L5 - Business Cycles and Aggrgate Spending Flashcards Preview

18ECA001 - Principles of Macroeconomics > L5 - Business Cycles and Aggrgate Spending > Flashcards

Flashcards in L5 - Business Cycles and Aggrgate Spending Deck (55)
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1
Q

What is the Factor Market?

A
  • a marketplace for the services of factor of production,
  • a factor market facilitates the buying inputs like –> Labour, Capital, Land, Raw Materials that are used by a firm to market a finished product
  • This is separated from the goods and service market, which is the market for finished products or services
2
Q

What are some examples of a Factor Market?

A
  • Labour
  • Land
  • Entrepreneurship
  • Capital
3
Q

What is Labour as a Factor Market?

A
  • Labour is the human input into production e.g. the supply of workers available and their productivity
  • An increase in the size and the quality of the labour force is vital if a country wants to achieve growth.
  • In recent years the issue of the migration of labour has become important.
  • Can migrant workers help to solve labour shortages?
  • What are the long-term effects on the countries who suffer a drain or loss of workers through migration
4
Q

What is Land as a Factor Market?

A
  • Land includes all natural physical resources – e.g. fertile farm land, the benefits from a temperate climate or the harnessing of wind power and solar power and other forms of renewable energy.
    = Some nations are richly endowed with natural resources and then specialise in the their extraction and production – for example – the high productivity of the vast expanse of farm land in the United States and the oil sands in Alberta, Canada. Other countries such as Japan are heavily reliant on importing these resources.
5
Q

What is Capital as a Factor Market?

A
  • capital goods are used to produce other consumer goods and services in the future
  • Fixed Capital –> machinery, factories
  • Working Capital –> stocks of finished and semi finished goods which will be “consumed” in the near future
  • Infrastructure –> roads, railways, airports, docks
6
Q

How is a Business Cycle defined?

A
  • Also know as a Trade cycle
  • periodic fluctuations in the rate of economic activity, as measured by levels of employment, prices and production
  • The term was first used in 1919, although industrial cycles are evident from the middle of the 19th century
7
Q

What is one of the Central Problem for Macroeconomic Policy Makers?

A
  • is to decide how to manage the economy in such a way that inflation is kept under control while unemployment is also kept to a minimum
8
Q

What were the First Industrial Cycles?

A
  • In the UK from 1800 to 1860 there were 14 cycles, averaging 4.3 years; between 1860 and 1914 there were 7 cycles with an average length of about 7.5 years, although UK industry was generally depressed after 1873 until the Great War
  • The greater regularity (people working everyday in industry) and increasing length of the cycles after 1860 was due to the increased importance of the investment cycle relative to the trade cycle
9
Q

What are the different stages of a business cycle?

A
  • Peak
  • Recession
  • Trough
  • Recovery
10
Q

What is a Peak in a Business cycle?

A

the top of the cycle – productive capacity fully utilised shortages may start to develop

11
Q

What is a Recession in a Business Cycle?

A
  • is a downturn in activity. A recession is defined as a fall in real GDP for two successive quarters. Typically incomes and employment levels fall. Profits may also decline as some firms experience financial difficulties. A recession that is deep and long –lasting is called a depression.
  • 08/09 wasn’t a depression only a bad recession
  • in economic downturns show a loss of income is not equal - some are affected more than others
12
Q

What is a Trough in a Business Cycle?

A

characterised by high unemployment and low demand in relation to the capacity to produce. Business confidence is low

13
Q

What is a Recovery in a Business Cycle?

A

characterised by rising incomes, employment and consumption. Business expectations become more optimistic and new investment projects are begun.

14
Q

What were some of the main Statistics of the Great Depression?

A
  • It was the Great Depression in the 1920’s with unemployment reaching 2 million in 1922 and peaking at around 3 million (22%) in 1932 – that led to the development of Macroeconomics
  • In many industries unemployment was much worse: in 1931-2 34.5% of coal miners, 36.3% of pottery workers, 43.2% of cotton operatives, 43.8% of pig-iron workers, 47.9% of steelworkers and 62% of shipbuilders and ship-repairers were unemployed
15
Q

Who first recognised the damaging effects if recessions the workforce?

