Part of the daily news coverage on the Internet, CNN, major television and cable networks, and newspapers is devoted to the state of the economy. There are stories on the stock market, jobs, and inflation, forecasts of recovery or recession, updates on the status of foreign trade, and numerous other topics devoted to reporting the pulse of the economy. What should be clear from the media is that the U.S. economy continually changes: It goes through upswings and downswings, or periods of expansion and contraction, and never stays at a particular level of activity. Two data series discussed in Chapter 4 attest to this movement: the unemployment rate and real GDP, both of which change on a regular basis.

This chapter deals with fluctuations in the level of production, or economic activity, in the macroeconomy. It identifies the pattern of these fluctuations and provides a foundation for understanding why they occur.

CHANGES IN MACROECONOMIC ACTIVITY

Generally, when people say that the economy is getting better or worse, going into an upswing or downswing, or expanding or contracting, it is because the economy's real GDP is increasing or decreasing. Sometimes, however, people focus on changes in the unemployment rate as their gauge of changes in the economy. Regardless, these two indicators are related: Changes in real GDP cause changes in unemployment. Increases in production bring about reductions in unemployment, and decreases in production increase unemployment.

Figure 5.1 shows changes in real GDP from 1980 through 2011 in the upper graph and changes in the unemployment rate over the same period in the lower graph. In the top graph, notice that real GDP constantly changes and that it does not change at the same rate from year to year. In some years, growth or decline was more rapid than in other years. In the bottom graph, notice the change in unemployment that results from changes in real GDP. For example, unemployment began to grow when real GDP fell in late 1990, in 2001, and in 2008.

While the connection between production and employment is fairly straightforward, the connection between production and price levels is not. We learned in the last chapter that when real GDP approaches its full production level and people continue to spend, demand-pull inflation may occur. However, when real GDP increases, but is well below the full-production level, or when real GDP decreases, price levels may remain relatively stable. Since price levels may, or may not, be affected by production levels, we use the expression “changes in economic activity” to refer to changes in production and employment and not prices.

Business Cycles

Changes in economic activity do not occur randomly or haphazardly, but rather in wavelike patterns called business cycles. These patterns provide some degree of predictability that enables us to better use macroeconomic policy tools to address downswings. Business cycles are recurring periods of growth and decline in real output, or real GDP. A business cycle goes through four phases: a recovery, which is an expansionary phase during which real GDP increases; a peak, where maximum output occurs; a recession, during which real GDP falls; and a trough, where real GDP reaches its minimum.¹ Figure 5.2 illustrates the wavelike movement of business cycles and shows how the phases of the cycle are repeated.

FIGURE 5.1 Real Gross Domestic Product and the Unemployment Rate for 1980 through 2011^a

The economy is always in some phase of a business cycle. It does not remain stationary at a particular level of output until some force causes it to increase or decrease. Instead, the economy is always expanding, contracting, or at a turning point in activity.

FIGURE 5.2 Phases of the Business Cycle

Cyclical Behavior of the U.S. Economy Figure 5.3 gives us a good historical view of business cycles in the United States by tracing these wavelike patterns since the early 1920s. It also points out some important properties of business cycles. First, the phases of business cycles are not of equal length: Some phases last just a few months, whereas others last for years. Notice also that after the 1940s, periods of expansion outweigh periods of contraction and there is less severity in the cycles. This might be due in part to the federal government's commitment to a healthy economy, a better understanding of the economy, and improved information to make economic decisions. A second important property of business cycles is the unequal intensity, or strength, of expansions and contractions. For example, the output declines from 1929 to 1932 and in 1945 were dramatic, whereas others, like the decline in the early 1980s, are not as severe.

FIGURE 5.3 Economic Activity: A Long-Term View

Every business cycle is unique in the lengths of its phases and the intensity of its recovery and recession. Regardless of the messages of some financial gurus, as you can see, there is no exact rule for determining the duration and magnitude of recessions and recoveries or for defining the exact amount of time required for each business cycle.

