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What we've done so far in this lecture is pretty pretty signifigant.
It's actually a lot of, a lot of material that we've covered.
What we've done is to provide a complete representation of what the economy's
equilibrium will look like. We've shown there are various ways of of
doing this. I can think of equilibrium either as
being in terms of withdrawals in planned injections, being equal to each other.
Or one could think of equilibrium in terms of planned aggregate expenditure
being equal to GDP. They're both really just different ways
of saying the exact same thing. And we've also established that there are
automatic forces in the economy that ensure the economy actually is at its
equilibrium. And see that the assumption that firms
respond to any disequilibrium, that is to any unplanned changes in their
infantries. In a way, that takes the economy back to
back to equilibrium. So, equilibrium is where we expect the
economy to be. What I now want to do is address the
question, how does this relate to the business cycle?
Or more precisely, how does this relate to the creation of output gaps?
Remembering that an output gap is a situation where the economy's actual GDP
differs from the economy's potential GDP. So, I want to start with the following.
Let's suppose it just happens to be the case that the economy's equilibrium
coincides with its potential GDP. So, I want to start from a situation
where there is no output gap. So, you can see this illustrated in the
diagram here. The economy's equilibrium corresponds to
Y star. Y star is annotation for the economy's
potential flow of GDP. The output gap here is 0.
Now, this is an equilibrium. The economy is at rest.
There is no reason to expect that this situation would change.
That is, there's no reason that this should change unless there is some
exogenous change that has been imposed on the economy.
Something happening external to the model that disturbs the economy and leads to
changes. So, what would be an example of an
exogenous change? Well, an example that Keynes in the
general theory emphasized a lot was the possibility of a revision to firms'
planned investment. And Keynes thought this was pretty
crucial to understanding the existence of output gaps.
Remember that within this model, we actually don't have an explanation for
why this might occur. This is completely exogenous to the
model. But Keynes himself thought that these
changes, the planned investment were very a very significant feature of modern
economies. And he attributed that to the fact that
investment is such a forward-looking economic variable.
We've talked about this before. How investment decisions made in the
current period are actually made on the basis of what our firms think might be
the state of the economy in some future period.
It's very hard to know what that might be.
So, Keynes thought that firms investment decisions were not necessarily grounded.
You know, a very sort of scientific analysis of what the future might hold.
But we're very much subject to business peoples' expectations, feelings gut
feeling perhaps, about what the future might might have in store.
And that those sorts of calculations, those very subjective calculations can be
quite variable. So, business people might wake up one
morning, for example, and for whatever reason, start to feel pessimistic about
the future, and think, well, maybe this isn't such a good time to be engaging in
large-scale investment. And therefore, they downsize their
planned investment spending. But it doesn't have to be that.
It could be any reason, anything going on there, external to the model that has led
to a downward revision in planned investment.
What we want to do is see how we can analyze such an exogenous change in the
context of this particular model. So, to repeat, we're starting from a
point of no output gap, where the equilibrium coincides with the economy's
potential. We then, introduce an exogenous change.
In this case, a full in planned investment.
What happens? In the first instance, that will show up
in planned injections. Remembering planned investment is one of
the components of planned injections. The economy's planned injections line
will therefore, shift downwards. It might take you a little while to get
used to looking at diagrams like this and working out exactly what is going on.
The way to think about it, and I think this is helpful, is to start labeling
bits of the diagram, so you can keep track of, you know, the beginning point
and what happens next. So, our beginning points, and let's start
with withdrawals in planned injections. Let's call our beginning point, point a.
After the exogenous fall in investment, the relevant point that relates to
planned injections is no longer point a. But is point b.
As far as planned injections are concerned, we have moved from point a to
point b. As far as withdrawals are concerned,
however, we are still at point a. Nothing has happened to withdrawals.
Indeed, nothing has yet happened to the economies income.
Firms are still producing y star, that hasn't changed yet.
The only change at this point in our story is a full in-planned investment.
A downward movement of the planned injections line.
So, any difference is planned injections their own point in planned injections is
now point b. But straight away, you can see we're now
in a disequilibrium. We're now clearly in a disequilibrium
because we have an imbalance between withdrawals in planned injections.
Now, the fact that planned injections have fallen has implications for planned
aggregate expenditure. Of course, planned injections is such an
important component of planned aggregate expenditure.
Planned aggregate expenditure also, shifts down and it will shift down in
line with the fall in planned injections. The economy, if you like, now operates
according to a new, lower planned aggregate expenditure line.
This line here which I've labeled PAE I. And again, let's label where we started
and where we're going. Now, original equilibrium is called point
a prime. That point, however, no longer
corresponds to where we are in terms of planned aggregate expenditure.
Because planned aggregate expenditure has fallen to b prime.
Now, I'll repeat, nothing has yet happened to production.
There's been time for that to adjust yet, so in terms of production, it's still y
star. In terms of planned aggregate expenditure
however, we are now at a point b star, which is below a star.
So again, this is a situation of disequilibrium.
We now have an imbalance between firms production and the economy's planned
aggregate expenditure. Firms are overproducing relative to what
the economy wishes to wishes to, to to purchase.
