Economic Cycle 3: Economic models

1. Economic Cycles – Part 3
Economic models
WACE Economics Unit 4
Video 9.3

2. (c) Andrew Tibbitt 2017 Slide 2
Cycles are demand-side movements around a longer
term, supply determined, trend line. Therefore an
explanation of cycles will focus on the components of
aggregate demand:
• Consumption (C)
• Planned Investment (Ip)
• Government Spending (G)
• Net Exports (X-M)
AD = C + Ip + G + X - M
Cycles are a demand-side story

3. (c) Andrew Tibbitt 2017 Slide 3
Manufactured
goods
Services
Slump or trough
(big gap, little
change in size)
Production Possibility Frontiers
The GDP or output gap is the crucial
feature of the diagram.
The stage of the economic cycle is
indicated by the actual size and
change in the size of gap.
PPF
Q1
Q2
GDP or
output gap

4. (c) Andrew Tibbitt 2017 Slide 4
Manufactured
goods
Services
Recovery or
upswing
(smaller gap,
reduction in size)
Production Possibility Frontiers
PPF
Q1
Q2
GDP or
output gap
The GDP or output gap is the crucial
feature of the diagram.
The stage of the economic cycle is
indicated by the actual size and
change in the size of gap.

5. (c) Andrew Tibbitt 2017 Slide 5
Manufactured
goods
Services
Boom
(small gap, little
change in size)
Production Possibility Frontiers
The GDP or output gap is the crucial
feature of the diagram.
The stage of the economic cycle is
indicated by the actual size and
movement in the gap.
PPF
Q1
Q2
GDP or
output gap

6. (c) Andrew Tibbitt 2017 Slide 6
Manufactured
goods
Services
Downswing
(bigger gap,
increase in size)
Production Possibility Frontiers
PPF
Q1
Q2
GDP or
output gap
The GDP or output gap is the crucial
feature of the diagram.
The stage of the economic cycle is
indicated by the actual size and
change in the size of gap.

7. (c) Andrew Tibbitt 2017 Slide 7
%
GDP
Time
BOOM
Production near
PPC
RECOVERY
Production rises
back towards PPC
Good 1
Good 2
Good 1
Good 2
Good 1
Good 2
Good 1
Good 2
DOWNSWING
Production falls
below PPC
SLUMP or TROUGH
Production way below PPC

8. (c) Andrew Tibbitt 2017 Slide 8
AEx
(Expenditure)
Y (Income)
45o (Ex = Y)
AEx1
Capacity
Big
Recession
Recovery
Boom
Keynesian income and expenditure model
Y1 Y2 Y3
AEx2
AEx3
Reduction in size of GDP gap

9. (c) Andrew Tibbitt 2017 Slide 9
%
GDP
Time
Ex
Y
45o
AE Boom
Ex
Y
45o
AE Down
Ex
Y
45o
AE
Recession
Ex
Y
45o
AE
Recovery
Small deflationary gap.
Income near capacity.
Bigger deflationary
gap. Income falls
away from capacity.
Large deflationary gap.
Lots of unused capacity.
Smaller deflationary
gap. Income rises
towards capacity.

10. (c) Andrew Tibbitt 2017 Slide 10
AS
AD in boom (stable
but strong)
AD in recession
(stable but weak)
AD shifts right in
upturn or recovery
PRICE
LEVEL
REAL GDP
Big
Recession
Recovery
Boom
Keynesian AD / AS model
AD1 AD2
AD3

11. (c) Andrew Tibbitt 2017 Slide 11
%
GDP
Time
Equilibrium near
capacity.
Lots of unused capacity.
Income rises
towards
capacity.
Price
Level
Real GDP
AD
Boom
AS
Real GDP falls away
from capacity.
Price
Level
Real GDP
AD
Down
AS
Price
Level
Real GDP
AD
Recession
AS
Price
Level
Real GDP
AD
Recovery
AS

12.  Only a model – a model that helps understand
fluctuations in economic activity
 Real world more complex – economies don’t pass
through clear-cut sequence of stages
 Government and RBA has limited power to control
short-term fluctuations in the economy
 Models pay little attention to changes in aggregate
supply (or potential output) at different stages of
cycle
 Difficult to measure potential output and hence size of
output gap
(c) Andrew Tibbitt 2017 Slide 12
Evaluation of economic cycle models

13. Economic Cycles – Part 4
Mind Map Summary
WACE Economics Unit 4
Video 9.4

14. (c) Andrew Tibbitt 2017 Slide 14
Boom
Downturn
Recession Recovery
Cumulative
processes
ShocksFloors
Ceilings
Counter-
cyclical
policies
Automatic
Trend
pathDiscretionary
Net
exports
Government
spending
Economic
Cycles
Consumption
Investment
Aggregate
demand
Boom
Downturn
Recession
Recovery
Cumulative
processes
Shocks
Floors
Ceilings
Counter-
cyclical
policies
Automatic
Trend
path
Discretionary
Net
exports
Government
spending
Consumption Investment
Aggregate
demand
Accelerator
process
stages
changes in
away
from
are
caused
by
Multiplier
process
changes in
are
dampened
by

15. (c) Andrew Tibbitt 2017 Slide 15
End of part 3