Economic Fluctuations

The generation of the 1930's thought of changing economic conditions as "business cycles," and that term is often still used. Some modern economists are less certain that these movements are cyclical, and so we will reserve judgment on that, and use the term "economic fluctuations."

Keynes' thinking was that economic fluctuations could be caused by changes in the autonomous components of expenditure, and he put particular stress on saving and investment.

Assumptions

Recall the assumptions of the simple Keynesian model:

  1. The consumption function: Consumption depends on income but increases less than proportionately when income increases.
  2. We have equilibrium when total spending equals total income, i.e. Y=C+I+G+NX
  3. The model can be illustrated by a diagram that plots income and the components of expenditure.

A Drop In Consumption

We want to use the multiplier approach to understand macroeconomic changes. So: what would be the results of a change in consumption? Specifically, what happens if autonomous consumption drops by 500?

In the numerical example we have been using, we have a drop in autonomous consumption from 500 to zero, that is, a drop of 500. Recall, we have a multiplier of =3.33. Multiplying these together, we get the drop in equilibrium income.

Figure 2: A Decrease in Autonomous Consumption

Consumption and Saving

Our first step will be to define saving. Saving can simply be defined as income minus consumption:

saving
Saving is income minus consumption. Algebraically, S=Y-C, where S is saving, Y is income, and C is consumption.

When saving is negative, it means that assets are decreasing. In economic jargon, negative saving is called dissaving.

Paradox of Thrift

Saving has the same two components
autonomous saving
the part that doesn't depend on income
induced saving
the part that does depend on income
Now suppose How do the two changes balance out? In this simple model, they cancel out exactly -- although people have tried to increase their saving, the result is a drop in equilibrium income and no change in saving. This is called The Paradox of Thrift. (In more complex and realistic models, the offset is less than 100%).

INVESTMENT DROPS

Now assume that investment drops from 1000 to 500. Remember, the multiplier is , and since the MPC is 0.7, that is , or 3.333.... Using this information, the new equilibrium will be

Y = *(a+I)

That is

Y = 3.333*(500+500)

which in turn is

Y = 3333.33

We see that, when investment drops by 500 in our numerical example, equilibrium income drops by 1666.67.

Graphic View

Figure 3: A Decrease in Investment

THE MULTIPLIER, AGAIN

Since it applies in the same way to all components of autonomous spending, or, equivalently, is called the "autonomous spending multiplier."

Some economists (the late Robert Theobald, for example) believe that a drop in autonomous consumption got the Great Depression of the 1930's started off. We do know that as the Great Depression continued into 1931-2, gross investment dropped to essentially zero, making an already bad situation worse still. The crash of investment spending contributed to the severity of the great depression.

Booms

We should point out that an increase in consumption would also have a multiplier effect. Thus, changes in autonomous consumption could also be a key factor in explaining booms. Indeed, many economists believe that the great boom of the mid-1980's was a result of a surge in consumption spending. Probably, one reason for this increase in consumption was the reduction in income tax rates, but in any case, it was a surge in consumption spending that led the boom.

Of course, an increase in investment will also have a "multiplier effect," and perhaps lead to a boom. Historically, many booms have been led by surges of investment. In general, Keynesian economists (and indeed most others) regard changes in investment, too, as major factors leading to economic fluctuations, both recessions and recoveries.

The Accelerator Principle

There is another reason why investment is associated with booms. Investment can be a source of feedback to keep a boom (or bust) going over a longer time period.

Suppose that aggregate demand has increased -- for any reason at all, it doesn't matter. Businessmen find that, in order produce the increased output, they need to invest in expansions of their factories, workshops and warehouses. In other words, the amount of investment will depend on the rate of increase of production -- not just on the amount of production. So, when production is growing rapidly, businessmen have to invest a lot, and keep investing a lot, just to keep up with orders. This is called the "Accelerator Principle."

Impact of International Trade

So far, we have been assuming that NX is zero -- trade is balanced. What if it is not?

Changes in Net Exports will have a multiplier effect, as for other components of autonomous spending. In the numerical example we have been using, the multiplier is 3.33. For every dollar of additional exports, then, equilibrium income would increase by $3.33; and for every dollar decrease in imports, similarly, equilibrium production would increase by $3.33.

This example gives us an idea why business fluctuations spread from country to country. If one country is very prosperous, its citizens increase their buying of imports from other countries. In the other countries, there is an increase in net exports, which in turn will increase equilibrium income by a multiple.

Once again, we can visualize the impact of a change in net exports using the diagram with income on the horizontal axis and the components of aggregate expenditure on the vertical axis. In this case, we hold autonomous consumption constant at 500 and investment constant at 1000, and let NX increase from 0 to 500.

Figure 4: Change in Net Exports

Summary

A change in any of the three components of autonomous spending,

can have "a multiplier effect." This is expressed by the autonomous spending multiplier, .

These "multiplier effects" provide a rough first approximation to the changes in income that will result from changes in autonomous spending.