Topic 8 - Business Cycle & Economic Fluctuations

PSCI 150 : INTRODUCTION TO ECONOMICS
Bachelor of Political Science, KIRKHS, IIUM

1. PSCI 1500: Introduction to Economics Business Cycle & Causes of Economic Fluctuations

2. Business cycle refers to wave-like fluctuations in aggregate economic activities i.e. national income, employment and output . It is composed of periods of good trade with rising prices and low unemployment percentages and followed by periods of bad trade with falling prices and high unemployment percentages . Business Cycle What is a business cycle?

3. Business Cycle

4. PEAK OR BOOM Maximum output , business activity at maximum level. Lowest unemployment rate, full or nearly full employment Price level likely to rise Real GDP Year PEAK RECESSION TROUGH RECOVERY PEAK RECESSION Contractionary phase – decline in the GDP, total output, income, trade volume and price level Unemployment rate increases, a deep and long recession is known as depression . TROUGH The period where the GDP and output is at the minimum level. Unemployment rate is its maximum. RECOVERY Expansionary phase - GDP output and price level increase. Unemployment rate decline. PHASES OF BUSINESS CYCLE

5. Example :Cyclical Behavior of the U.S. Economy Economic Activity (1900–1984) Changes in Macroeconomic Activity

6. (continued) Economic Activity (1900–1984) Example :Cyclical Behavior of the U.S. Economy Changes in Macroeconomic Activity

7. 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

8. Total Spending and the Level of Economic Activity Spending & Macroeconomic Activity

9. 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

10. 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 .

11. 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.

12. Business Sector Business Sector & the Circular Flow Business Investment Spending, Saving, and Taxes

13. 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 Sector

14. 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

15. Saving, Investing, and Borrowing by Households and Businesses Business & HOUSEHOLD Sector

16. 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 ) Business & HOUSEHOLD Sector

17. 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.

18. Government Sector Government Sector & the Circular Flow The Government Sector and the Circular Flow

19. 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 Government Sector

20. 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.

21. Foreign Sector Foreign Sector & the Circular Flow The Foreign Sector and the Circular flow

22. 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

23. Summary of Total Spending & ECONOMIC Activity Total Spending drives the economy’s production, employment, and income levels.

24. Multiplier Effect Multiplier Effect A change in total output & income that is generated by a change in non-income determined spending, becomes larger than, or a multiple of , the initial change in the spending itself.

25. 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

26. Multiplier Effect Effect on Total Output and Income from a Non-income-Determined Spending Injection of $10,000,000

27. 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 part of their income on new goods and services, which again, provides income to the 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

28. (Cont’d) How does non-income determined 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 process will be continuously repeated, leading to the non-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. Multiplier Effect

29. review Explain each phase of macroeconomic activities using a business cycle . Describe the sources for “non-income determined spending” in a four –sector macroeconomic model . Discuss the injection - leakages relationship within a three sector macroeconomic model.