Causes of Economic Fluctuations

What causes the economy to expand and contract? This is likely the most important macroeconomic question to be asked. If we understand why we have recessions and recoveries, we can foster the upswings and control the downswings.

For centuries, people have pondered the causes of economic fluctuations. Over the years, some theories, like one attributing business cycles to sunspots, have emerged and disappeared while others have been accepted and refined. And some, like the conspirators theory in Applications 5.1, “What's Causing the Economy to Change?,” go beyond what one typically expects to hear.

Today, there are several theories about what causes economic activity to change. When considering the merits of these theories, it is helpful to remember what we learned in Chapter 1: Theories are abstractions that are based on assumptions and focus on the relationship between two variables. That is, different macroeconomic theories use different assumptions and variables, and explain the economy's behavior from different perspectives.

APPLICATION 5.1

There are several popular theories today that deal with causes of recessions and recoveries. In addition to this chapter, Chapter 9 presents several other generally accepted theories. However, to fully appreciate and understand the working of the macroeconomy, as well as these macroeconomic theories, it is important to have a solid grasp of some basics. That is the goal of this chapter.

TOTAL SPENDING AND MACROECONOMIC ACTIVITY

Analyzing the macroeconomy is not easy: Sometimes it is difficult to bring orderly relationships to such a large picture. To ease our study, economists tend to think of the macroeconomy as having four large groups or sectors: households, businesses, government, and the foreign sector. All macroeconomic activity falls into one of these groups, and each group makes decisions that play an important role in the health of the economy.

Economists have also identified an important macroeconomic relationship that we need to understand: Changes in total (aggregate) spending in the economy cause changes in total (aggregate) production and employment. Total, or aggregate, spending is all of the spending for all new goods and services that occurs in the economy. Total spending is the spending of each of our major groups—households, businesses, government units, and foreign buyers—together.

In a market economy, spending is the driver. As long as buyers spend their money, producers will continue to produce goods and services and hire people to do so. If total spending decreases—people quit buying homes, the government cancels a major aircraft order, developers quit building shopping centers—producers respond by decreasing production, which in turn results in a decrease in employment and in incomes. If total spending increases, producers respond by increasing output, which in turn results in an increase in employment and in incomes. Thus, a reduction in spending leads to a recession because of its dampening effect on output, employment, and income. An increase in spending leads to a recovery because of its expansive effects. The relationship between spending and output, employment, and income is summarized in Figure 5.4.

FIGURE 5.4 Total Spending and the Level of Economic Activity

Obviously the spending behavior of households, businesses, the government, and foreign buyers is critical to the health of the macroeconomy. In the next few pages, we will examine each group and the factors that significantly influence its spending behavior.

The Household Sector

Households constitute the largest spending group in the economy and buy far more goods and services than do businesses, government, and foreign purchasers combined. For example, households purchased almost $11 trillion of the approximately $15 trillion output produced in 2011.² Furthermore, individuals do not radically alter their spending patterns from year to year, making this spending fairly stable as it generally increases. It is fortunate for the economy that the largest spending group is so steady in its spending patterns.

Technically speaking, we call aggregate household spending on new goods and services personal consumption expenditures. Figure 5.5 plots real personal consumption expenditures for 1980 through 2011.³ Notice that the line almost always slopes upward with little fluctuation.

FIGURE 5.5 Real Personal Consumption Expenditures for 1980–2011^a

The Household Sector and the Circular Flow Most of the spending that we do comes from income that we earn. We deliver pizzas, work as CEOs, own and run bed-and-breakfasts, and do a host of other activities to earn money. In the macroeconomy, then, we know that the majority of spending by the household sector on new goods and services comes from the income earned by households, or is income-determined spending.

Figure 5.6 builds on the circular flow model introduced in Chapter 2; it illustrates some of the important factors that influence household spending and how they are related. For now, observe lines 1, 2, 3, and 4. Line 1 shows a flow of earned income from selling factors of production to businesses (line 2), and line 4 shows a flow of personal consumption expenditures for goods and services (line 3). You can see that earned income provides the spending power to purchase goods and services.

