Question

All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises. Any event or policy that raises consumption, investment, government expenditures, or net exports at a given price level increases aggregate demand, vice versa. Questions a) Which variable, investment or consumer spending has more affect on the business cycle? Why? (6 points)

Answer 1

a) Depending upon the structure of the economy, the effect of Consumption Spending or Investment Spending will have a higher role in the business cycle in the economy. If the economy is more consumption dominated, then Consumption Spending has a higher role, whereas, if the economy is more investment dominated, then Investment Spending has a higher role. Since, increase in both the same multiplier effect [i.e. 1/(1 – MPC)] (assuming lump-sum investment), the result depends upon the structure of the economy.

b) Recession is defined as: “a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters“.

Two macroeconomic variables which decline during recession are output (real GDP) and investment spending. This is because as GDP is reduced, the value of currency falls, money demand falls, the investors become bearish about the economy in general, and hence, all these macro factors lead to the decline in investment spending

One macroeconomic variable which increases during recession is unemployment. As GDP declines, firms produce less, and thus they lay-off workers in the face of recession, leading to higher unemployment.

c) Expansion is the phase of the business cycle where real GDP grows for two or more consecutive quarters, moving from a trough to a peak, whereas, Contraction is the phase of the business cycle where real GDP falls for two or more consecutive quarters, moving from a trough to a peak.

In the past three quarters, Thailand has grown at 1%, 0.4% and 0.1% respectively. Clearly, the Thai economy has contracted.