal and monetary policy)
• Exogenous Variables. These are (1) outside the
scope of macroeconomic analysis proper, or (2)
outside the control of domestic policy, or (3) have
significant independent movement
B. Aggregate Demand
B. Aggregate Demand
C. The Multiplier Model
C. The Multiplier Model
Multiplier model is a theory developed by J. M. Keynes that
emphasizes the importance of changes in autonomous
expenditures (especially investment, government spending,
and net exports) in determining changes in output and
employment
Multiplier is a term in macroeconomics denoting the change in an
induced variable (such as GDP or money supply) per unit of change in
an external variable (such as government spending or bank reserves)

The expenditure multiplier denotes the increase in GDP that would

result from a $1 increase in expenditure (say, on investment)
C. The Multiplier Model
= 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡

Recall:
Consumption Function
from chapter 21
C. The Multiplier Model
Now we add Investment.
Total Expenditure becomes
TE = C + I

This Multiplier Model (or also

called as Keynesian cross)
shows how output “M”
equals expenditure when the
expenditure curve crosses
the 45° line. (See point E)
C. The Multiplier Model
Above “E”: Output
will contract towards
equilibrium

Equilibrium
Below “E”: Output
will expand towards
equilibrium
C. The Multiplier Model
Equilibrium is the state in which an economic entity is at rest
or in which the forces operating on the entity are in balance
so that there is no tendency for change. Otherwise, it is
disequilibrium.
• The equilibrium level of GDP occurs at point E, where planned
spending equals planned production.

• At any other output, the total desired spending on consumption

and investment differs from the planned production.

• Any deviation of plans from actual levels will cause businesses to

change their production and employment levels, thereby returning
the system to the equilibrium GDP.
C. The Multiplier Model
The multiplier is the impact of a 1-dollar change in exogenous
expenditures on total output.
In the simple C + I model, the multiplier is the ratio of the
change in total output to the change in investment.
Δ 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡 𝑌𝑡 − 𝑌𝑡−1
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
Δ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼𝑡 − 𝐼𝑡−1
For example, suppose investment increases by P100 billion. If this
causes an increase in output of P300 billion, the multiplier is 3.
300 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =𝟑
100 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
C. The Multiplier Model
Relationship between Multiplier and MPC:

1 1
𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
1 − 𝑚𝑝𝑐 𝑚𝑝𝑠
Ex: Suppose Investments increase by 10 billion pesos and the
MPC is equal to 0.8, how much will total output (GDP)
increase?

1 1
Δ𝑌 = ∗ Δ𝐼 = ∗ 10𝐵 = 𝟓𝟎𝑩
1 − 𝑚𝑝𝑐 1 − 0.8
Answer: 50 billion pesos
C. The Multiplier Model
The Graph shows how the
Multiplier Model (or Keynesian
Cross) relates with the AS-AD
Approach
D. Fiscal Policy and The
Multiplier
D. Fiscal Policy and The Multiplier
Recall this graph
from slide 18:
TE = C + I
D. Fiscal Policy and The Multiplier
Now we add
Government Spending:
TE = C + I + G
“You can treat this like
a three-layered cake”

The Equilibrium
level of GDP is
at point E
D. Fiscal Policy and The Multiplier
Above “E”: Output
will contract towards
equilibrium

Equilibrium

Below “E”: Output

will expand towards
equilibrium
D. Fiscal Policy and The Multiplier
Fiscal-Policy Multipliers

1 1
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
1 − 𝑚𝑝𝑐 𝑚𝑝𝑠
To show the effects of an extra $100 billion of
G, the C + I + G curve in the figure has been
shifted up by $100 billion.

The ultimate increase in GDP is equal to the

$100 billion of primary spending times the
300 expenditure multiplier.

In this case, because the MPC is 2⁄3, the

multiplier is 3, so the equilibrium level of GDP
rises by $300 billion.
D. Fiscal Policy and The Multiplier
Effect of tax
Each dollar of taxes paid shifts the CC
schedule to the right by the amount of
the tax.
A rightward CC shift also means a
downward CC shift, but the downward
CC shift is less than the rightward shift.
Why?
Because the downward shift is equal to
the rightward shift times the MPC.
Thus, if the MPC is 2⁄3, the downward
shift is 2⁄3 times $300 billion = $200
billion. Verify that WV = 2⁄3 UV.
D. Fiscal Policy and The Multiplier
Impact of Taxes
Tax changes are a powerful weapon in affecting output.
However, the tax multiplier is smaller than the expenditure
multiplier by a factor equal to the MPC:

𝑀𝑃𝐶 𝑀𝑃𝐶
𝑇𝑎𝑥 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
1 − 𝑀𝑃𝐶 𝑀𝑃𝑆