FIGURE 5.6 Household Spending, Borrowing, Transfers, Saving, and Taxes

While earned income is the major source of household spending, it is not the only source. Households can also spend from funds that they borrow through bank loans, credit card purchases, or such, and from government transfer payments, which are payments from the government for which no direct work is performed in return. Social Security payments, unemployment compensation, and agricultural subsidies are examples of transfer payments. Checks from working for a government are not transfer payments.

When households make personal consumption expenditures from money that they borrow or receive in transfers, we call that nonincome-determined spending. It is important to separate income- and nonincome-determined spending. Since nonincome-determined expenditures are based on sources other than earned income, they become injections into the spending stream. That is, they are expenditures over and above what household earned income alone would allow. Injections into the spending stream are important because they lead to an expansion of output, employment, and income in the economy as businesses produce more to meet this additional demand. In Figure 5.6, transfers and borrowing are shown as injections into the circular model.

We also know that households do not spend all of their income: Some is used to pay taxes and some is saved. Households pay a variety of taxes to various government units. Households also save in a variety of ways through the use of financial institutions such as banks, brokerage houses, credit unions, and insurance companies. Both saving and taxes are leakages from the spending stream because they are income that households are not spending. Leakages from the spending stream cause output, employment, and income in the economy to shrink as businesses cut back production in response to a reduced demand.

UP FOR DEBATE

In summary, the amount that households spend is influenced by

• earned income,
• borrowing,
• transfers,
• saving, and
• taxes.

When people earn more or less, change their saving habits, or change any of the other factors just listed, total personal consumption expenditures and the economy as a whole can be affected. For example, fear of a recession could cause people to increase saving, with a resulting decline in spending; or a decrease in interest rates could encourage people to borrow for new cars, home remodeling, and other spending purposes.

Although personal consumption expenditures is the largest component of total spending, the impact on the economy of changes in the household sector is affected by spending in the business, government, and foreign sectors. As a result, we need to examine the other sectors and consider all of them together before drawing any conclusions about the economy.

Up for Debate, “Is Saving a Healthy Habit?”, examines conflicting messages about saving. Do you agree with the underlying message that what may be good for the individual may not be good for the group?

FIGURE 5.7 Real Gross Investment for 1980–2011^a

The Business Sector

Businesses play an extremely important role in the macroeconomy because of their spending habits. The size of business spending on new goods is huge: Each year they put hundreds of billions of dollars into new machinery and equipment, replacement parts, buildings, inventories, and the like. Technically, we term this investment spending, and we label it nonincome-determined spending because investment spending does not come from household earned income.

Investment spending is not steady and tends to fluctuate from year to year. Figure 5.7 plots real gross investment for 1980 through 2011 and shows how this spending fluctuates. This figure gives us an excellent picture of a very important piece of macroeconomic reality: Changes in investment spending are a primary cause of changes in economic activity. When business spending declines, it can bring about a slowdown or recession; when it increases, it can help pull the economy into a recovery. Figure 5.7 shows serious declines in investment spending in 1982, 1990 and 1991, 2001 and 2002, and a dramatic decline that began in 2008. During these years the United States experienced recessions and increasing unemployment rates.

Business Spending and Profit Expectations Why does business spending fluctuate? Business spending habits in the aggregate are very different from household habits because the motivation for spending is different. Householders look to their earned income as the basis for spending to support a lifestyle. Households tend to have fairly stable expenditures for housing, food, and other necessities and/or luxuries. Businesses look for the potential to make a profit as their basis for spending. Businesses invest in new buildings and equipment and larger inventories if they expect to earn enough profit from the investment to make it worthwhile. The reason Wal-Mart constructs a new Sam's Club or Ford retools a truck plant is that these companies expect to increase their profit levels with these expenditures.

Sometimes businesses plan for new investment spending—perhaps a technology upgrade—but “hold on” to those plans and postpone them because the timing is not right. Most investment spending is postponable: Building a new box store, constructing a new ride at a theme park, remodeling corporate headquarters, or even buying a new pizza oven by a mom-and-pop operation are likely not expenditures that must be made for day-to-day operations to continue. Since most businesses can delay major capital expenditures until profit expectations increase, this adds to the reasons for fluctuations in business spending.

