Aggregate Demand & Recession

C - Consumption

Household sectors uses a part of their income for consumption and save the remaining. As the income goes up and the consumption also goes up. Consumption Function gives the relationship between consumption (C) and disposable income (DI) assuming that other factors remaining constant

Marginal propensity to consume, MPC = ΔC / ΔDI = change in C when DI changes by a unit

MPC for richer or super-rich would be 0 whereas for poor it would be 1.

I - Investments

Firms sectors does following economic activities

  a)  Private investment expenditure:

      – Planned Investment Expenditure (= investment spending = investment demand). It includes the mainly fixed investment expenditure, i.e., expenditure on final investment goods such as plant, machinery. These private investment undertaken for profits and the demand of the same depends on following:

            i) Revenues generated by the investment project

            ii) Interest rates (and taxes) that influence the costs of investment

            iii) Business expectations about the state of the economy.

     – Unplanned inventory adjustment

  b) Use retained earnings (business savings) and loans and other sources to fund investment

Investment Curve

Investment curve is downward sloping as when interest rate goes down, investment spending will go up as more projects for investment becomes viable. The investment curve assumes that expectations (subjective) of the future remains unchanged. But in reality, the expectation or the assessment of return on project can suddenly change due to the environmental factors (i.e. national or international economic events).

The business expectations are subjective in nature and are often influenced by current and recent rates of return. But the business expectation can be highly volatile due to changes in the business climate. The political, ideological, psychological and other influences on future expectations.  Since expectations are subjective, it is not possible for economists to predict when interest rate goes down whether investment spending will go up or down. Investment spending whether go up or down is dependent on the gap between the interest rate and expected return.

In short, investment curve does not explain things realistically. Reduction in interest rate may not necessary increase the investment demand, there are chances that business expectations (i.e. expected rate of returns) get worsen so much that there is net drop in investment demand even though interest rates are reduced.

Aggregate Demand Curve or Total Expenditure curve

It is curve between total expenditure (TE) v/s total production or supply. where

TE = C + I

Assumptions:
1. I or investment has to be observed and statistically estimated (as subjectivity involved).
2. Firms produce more (subject to capacity constraints) if market demand is greater than their current production
3. Firms produce less if market demand is less than their current production
4. Prices are not changed till full capacity is reached

When there is an excess production over the expenditure and hence the demand, there is an inventory leftover with the producers, which leads to a reduction in either the prices or the quantity of output and hence reducing the total output of the economy. On the other hand, if there is an excess of expenditure over supply, then there is excess demand leading to a increase in prices or output. Eventually, this takes the economy to the equilibrium condition where the total expenditure equals to aggregate income. The equilibrium point is defined by the intersection total expenditure curve with 45deg curve.

Important points:
1. economy will approach to equilibrium but not to the potential output.
2. the economy does not stay in a perpetual state of equilibrium but the Aggregate expenditure and Aggregate Supply adjust each other towards equilibrium. In long term as investment will also increase the potential output (K).
3. when the slope is greater than 1, it's an unstable equilibrium. The slope of the total expenditure curve is factor of slope of C & I. That means, it is factor of MPC. MPC is not likely to greater than 1.
4. This theory is against the Say's law which states that the supply creates its own demand.

Policy are for Aggregate Demand Management i.e. C+ I + G +X
G -> Linked to Fiscal Policy -> Government spending i.e. Ministry of Finance
X -> Foreign policy
C + I -> Linked to monetary policy -> RBI

Recession or Expansion

Investor can shift the TE curve by increasing the investment and shift the aggregate demand curve upward and so can shift the equilibrium to higher level (toward potential output). And similarly, reduction in investment can take to further sub-optimal level (away from potential output).

It is important to note that household sector has less influence on this, and investment sector has more influence on recession or expansion. In short, expansion/recession is caused by subjectivity (optimism / pessimism) of investment sector. It is not less consumption but it is less investment that is a main reason for recession.

Multiplier effect of investment

A change in investment spending arising from say a change in future expectations starts a chain reaction in which the initial change in aggregate production leads to changes in consumer spending leading to further changes in production levels.  Thus production ultimately increases more than the initial increase in investment spending.

Government Intervention

As per the Keynes's theory, expenditure of government can shift the aggregate demand curve upward. Expansionary Fiscal Policy tries to shift the aggregate demand curve upward through following ways:
1. Increasing government expenditure on goods and services (G ↑)
2. Lowering taxes on households (C ↑)
3. Increasing private investment etc.
The aggregate demand & output goes up not only due to the initial ↑ in expenditure but subsequent rounds of increases (multiplier effect).

Fiscal policy operates through changes in government expenditure and revenue (taxes).  Increasing government expenditure can play a very important role in recession/depression when investment demand is not very sensitive to changes in the interest rate. 

For increasing the expenditure, government need to arrange money. It is possible by
1. increasing taxes,
2. print money,
3. borrow money from bank etc.

1. increasing taxes to come out recession is not a good idea as the disposable income of the household will go down and so may decrease the aggregate demand (counter effect). Many economist (not all) believes that increased taxes for super-rich can though have positive effect on increase aggregate demand.

2. printing money is a good idea.. more money supply will lead to more demand and so more demand will lead to more production (as under recession - under utilized). Note: increased demand will not lead to higher price, it will lead to higher production.

3. borrow money from bank can be a good idea provided banks are having excess liquidity. If less liquidity, only option 2 is more viable.

Monetary policy operates with the changing the interest rate. Recall: interest alone does not necessarily influence investment. It dependent on the gap in interest rate and the expected rate of return. So, monetary policy may not be very effective in recession. The influencing demand is more direct way of coming out of recession, rather than indirect way of controlling interest rate. Additionally, in recession, both bank and firms are hesitant to tak /give loans.

Recall: problem in recession is low demand. So government should directly intervene to grow demand. Monetary policy is just an indirect way and fiscal policy is more direct way to do this. Monetary policy is just required to supportive - there is nothing wrong with monetary policy but it is not solution to recession.

Notes

Recession -> less demand -> due to less investment -> due to low/negative gap between return on investment & interest rate

Monetary policy -> change interest rate -> It is a indirect and not effective way to come out of recession

Fiscal policy -> increase government expenditure  (i.e. increase investment) -> multiplier -> increased consumption -> increased investment -> multiplier -> increase aggregate demand -> It is a direct way to come out of recession

Why dividend are not taxed? -> reduce the investment -> slowdown in growth

Fiscal deficit can be regarded as positive when country is in recession. It indicate that government is spending more than their revenue. And it is good to come out of recession.

Joke: Economists are who predict the future events and then explain why this did not happen.