A
  • Although Marx in the 1850’s was the first to recognise the damaging effects of recessions the workforce –the rise in the industrial reserve army; and J.A. Hobson (1896), identified the cause as ‘over-production’ - due to savings being too high and consumption too low (due to the unequal distribution of incomes, as the rich spent less than the poor),
  • It was not until the 1930s that the problem was thought to be serious enough to merit government involvement
16
Q

What were Robbins and Schumpeter’s Response to the Great Depression?

A
  • Economists argued the economy was “fundamentally sound” –indeed two very famous contemporary economists – Lionel Robbins at the LSE and Joseph Schumpeter at Harvard both said that nothing should be done! I
  • Indeed Schumpeter added –> this is not all: our analysis leads us to believe that recovery is sound only if it does come of itself.”
17
Q

What were the UK’s Treasury Response to the Great Depression?

A

It is the orthodox treasury dogma, … that whatever might be the political and social advantages, very little additional employment can in fact… be created by state borrowing and expenditure

18
Q

What was Keynes’s (1929) Response to the Great Depression?

A

I know of no British economist of reputation who supports the proposition that schemes of National Development are incapable of curing unemployment

19
Q

What is Keynes’s General Theory about?

A
  • In his General Theory of Employment, Interest and Money (1936) Keynes argued that effective demand was the key to full employment
    Written against the background of the Great Depression the model which underlay Keynes thinking was based on the short run over which an excess supply of output can prevail, and critically, which would NOT be eliminated automatically (as Schumpeter and Robbins had suggested)
20
Q

What is the Short -run in Macroeconomics ?

A

Analysis of the short run in macroeconomics is concerned with explaining why national output can deviate from its potential level
- It is about the GDP gap and how to keep both positive and negative as small as possible –> that is how to keep actual GDP as close as possible to potential GDP

21
Q

What is the Short-run in Microeconomics?

A
  • analysing the behaviour of firms during the period in which their capital stock is taken as given and they can only change their variable input ( labour and materials)
22
Q

What is the Long-Run in Macroeconomics?

A
  • the period it takes the economy to return to the level of potential GDP/assumed equilibrium after it has been disturbed by an exogenous shock
  • there is also a longer run which permits growth in productive capacity and therefore growth in potential output
23
Q

What is the Long- Run in Microeconomics?

A

a period within which the capital stock can vary

24
Q

What are some Key Assumptions for Macroeconomic Theory?

A
  • Not using output as a way to describe GDP in theory
  • Aggregation across industry
  • The Government Sector
  • Time Scales –> Short/Long run
25
Q

What are the Reasons why we don’t use output as a way to describe GDP in Theory?

A
  • wouldn’t be dealing with a aggregate economy in which we found out the value added of each sector
  • This is because such microeconomics models require so much detail that they make it difficult to handle many important issues that affect the whole economy simultaneously
  • we do not apply tools of demand and supply on an industry-by-industry basis in macroeconomics as they are not appropriate for handling most important macro problems
  • Macro economists want to explain why an economy may have unemployment and excess capacity for some time whereas microeconomics look at how prices moves to clear markets
26
Q

Why is Aggregation across Industries a Key Assumption in Macroeconomic theory?

A
  • industry structure is fixed, when national output expands/contracts all sector are assumed to expand/contract together
  • in elementary macroeconomics we assume the existence of a single productive sector producing a homogeneous output
27
Q

Why is the Government Sector a Key Assumption in Macroeconomic theory?

A
  • to maintain the simplicity of the assumption we ignore the fact that the government is a producer and treat the government as a purchaser of output of the private industrial sector
28
Q

Given the short-run nature of the Aggregate Expenditure Model what are some simplifying Assumptions Keynes made?