An important factor that influences expected profit and investment spending is expectations of future overall levels of economic activity. Fear of a recession can discourage investment spending as businesses speculate that falling demand and growing inventories of unsold goods will make their operations unprofitable. Likewise, expectations of healthy sales and a surge in economic activity can bring about an increase in business spending. Predictions of economic doom-and-gloom coupled with the reality of falling demand and rising unemployment from the end of 2008 through 2010 helped to scare businesses into postponing investment spending plans. The economy was so skittish that the stock market reacted to many announcements, even the possible spread of swine flu.

The price tag on a business's investment plans can be staggering. Imagine the construction costs for a new stadium for one of the major league baseball teams or even for a medical center in your hometown. Since most businesses borrow the funds for their investment spending, the interest rate that they must pay to borrow greatly influences the level of investment spending. If the interest rate is high, businesses may decide that it is best to postpone spending because the high cost of borrowing reduces the expected profitability of the investment. If the interest rate is low, businesses may take advantage of the reduced cost of funds and increase their borrowing.

Application 5.2, “Interest Rates and Investment Spending,” provides a very simple example of how an investment decision can be affected by the interest rate. In this application, a 5-year loan for $200,000 at an 18 percent interest rate would cost a business owner $1,212.10 more in monthly payments, or a total of $72,726 more than would the same loan at a 6 percent interest rate. The importance of the effect of changes in the interest rate on economic activity will be discussed further in Chapter 8.

APPLICATION 5.2

The Business Sector and the Circular Flow The circular flow model in Figure 5.8 shows the role of the business sector in economic activity. Line 1 is business investment spending, which is an injection into the spending stream because it is nonincome-determined spending. Line 2 represents business saving, called retained earnings. Line 3 represents business taxes: corporate income tax, sales tax, and license fees, to name a few. Both business saving and taxes are leakages from the spending stream.

Notice the addition of financial institutions to Figure 5.8. These are important for business saving and investment borrowing. Businesses use financial institutions to hold their savings through deposits, stocks, bonds, or some other security that earns money until the funds are needed. Financial institutions also provide the means for financing investment spending through loans, new shares of stock, or simply redeeming the retained earnings.

The Saving–Borrowing Relationship This is a good time to point out a critical flow in the macroeconomy: the saving–borrowing relationship. Figure 5.9 adds household saving and borrowing back into the circular flow and allows us to see a fuller picture of saving and borrowing. Through financial institutions, dollars saved by households and businesses—dollars that are leakages from the spending stream—can be borrowed and spent by other households and businesses and thereby returned to the spending stream. In other words, financial institutions are vehicles for changing leakages from the spending stream into injections.

FIGURE 5.8 Business Investment Spending, Saving, and Taxes

FIGURE 5.9 Saving, Investing, and Borrowing by Households and Businesses

Since the motivations for saving and for borrowing are not the same, it is important to understand that the amount saved may not equal the amount borrowed. In other words, the economy could experience conditions where savings are greater than borrowing, savings are less than borrowing, or savings equal borrowing.

Because saving is a leakage from the spending stream and spending from borrowing is an injection into the stream, overall spending in the economy and the resulting levels of output and employment are influenced by this relationship. When saving is greater than borrowing, the relationship will foster a decrease in total spending and a downturn in the economy. When saving is less than borrowing, the relationship will foster an increase in total spending and an upturn in the economy. We need to understand that, at this point, we have isolated this saving–borrowing relationship. Before we draw any big picture conclusions, we need to put other relationships into the model.⁴

The Government Sector

Government—federal, state, and local—is another sector that has a major impact on the economy because of its own spending as well as its power to influence spending in the other sectors through the taxes that are imposed. And, as we will soon learn in Chapter 6, the federal government can use its spending and taxing to change the direction of the economy. We classify government spending into two major categories: purchases of goods and services, and transfer payments.

