Variations in aggregate demand – a phenomenon
popularized since Keynes major work on the general theory of income. Employment
and output (1936) – is generally observed to be major cause of business cycles.
In recent times however, other factors such as changes in aggregate supply,
random stocks and the problems associated with policy formulation and
implementation are also used to explain cyclical fluctuations in the level of
economic activities. We will examine each of these factors in turn.
popularized since Keynes major work on the general theory of income. Employment
and output (1936) – is generally observed to be major cause of business cycles.
In recent times however, other factors such as changes in aggregate supply,
random stocks and the problems associated with policy formulation and
implementation are also used to explain cyclical fluctuations in the level of
economic activities. We will examine each of these factors in turn.
Fluctuations
in aggregate demand
in aggregate demand
As were learnt in the last section, aggregate
demand is composed of consumption expenditures of households, government
expenditure, investment expenditure and net exports. These variables generally
respond to changes in income. However, the type of changes in aggregate demand
(or in any of its components) that is used to explain business cycles are not
the income induced changes (i.e. changes that are results of changes in
income).
demand is composed of consumption expenditures of households, government
expenditure, investment expenditure and net exports. These variables generally
respond to changes in income. However, the type of changes in aggregate demand
(or in any of its components) that is used to explain business cycles are not
the income induced changes (i.e. changes that are results of changes in
income).
Rather it is shifts in aggregate demand (changes
in any of the components of aggregate demand that is on accounting of a change
in a factor other than income) that is used to explain business cycles.
Consumption expenditure is the largest single component of aggregate demand
(usually accounting for about two-thirds of the total). Consumption expenditure
may shift as a result of one or more of the following factors.
in any of the components of aggregate demand that is on accounting of a change
in a factor other than income) that is used to explain business cycles.
Consumption expenditure is the largest single component of aggregate demand
(usually accounting for about two-thirds of the total). Consumption expenditure
may shift as a result of one or more of the following factors.
1.
Changes in taxes
Changes in taxes
2.
Changes in transfer payments
Changes in transfer payments
3.
Changes in consumer tastes
Changes in consumer tastes
4.
Changes in expectations and
Changes in expectations and
5.
Changes in the real interest rate.
Changes in the real interest rate.
Investment expenditure is composed of three
components- inventory investment, investment in plant and machineries and
investment in residential construction. Of these, plant and equipment
constitute the largest single component and hence exert the greatest influence
on changes in investment. In general, of all the components of aggregate
demand, shifts in investment constitute a major source of business cycles.
Shifts in investment are generated by changes in the real rate of interest,
among others,the higher the real interest rate, the higher the desired stock of
inventory as well as the level of investment in physical capital (machineries
and equipment).
components- inventory investment, investment in plant and machineries and
investment in residential construction. Of these, plant and equipment
constitute the largest single component and hence exert the greatest influence
on changes in investment. In general, of all the components of aggregate
demand, shifts in investment constitute a major source of business cycles.
Shifts in investment are generated by changes in the real rate of interest,
among others,the higher the real interest rate, the higher the desired stock of
inventory as well as the level of investment in physical capital (machineries
and equipment).
The same is true for residential construction
(especially when we consider the rate on mortgages). However, other
non-economic factors affect residential building and construction. These
factors are generally demographic and cultural. Devaluation of the national
currency (or simply put, the exchange rate) is another factor that affects not
only net exports but also other components of aggregate demand such as
consumption, investment and government expenditures.
(especially when we consider the rate on mortgages). However, other
non-economic factors affect residential building and construction. These
factors are generally demographic and cultural. Devaluation of the national
currency (or simply put, the exchange rate) is another factor that affects not
only net exports but also other components of aggregate demand such as
consumption, investment and government expenditures.
The low value of the Nigerian naira vis-à-vis
the U.S. dollar for example, has led to a great inflow of foreign exchange from
personal sources, which are used for investment in the construction of personal
(residential) buildings. Hence, the recent expansions in the residential
building and construction industry in some cities in Nigeria is attributable to
the dollar effect of Nigerians sojourning in foreign countries. Government
expenditures are also largely influenced by non-economic factors such as the
outbreak of civil wars, famine, pestilence etc., which makes it necessary for
government to increase its expenditures. Post-war periods are usually periods
of economic prosperity because of the reconstruction activities of the
government.
the U.S. dollar for example, has led to a great inflow of foreign exchange from
personal sources, which are used for investment in the construction of personal
(residential) buildings. Hence, the recent expansions in the residential
building and construction industry in some cities in Nigeria is attributable to
the dollar effect of Nigerians sojourning in foreign countries. Government
expenditures are also largely influenced by non-economic factors such as the
outbreak of civil wars, famine, pestilence etc., which makes it necessary for
government to increase its expenditures. Post-war periods are usually periods
of economic prosperity because of the reconstruction activities of the
government.
However, such reconstruction ultimately comes to
an end and another phase is introduced into the business cycle. Changes in all
the above factors (generally called aggregate demand shocks), generate
fluctuations in aggregate demand, which lead to cyclical variations in the
level of economic activities. Fluctuations in aggregate demand are usually
translated into business cycles by the combined effect of the accelerator and the
multiplier.
an end and another phase is introduced into the business cycle. Changes in all
the above factors (generally called aggregate demand shocks), generate
fluctuations in aggregate demand, which lead to cyclical variations in the
level of economic activities. Fluctuations in aggregate demand are usually
translated into business cycles by the combined effect of the accelerator and the
multiplier.
