Business Cycles

Short-run: Involves expansions and contractions

Long-run: Shows increases in GDP

The Short-run Business Cycle

Aggregate Expenditure Model

  • Assume – when there are output gaps, in the short-run, firms change output, not prices (menu costs like advertising, packaging, legal) – Keynes
  • When Y does not equal PAE, there is an output gap (i.e. expenditure/demand is not met by anticipated demand)
  • Firms change output by affecting the level of inventory they hold. 
  • In the short run, output changes; in the long run, prices change
Inventory
  • IP – Planned Investment
  • I – Actual Investment.  If expenditure by consumers decreases, inventory held increases and investment (purchase of inventory) increases.  
  • The difference is the change in output that firms make instead of prices
Consumption, savings and investment
  • C = exogenous C + c(Y-T)
  • Consumption is both dependent on income and net government transfers, and exogenous consumption
  • S=I
  • Savings equals investment in a closed economy
Fiscal Policy
  • Governments can influence output through G, T and t (government spending, transfers and taxes)
  • To reduce a contractionary gap, increase G or reduce T
  • Automatic stabilisers – reduction of Y means less taxes and more transfers (they are proportional to T), which increases spending

The Long-run Business Cycle

Aggregate Demand / Aggregate Supply (AD-AS Model)

AD AS Model

In the Keynesian short-run model of the economy, firms change output in the short-run.
In the long-run AD/AS model, firms change price, not output.

Long-run Average Supply

The AE or AD/AS model is the total spending for an economy, not an individual market (micro)

  • LRAS is perfectly inelastic as firms adjust prices, not quantity.  In the long-run, the profit incentive from adjusting output to the difference between prices and variable costs disappears.
  • Increased demand results in increased prices while quantity stays the same.  This causes inflation.

Output Gaps

  • Take Y as short-run output and Y* as the long-run potential output at full employment (i.e. no cyclical unemployment)
  • If Y* > Y, SR GDP is less than the economic potential (recessionary gap / contraction).  
  • If LRAS is to the left of short-run equilibrium, Y* < Y (expansionary gap).
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