Governments provide us with many needed services and, as a result, make government purchases of goods and services to do so: fire trucks, police radar detectors, defense systems, park benches, paper, and the services of government employees to fix roads and maintain a court system, to name a few. Technically, we classify government purchases of goods and services as nonincome-determined spending because they do not come directly from household earned income. Government purchases have the same impact on the economy as does other spending: Increases in government purchases can increase economic activity and decreases can decrease output, employment, and income.

In most years, government spending for new goods and services is the second largest component of total spending. Figure 5.10 plots real government purchases of goods and services for 1980 through 2011. This figure shows that, like household spending and unlike business spending, government purchases tend to be stable and increase over time.

Government also uses a substantial portion of its funds for transfer payments, such as Social Security and unemployment compensation, which go to individuals or households that perform no direct work in return. These transfer payments can then be used to buy groceries, pay for prescriptions or rent, or make other personal consumption expenditures. Household spending from transfers is nonincome-determined spending because it does not come from household earned income. In 2011, about $2.3 trillion went from government to households as transfer payments.⁵

We want to point out the importance of thinking of government spending in terms of the two categories just discussed: government purchases and transfer payments. This distinction will help you to better understand the material in this chapter and the following one.

FIGURE 5.10 Real Government Purchases of Goods and Services for 1980–2011^a

The Government Sector and the Circular Flow The government sector is added to the basic circular flow model in Figure 5.11. Line 1 shows the flow of transfer payments, which can be used for consumption spending; line 2 represents government purchases of goods and services; and lines 3 and 4 show taxes going from households and businesses to government. This model shows that government purchases are a direct injection into the spending stream, transfers provide an injection through households, and taxes are a leakage.

The Government Taxing–Spending Relationship There is another relationship like the saving–borrowing one that is important to economic activity: the government taxing–spending relationship. This one, however, is slightly more complicated because while government taxing and spending may be equal, the amount leaked from the spending stream may not equal the amount injected because of saving. That is, taxpayers may pay their taxes using part of their incomes that would have been saved and part that would have been spent, and transfer recipients may save part of their payments. For readers who want to explore the details of this complication, footnote 6 gives that information.⁶ For our purposes here we will discuss the amounts leaked from and injected into the spending stream through the government sector, rather than taxes and spending.

FIGURE 5.11 The Government Sector and the Circular Flow

Sometimes the amount that flows into the government in taxes does not equal the amount that is returned to the spending stream through government purchases and spending from transfers. When the amount that is leaked through taxes is greater than the amount returned through these injections, a downswing in economic activity is fostered. When the amount that is leaked in taxes is less than the amount returned through these injections, an upswing in economic activity could result. When they offset each other, there is no change in economic activity from this relationship.

When we complete our discussion of all four economic sectors, we will put the government sector relationships together with the others to get a complete picture.

The Foreign Sector

The fourth major sector that has an impact on the direction of the macroeconomy is the foreign sector. While it is the smallest of the four, it has been growing significantly in importance. Most of us interface daily with some aspect of today's global economy: We buy electronics manufactured in Asia, work on farms that have corn sold to Mexico, wear shoes from Brazil and China, read foreign papers, go to college credit programs in Europe, and surf for good foreign stock opportunities. In short, the lines between domestic and foreign products and services have become increasingly blurred.

We term goods and services produced in the United States and sold abroad as U.S. exports, and goods and services produced in foreign countries and sold in the United States as U.S. imports. Generally speaking, exports increase spending in the economy and imports take spending out of the economy. As a result, we tend to think of exports as injections and imports as leakages. In 2011, exports were 13.8 percent of GDP and imports were equal to 17.7 percent of GDP.⁷

The real values of U.S. exports and imports from 1980 through 2011 are plotted in Figure 5.12a. Notice that the values of exports and imports have generally grown over the years and that the value of U.S. imports has usually been more than U.S. exports. When we subtract imports from exports, we get the difference between their values, or net exports. Net exports is positive when exports are greater than imports and negative when exports are less than imports. Net exports of goods and services for 1980 through 2011 is plotted in Figure 5.12b. Negative net export years fall below the zero line on the graph. It is easy to observe that for most years net exports is negative—and exceptionally negative between between 2002 and 2008.