A
  • The industrial structure of the economy is fixed
  • Firms’ output is aggregated into a single productive sector producing output which is homogeneous
  • The price level is fixed: i.e. real and nominal values are identical, or alternatively, all variables are measured in real terms (constant prices)
  • Excess Capacity exist so there is no constraints from producing more output by shortage of capital stock or labour
  • Closed economy –> no foreign trade
  • no government
  • unique equilibrium at potential output which is characterised by normal rates of utilisation of all resources currently, however, there is excess capacity
29
Q

What is the Basic Model of Aggregate Expenditure when looking at Consumption?

A
  • Keynes’s most basic contribution was to ask what determines the level of aggregate expenditure?
  • Keynes divided production into consumption goods (C) – purchased by households and capital goods (investment, I) – purchased by firms. If he could explain the determinants of C and I he would have a theory of aggregate spending
    In terms of a model of C and I Keynes divided each into autonomous and induced spending
    -Autonomous (or exogenous) spending is that spending which is independent of current income
  • Spending which rises with income is referred to as induced spending
  • some products are endogenous in one model and exogenous in another - HAVE TO KNOW WHICH IS WHICH IN THE THEORIES
30
Q

What is Autonomous/ Exogenous Spending?

A
  • spending is that spending which is independent of current income
  • these are necessities - the minimum level of spending/ consumption that must take place even if the consumer has no income
  • if they dont have any income they may have to borrow money or use savings
  • it also includes external factors - spend more on ice-cream in hot weather
31
Q

What is the Consumption Function?

A
  • describes the relationship between household consumption spending and the variable that influence it
  • In the simplest theory it is primarily determined by Y(d)
32
Q

What are the 4 main groups of Decision Makers?

A
  • Households
  • Firms
  • Government
  • Exporters

The theory of GDP looks at the desired spending in each of these 4 categories

33
Q

What is desired spending?

A

refers to what people want to spend out of the resources that are at their command (i.e. their income or wealth)

34
Q

What is the Marginal Propensity to Consume (MPC)?

A
  • if income was to rise how much would consumption rise as a percentage of the change in income
  • The fundamental psychological law implies a new concept: the marginal propensity to consume (mpc)
  • This is defined as: ΔC/ ΔY where 0< ΔC/ ΔY <1
  • 0= spending hasnt changed
  • 1 spent all of the increase in income
  • This says that the change in consumption is less than the change in income
  • Keynes argues that the mpc is smaller at higher levels of income and larger at lower levels of income suggesting that the implied consumption function is non-linear
35
Q

What is the MPC of those that are very rich?

A

MPC is low- can’t really spend much more

36
Q

What is the MPC of those that are very poor?

A

MPC is high - can finally buy more non-essential goods

37
Q

What is the Average Propensity to Consume (APC)?

A
  • Keynes also says that “on average” C and Y will rise (or fall) together. This is called the average propensity to consume (apc) which is defined as C/Y=(a/Y)+b
  • Again Keynes believed that the C/Y ratio would fall as incomes increased: “…a greater proportion of income being saved as real income rises.” [GT p.97]
  • This also implies that the consumption function is not linear.
  • apc varies inversely with income
  • break-even level for income when APC = 1
  • when APC > 1 –> C>Y(D) and households run down savings and borrowings
  • when APC< 1 –> C
38
Q

What is the Linear Consumption Equation?

A

This can be written as a linear equation, such that C= a +bY , where:

  • a is autonomous consumption
  • b is ΔC/ΔY = the marginal propensity to consume (mpc),
  • Keynes thought it was curved –> we use a simplified linear equation but we get basically the same result
39
Q

What does the Linear Consumption Equation look like on a graph?

A
  • Income on the x-axis, Consumption of the y-axis

- diagonal line of C=a + bY where b is the gradient and a is the y intercept

40
Q

What happens when MPC=45 degree?

A
  • MPC is at unity
  • helps to find the break-even level of income at which C=Y(D)
  • if b<45 degrees MPC is less that unity
41
Q

What is the Savings Function?