The
accelerator
accelerator
The accelerator is a principle in economics that
attempts to show the relationship between changes in output (income) and
changes in the capital stock (investment). The principle is based on the
following reasoning. At the micro level, a firm will undertake to increase its
capital stock (i.e., invest) only when its sales volume (income) is increasing.
If sales (demand) are constant, for example, there is no need to increase
production beyond its present level. Hence, there is no need to make additional
investment in capital (machineries and equipment). On the other hand, if sales
(income) are falling, the firm may even cut back on investment by not replacing
worn-out capital. If we translate this to the macro level, given in a fixed
quantity of capital is needed to produce a unit of output, then the capital output
ratio, written as
attempts to show the relationship between changes in output (income) and
changes in the capital stock (investment). The principle is based on the
following reasoning. At the micro level, a firm will undertake to increase its
capital stock (i.e., invest) only when its sales volume (income) is increasing.
If sales (demand) are constant, for example, there is no need to increase
production beyond its present level. Hence, there is no need to make additional
investment in capital (machineries and equipment). On the other hand, if sales
(income) are falling, the firm may even cut back on investment by not replacing
worn-out capital. If we translate this to the macro level, given in a fixed
quantity of capital is needed to produce a unit of output, then the capital output
ratio, written as
K/Y
(Where K is capital and Y is income or output),
is constant. Hence for output to increase, there have to be an increase in
capital stock (net investment). An increase of Y in aggregate output or income,
for example, requires an increase in capital stock (an investment) of K/Y.
Hence, the change in capital stock (investment can be expressed as
is constant. Hence for output to increase, there have to be an increase in
capital stock (net investment). An increase of Y in aggregate output or income,
for example, requires an increase in capital stock (an investment) of K/Y.
Hence, the change in capital stock (investment can be expressed as
I = 
Y
Y
Equation 7.2 is the accelerator principle, which
suggeststhat investment (the change in capital stock) is relatedto the rate of change
of national income/output (Y).Given the constancy of K/Y,I vary directly with
Y. Thus, the accelerator
principle implies that investment can only be undertaken when there is an increase
(a growth) in income and output.4A fall in income/output will lead
to negative investment because businessmen will see no need to replace existing
capital stocks. Similarly, a constant rate of investment can only be achieved
when the rate of growth of output is constant.
suggeststhat investment (the change in capital stock) is relatedto the rate of change
of national income/output (Y).Given the constancy of K/Y,I vary directly with
Y. Thus, the acceleratorprinciple implies that investment can only be undertaken when there is an increase
(a growth) in income and output.4A fall in income/output will lead
to negative investment because businessmen will see no need to replace existing
capital stocks. Similarly, a constant rate of investment can only be achieved
when the rate of growth of output is constant.
The
accelerator – multiplier interaction
accelerator – multiplier interaction
A growth in output and income will not only lead
to an increase in the capital stock, the effect of any positive investment on
the level of economic activities will be amplified via the multiplier process
(discussed in the last chapter) leading to a further and multiplied growth in
output and income. The same is true for a fall in income/output and the
subsequent in the capital stock.
to an increase in the capital stock, the effect of any positive investment on
the level of economic activities will be amplified via the multiplier process
(discussed in the last chapter) leading to a further and multiplied growth in
output and income. The same is true for a fall in income/output and the
subsequent in the capital stock.
The combination of the accelerator and the
multiplier tend to generate explosive expansions and acute contractions in the
level of economic activities. As income/output increases, the growth in income is
accelerated by the accelerator – multiplier process until a boom is reached.
After the boom, output/income naturally falls. Again, the fall in income is accelerated
by the combined effect of the accelerator and multiplier until the level of
business activities is brought to its critical minimum.
multiplier tend to generate explosive expansions and acute contractions in the
level of economic activities. As income/output increases, the growth in income is
accelerated by the accelerator – multiplier process until a boom is reached.
After the boom, output/income naturally falls. Again, the fall in income is accelerated
by the combined effect of the accelerator and multiplier until the level of
business activities is brought to its critical minimum.
Random
stocks and long lags
stocks and long lags
This approach to the explanation of business
cycles suggests that random shifts in expenditures translate into systematic
cycles of output and employment. The approach (making use of time lags) posits
that the effect of change in any economic indicator on business decisions is
usually spread over a period of time. If on account of a fall in interest rate,
for example, investment in a new project becomes profitable; such investment
cannot be established immediately. The planning and implementation of the
project will normally take a period of time. Hence, the increase in investment
expenditure is distributed over time. The problem however is that a long lag
can convert such shifts in aggregate spending (in this case, investment) into
cyclical fluctuation in national income.
cycles suggests that random shifts in expenditures translate into systematic
cycles of output and employment. The approach (making use of time lags) posits
that the effect of change in any economic indicator on business decisions is
usually spread over a period of time. If on account of a fall in interest rate,
for example, investment in a new project becomes profitable; such investment
cannot be established immediately. The planning and implementation of the
project will normally take a period of time. Hence, the increase in investment
expenditure is distributed over time. The problem however is that a long lag
can convert such shifts in aggregate spending (in this case, investment) into
cyclical fluctuation in national income.
