Business Cycle & Causes

of Economic Fluctuations
BUSINESS CYCLE
BUSINESS CYCLE
 PHASES OF BUSINESS CYCLE

PEAK OR BOOM
ü Maximum output, business activity at maximum level.
ü Lowest unemployment rate, full or nearly full employment
ü Price level likely to rise

RECESSION
Ø Contractionary phase – decline in the GDP, total output,
Ø income, trade volume and price level
Ø Unemployment rate increases, a deep and long recession is known as
depression.
 PHASES OF BUSINESS CYCLE

TROUGH
ü The period where the GDP and output is at the minimum level.
ü Unemployment rate is its maximum.

RECOVERY
ü Expansionary phase - GDP
ü output and price level increase.
ü Unemployment rate decline.
 PHASES OF BUSINESS CYCLE

Real GDP

PEAK

Year
CHANGES IN MACROECONOMIC ACTIVITY

Example :Cyclical Behavior of the U.S. Economy

Economic Activity (1900–1984)

CHANGES IN MACROECONOMIC ACTIVITY

Example :Cyclical Behavior of the U.S. Economy

Economic Activity (1900–1984)

(continued)
SPENDING & MACROECONOMIC ACTIVITY

RELATIONSHIP BETWEEN TOTAL SPENDING &

BUSINESS CYCLE

Total /aggregate spending refers to total of

combined spending by all units in the economy
(households, businesses, government, foreign
sectors) for new goods & services
SPENDING & MACROECONOMIC ACTIVITY

Total Spending and the Level of Economic Activity

 HOUSEHOLD SECTOR
 Household Sector & the Circular Flow
Income-Determined Spending - Household spending on
new goods and services using income earned from
providing resources to producers. Flow (1) and (2).

Household Spending, Borrowing, Transfers, Saving, and Taxes

 HOUSEHOLD SECTOR
• Personal Consumption Expenditures

Household spending on new goods and services.

• Transfer Payments

Money from the government for which no direct work is

performed in return.

• Non income-Determined Spending

Spending that is not generated from household earned income.

 HOUSEHOLD SECTOR

• Injections into the Spending Stream

Spending that comes from a source other than

household earned income.

• Leakages from the Spending Stream

Uses for earned income other than spending, such as

taxes and saving.
 BUSINESS SECTOR
 Business Sector & the Circular Flow

Business Investment Spending, Saving, and Taxes

 BUSINESS SECTOR

• Investment Spending - Flow (1)

Also considered non income-determined spending.
Business spending on new goods, such as machinery,
equipment, buildings, and inventories.

• Retained Earnings/ Business Savings - Flow (2)

Portion of a business’s accumulated profits that has been
retained for investment or other purposes.

• Business Taxes - Flow (3)

Paid to the government
 BUSINESS & HOUSEHOLD SECTOR

Saving-Borrowing Relationship
 Relationship between the amount saved by
households & businesses, and the amount returned
to the spending stream through households &
businesses borrowing.

• Financial Institution**
 Important for the investment borrowing and
business savings for holding of the deposits
BUSINESS & HOUSEHOLD SECTOR

Saving, Investing, and Borrowing by Households and Businesses

 BUSINESS & HOUSEHOLD SECTOR
Saving-Borrowing Relationship
 Funds saved by households and businesses are the
leakages from the spending stream

 Financial institutions change the leakages into injection through giving of

borrowing
 Amount saved may not equal to amount borrowed
 Saving = Borrowing  leakages = injection

 Saving > Borrowing  decrease total spending, economic downturn (output &
employment decrease)

 Saving < Borrowing  increase total spending, economic rebound (output &
employment increase)
 GOVERNMENT SECTOR

Government Sector & the Circular Flow

• Government Purchases of Goods & Services

 Also considered non income-determined spending.

 Government spending on new goods and services.

 GOVERNMENT SECTOR

Government Sector & the Circular Flow

The Government Sector and the Circular Flow

 GOVERNMENT SECTOR
Government Tax-Spending Relationship

 Government tax leads to leakages in the spending

stream
 Government spending is the injection to the spending stream

 Tax received < Government spending Upswing/grow

 Tax received > Government spending Downswing
 Tax received = Government spending No change
 FOREIGN SECTOR
Foreign Sector & the Circular Flo w
• Exports (X) - Goods and services that are sold abroad.

• Imports (M) - Goods and services purchased from

abroad.

• Net Exports (X- M) - Exports minus imports.

 FOREIGN SECTOR

Foreign Sector & the Circular Flow

The Foreign Sector and the Circular flow

 FOREIGN SECTOR
 Foreign Expenditures
 Injections by foreign country that buy local products
i.e. Export (X)
 Also considered as the non income determined spending

 Local Expenditures
 Leakages from local country that buy foreign products i.e.
Import (M)

 Import – Export Relationship :

 If X > M  increase spending, economic grow
 If X < M  reduce spending, economic shri nk
 SUMMARY OF TOTAL SPENDING & ECONOMIC
ACTIVITY
• Total Spending drives the economy’s production,
employment, and income levels.
 MULTIPLIER EFFECT
Multiplier Effect

A c h a n g e in t o t a l o u t p u t & i n c o m e th a t i s
generated by a change in non-income
determined spending, becomes larger than,
or a m u l t i p l e o f , t h e i n i t i a l c h a n g e in t h e
spending itself.
 MULTIPLIER EFFECT

 Calculating the Multiplier Effect

Initial change in non-income determined spending

divided by the percentage of additional income not
spent will yield the total change in output and income.

Assuming 20% due to $2,000,000 (what was not

spent) from $10,000,000 initial injection
Thus, $10,000,000 / 0.20 = $50,000,000
 MULTIPLIER EFFECT

Effect on Total Output and Income from a

Non-income-Determined Spending Injection of $10,000,000
 MULTIPLIER EFFECT
How does non-income determined spending and multiplier effect
affect the economic activity?

 An initial injection of non-income determined spending provides

income to those who own the resources used to produce the goods
and services.

 Those who own the resources then spend par t of their income on
new g o o d s and s e r v i c e s , w h i c h a g a i n , p ro v i d e s i n c o m e to t h e
owners of resources used to produce goods and services.

 Those who own the resources, then again, spend part of their newly
received income to purchase goods and services.
 MULTIPLIER EFFECT
(Cont’d) How does non-incomedetermined spending and multiplier effect
affect the economic activity?

 Thus, the multiplier effect occurs because non-income determined

spending injected into the economy is spent again and again.

 This p r o c e s s w i l l be c o n t i n u o u s l y r e p e a t e d , l e a d i n g t o the n o n -
income determined spending later on becomes larger than, or a
multiple of the initial injection as the process repeat itself in the
circular flow of income stream.
 Large injection will therefore stimulate the economic
activity.
END