Well, we have a story about what happens in circumstances like this.
The story is that this equilibrium will not persist.
Firms will adjust their production. Firms are observing an unexpected
increase in their inventories. Firms therefore, cutback on production.
So, the economy's GDP starts to fall, the economy's income starts to fall.
Two things happen in response. First of all, the economy's withdrawals
move in line with the fallen income. So, we get reductions in saving taxation
and imports and that's shown by a movement down and along the withdrawal
schedule. Households cut back on their consumption.
And hence, the economy's planned aggregate expenditure is further reduced.
This time, not as a downward shift in planned aggregate expenditure, but as a
movement down and along planned aggregate expenditure.
This is just the story we told before about how the economy transitions to a
new equilibrium if it finds itself overproducing relative to planned
aggregate expenditure. When do these movements stop?
When we reach the new equilibrium. Once we've reach the new equilibrium,
let's call it point c in terms of withdrawals.
And the new low level of planned injection, let's call it point c prime in
terms of new well planned aggrehate expenditure and output.
Once we reach those points, this process stops, the economy is at an equilibrium.
And let me call that equilibrium Ye, e for equilibrium and let's call it 1.
So, this is actually pretty significant what you're observing here.
What you're observing here is a very systematic piece of economic analysis
that explains the emergence of a contractionary output gap.
The economy is now producing a flow of GDP below its potential.
It's producing a flow of GDP below its potential.
Because there has been an exogenous change.
In this instance, an exogenous formed planned investment pulling planned
injections down, pulling planned aggregate expenditure down.
Creating disequilibrium, creating firms adjusting via lowering production leading
to a new equilibrium below potential. What you're looking at is a recession.
Note the following. That new equilibrium is clearly
endogenous. We've reached the new equilibrium because
of what's happened within the model. Our model has explained why that new
equilibirum has been reached. It's endogenous because it has responded,
GDP has responded, to the exogenous change in planned aggregate expenditure.
Where does the contractionary output gap really come from?
It's come about because the economy's potential GDP has not changed.
That's still Y star. That's exogenous.
It's determined by factors completely outside of this model, none of which have
changed. It's the endogeneity of the economy's
equilibrium. And the exogeneity, the economies
potential output that is really at the heart of this Keynes explanation for
recessions. That's a really important and quite
profound insight. And prior to Kaynes, no one had really
thought about it this way, and I think it's a very powerful statement about the
actual nature of the business cycle. And what this particular piece of
analysis brings to our thinking about business cycles, the idea that there are
endogenous forces in the economy that can bring about an equilibrium.
that's different from the exogenously, given potential GDP.
let me just, emphasize that this is just one example of how a recession can can
emerge, but it's a particularly important example.
Have a look at this chart which shows real gross private domestic investment
for the United States economy. We've seen a few of these charts before.
Remember that the shaded areas represent periods of resession, so contractionary
output gaps. You don't have to look all that closely
to see a very systematic pattern going on here.
Prior to recessions, nearly always, leading up to the recession, we get
investment peaking, and then dropping. This is exactly what our previous
analysis showed, that these folds in investment can be responsible for
contractionary output gaps. They're not the only reason we can get
contractionary output gaps, and we'll discuss others as we go through this
material. But Keynes himself, was very, very very
keen to emphasize the important role played by planned investment.
And certainly, when you look at the economic data like this one, it's pretty
hard to to not conclude the changes to planned investment are certainly going to
be a very important part of the reason why economies find themselves in
recession. In the framework that we've been
developing this basic change in model. Now, provides us with a very systematic
way of understanding why that might be the case.
All right, let's look at a different sort of exogenous change now, a completely
different sort of exogenous change. Let's suppose, for some reason, we get an
increase in the exogenous component of consumption.
For whatever reason, it's endogenous. We don't know what the reason is.
But for whatever reason, households have decided collectively that they're going
to increase this part of their consumption expenditure.
What might that reason be? Well, who knows?
But it might be that households, but for whatever reason are feeling more
optimistic about the future. And decide that this might be a good time
to to increase their expenditure. For whatever reason, let's just assume
that something like this has happened. What impact that will this have on the
economy? Again, I want to start with a situation
where the economy is at its potential GDP.
So, our initial equilibrium can be illustrated either by point a, quality
between withdrawals in planned injections.
Or point a prime, where the planned aggregate expenditure line cuts the 45
degree line. All right, for whatever reason, we now
have this increase in exogenous consumption, what does that do to this
model? Well, it's going to show up in the
consumption function, very obviously. So, the economy's consumption function
shifts up. You can really see how this is an
exogenous shift in function. At potential GDP, household consumption
used to be there. Without the income having changed,
households now wish to increase their consumption.
So, it's an exogenous change in consumption.
It's not been caused by a change in income.
It's been caused by other factors. Now, the interesting question is how is
this possible? How is it that households have increased
their consumption if their income has not increased?
What makes this possible is presumably that households have found the funds they
need to finance that increase of investment from other sources.
For example, they may have withdrawn money from their savings accounts.
And that has implications for withdrawals.