A
  • Since income is either consumed or saved then Y = C + S and saving, S can be written as:
    S = Y – C = – a +(1 – b)Y
  • Thus savings are also a positive function of income, with a marginal propensity to save (mps) of (1 – b) and a negative intercept of – a
  • 1-mpc=mps
42
Q

What is the Average propensity to save (APS)?

A
  • proportion of disposable income that households want to save APS=S/Y(D)
  • aps varies directly with income
43
Q

`What is the Marginal Propensity to save (MPS)?

A

relates to the change in total desired saving to the change in disposable income that brought in about –> ΔS/ΔY(D)

44
Q

What are the Consumption and Saving Ratios?

A
  • APS + APC = 1

- MPS + MPC = 1

45
Q

What does the Savings function look like on a graph?

A
  • with Income on the x-axis and Saving y-axis
  • a diagonal line of S=-a+(1-b)Y
  • where -a is the y intercept
  • a/(1-b) is the x intercept
  • the gradient is (1-b)
46
Q

What does the Saving and Consumption function look like on a graph?

A

With Saving and Consumption on the y-axis and Income on the x-axis

  • the Consumption and Savings Function are draw as normal
  • then the diagonal line of Y=C+S is added
  • At the point Y=Y(0) the Consumption function crosses Y=C+S and the Savings function = 0
47
Q

How can the Saving and Consumption functions be associated with wealth?

A
  • if a sudden rise in wealth, there is less of current disposable income needs to be saved for the future thus large amounts of Y(D) spent of C than S, Thus the
    consumption function shifts up and the saving function shifts down
  • of wealth drops there is more incentive to save so the consumption function shifts down as saving function shifts up
48
Q

What is Desired Investment Spending?

A
  • Investment is the most volatile component of GDP and the hardest to forecast
  • It is usually negatively related to the rate of interest, although Keynes believed that business expectations were more important
  • At this stage we are going to assume that investment is exogenous; i.e. it is independent of income
49
Q

What does Exogenous Investment look like on a graph?

A
  • With Investment on the y-axis and Income on the x-axis

- Investment is a horizontal line at the value of y=I

50
Q

How is Aggregate Expenditure linked to Equilibrium GDP?

A
  • In an economy without government or trade the aggregate expenditure (AE) function is: AE = C + I
  • According to Keynes the level of AE determines the level of output in the economy. Hence AE = C + I = Y (GDP)
51
Q

What is the Marginal Propensity to Spend?

A
  • is the amount of extra total spending induced when GDP rises by £1
  • ΔAE/ΔY
  • denoted as ‘c’ and is different from mpc
  • marginal propensity not to spend –> denoted as (1-c)
  • only in this chapter mpc=c and mps=(1-c) –> as only household consumption varies
  • This changes when government and the international sector are added
52
Q

What does the Aggregate Expenditure function look like on a graph?

A
  • With Consumption and Investment on the y-axis and Income on the x-axis
  • Investment is a horizontal line at y=I
  • C is a diagonal line with a as the y intercept and b being the gradient
  • the AE line which is AE=C+I which crosses the y-axis at (a+I)
53
Q

What does the Equilibrium Income diagram look like on a graph?

A
  • with AE on the y-axis and income (Y) on x-axis
  • with the lines C+I and AE=Y=GDP (45 degree line) on the graph
  • Y(0) is where these two lines intercept
54
Q

how can you interpret the Equilibrium Income diagram?

A
  • The AE=Y line is the set equilibrium points between expenditure and income
  • The C+I line is the planned (or desired) expenditure function
  • At Y(0) planned expenditure is exactly equal to income so Y is constant
  • Above Y(0) planned spending is less than output so income will fall back to Y(0) due to excess supply –> cut production
  • Below Y(0) planned spending exceeds output so firms expand production to Y(0) to meet the excess demand
55
Q

What is Entrepreneurship as a Factor Market?

A
  • Regarded by some as a specialised form of labour input
  • An entrepreneur is an individual who supplies products to a market to make a profit
  • Entrepreneurs will usually invest their own financial capital in a business and take on the risks. Their main reward is the profit made from running the business