Now, let's suppose that's what's happened.
It's probably the easiest way to tell this story.
Households have withdrawn funds from their savings accounts in order to
finance this exogenous increase in consumption.
So, saving has decreased for this exogenous reason.
And if saving has decreased for this exongeonous reason, then the economy's
overall levels of withdrawals have also decreased.
So, the withdrawal schedule will shift downwards.
The final part of the story is to remember that consumption is a component
of planned aggregate expenditure. So, if the consumption function has
shifted up. So, also, has planned aggregate
expenditure. So, we go back to this withdrawal
schedule. The relevant point on the withdrawal
schedule in now point b. Straight away, you can see we are no
longer in equilibrium. The economy withdrawals, and now below
the economy's planned injections. In terms of planned aggregate
expenditure, we're now at b prime. We have more planned aggregate
expenditure even though the economy's GDP is unchanged.
It's still at Y star. Again, you're may now looking clearly at
a disequilibrium. This is a disequilibrium where there has
been an unexpected increase in planned aggregate expenditure.
Firms are going to be finding that their inventories are unexpectedly declining.
Firms will respond by boosting production.
So, the economy's GDP will increase. Now, what we're talking about here is an
increase of GDP above potential GDP. But remember, that's possible at least in
the short-run, if firms hire workers for much more overtime, for example.
Or firms run their factories 24 hours a day, instead of 12 hours a day.
You can push GDP above potential. Incomes in the economy will be
increasing. There's more GDP, there's more income.
What does an increase in income do? It stimulates more withdrawals.
So, we start to see that showing up as a movement up and along the withdrawal
schedule. It stimulates more consumption.
It leads to more planned aggregate expenditure.
We've told this story before. It leads to a new equilibrium.
And let's call this new equilibrium Ye1. And what we have here is the creation of
an expansionary output gap. So again, planned aggregate expenditure
has been the key. Again, we have our exogenous potential
GDP unchanged, but we have our actual equilibrium GDP being endogenously
determined within the model. In this case, increasing as a result of
an exogenous change a change, in this example, in household consumption
behavior. So, what we have here is a pretty
complete explanation of the existence of business cycles.
Complete in the sense that we now understand, through this frame work, the
importance of planned aggregate expenditure in generating the business
cycle. That should plan aggregate expenditure
decrease that can cause the economy's equilibrium GDP to fall and lead to a
contractionary output gap. Should planned aggregate expenditure
increase, you might end up in the opposite situation with a creation of an
expansionary output gap. So, let me just summarize this process
for you. I think the easiest way to always use
this framework is to identify your initial equilibrium.
And initial equilibrium will be, my apologies, there's a typo there.
Planned aggregate expenditure equals GDP or planned injections equals withdrawals.
That may or may not correspond to potential GPD.
Often, in these analysis, just from an analytical point of view, it's, it's
convenient to assume you start with potential GDP.
But It's not necessarily the case, and that's an equilibrium.
So, if nothing changes. That is where the economy itself will
stay. But what's interesting in this framework
is to introduce an exogenous change. There can be various types of exogenous
changes. It might be an exogenous change to one of
the components of planned injections, either planned investment, exports or
government spending. We focused in this lecture on planned
investment, but the same sort of analysis holds for the other two components with
planned injections as well. As an exercise, you might like to
convince yourself of that. Other things can change though.
there could be changes in exogenous consumption as we've analyzed.
Imports might have an exogenous component, that could change.
Texas might have an exogenous component, that could change as well.
All of those changes are likely to affect household consumption.
So, we have a framework that start in equilibrium.
We then introduce an exogenous change, and we see what happens next.
What happens next, is there'll be a shift in planned aggregate expenditure and as
the new planned aggregate expenditure schedule itself.
There'll be a situation of disequilibrium created.
An important point of disequilibrium is that it is associated with unintended
changes in inventories. Following on from that is the very
important assumption in this framework that firms when they observe that
intended change of inventories. Take that as a signal that they need to
adjust production. They need to adjust production because
they don't want to have the unintended change in inventories.
It's a signal that they've gotten their production wrong.
The change in production, of course, is equivalent to a change in the economy's
GDP. Remember that that's a change in income.
Production and income are two different words for the same thing at the level of
the macroeconomy. That's going to lead to what is sometimes
called induced or, if you like, endogenous changes to consumption and
withdrawals. And that's part of the transition process
to the new equilibrium, and then we move to a new equilibrium.
Where planned aggregate expenditures, once again, equals to GDP, planned
injections, once again equal to withdrawals.
And it may or may not correspond to a potential GDP.
Certainly, if we start at a potential GDP and there is an exogenous change, where
you end up is not going to be equivalent to potential GDP.
And so, we get the creation of output gaps.
So, it's a very rich, but very systematic story about why it is that we see periods
where economies have either contractionary or expansionary output
gaps. It's a framework that very clearly
identifies for us what we mean by macroeconomic equilibrium.
And even more clearly, identifies for us the circumstances in which that
equilibrium might change. And moreover, enables us to understand
why it is that the economy, in the short run, might find itself with a situation
where its actual GDP can be different from its potential GDP.