In addition to the impact on total spending levels from large, consistent negative net export numbers, there are other serious consequences from the substantial flow of dollars to other countries. Chapter 17, International Finance, explores this area in greater detail. It will help you to understand a declining value of the dollar for U.S. citizens traveling abroad as well as the increased purchases of U.S. assets like buildings and stock by foreign dollar holders.

The Foreign Sector and the Circular Flow Figure 5.13 uses a variation of the circular flow model to show the effect of exports and imports on the U.S. economy. Line 1 represents the injections into the U.S. economy that result from expenditures by foreign buyers on exported goods and services. Line 2 represents the leakages from the U.S. economy that result from expenditures by U.S. buyers on imported goods and services. Imports and exports have the same effect as the other leakages and injections: Purchases of imports deflect spending from the economy and foster a downswing, and purchases of exports by foreign buyers increase spending and foster an upswing. Spending on exports is another example of nonincome-determined spending since it does not come from U.S. household earned income.

Here, once again, is another important relationship—the export-import relationship—to consider. And, again, as with the other sectors, injections and leakages may not be equal. Exports can be greater than imports, which makes net exports positive, causing injections to be greater than leakages and overall spending in this sector to grow. Imports can be greater than exports, which makes net exports negative, causing leakages to be greater than injections and overall spending in this sector to decline. This relationship needs to be considered with the others in evaluating the direction of the overall economy.

FIGURE 5.12 Real U.S. Exports, Imports, and Net Exports of Goods and Services for 1980–2011^a

FIGURE 5.13 The Foreign Sector and the Circular Flow

Summary of Aggregate Spending, Leakages, and Injections

Let us review. Total, or aggregate, spending drives the economy's production, employment, and income levels. When total spending increases, the economy expands as output, employment, and income increase; when total spending decreases, the economy contracts as output, employment, and income fall. We compute total spending by aggregating the spending of households, businesses, governments, and foreign buyers. It is important to remember that of these four groups, business investment spending, because of its size and instability, is a major cause of changes in economic activity.

Some actions in each of the four spending sectors cause leakages from the spending stream. These include

• saving by households and businesses,
• paying taxes by households and businesses, and
• importing foreign goods and services.

Other actions in the four sectors cause injections into the spending stream. These include

• household spending from borrowed dollars,
• household spending from government transfer payments,
• business investment spending,
• government purchases of goods and services, and
• foreign purchases of exported goods and services.

The relationship between leakages and injections influences aggregate spending and, in turn, the economy's production and employment levels. Up to this point in our discussion, we have identified three important relationships: the saving–borrowing, the tax–government expenditures, and the import–export relationships. To assess the economy as a whole, we must consider these relationships together. For example, while saving could exceed borrowing, causing a downswing, government expenditures could exceed taxes, causing an upswing.

TABLE 5.1 Leakages, Injections, and Changes in Economic Activity

In looking at the big picture, we know that

• if all leakages from the spending stream are equal to all injections, the economy will not change;
• if leakages are greater than injections, the economy will fall into a recession; and
• if injections are greater than leakages, the economy will expand into a recovery.

These cause-and-effect relationships are summarized in Table 5.1.

Each of the pieces of the macroeconomic puzzle that we have just created is extremely important because of the impact that each can have on the economy. Even a ban on genetically altered grain and seed exports could have macroeconomic implications. As a result, these various pieces are watched closely by those concerned with the state of the economy. And the media are particularly interested in reporting consumer confidence indexes, saving patterns, transfer payment changes, investment declines, and such.

The Multiplier Effect

In this chapter, we have identified spending as either income-determined or nonincome-determined. There is just one example of income-determined spending: the spending on goods and services that comes from people's earned incomes. All of the other spending that we discussed—from borrowing and transfer payments, investment spending, government purchases, and spending on U.S. exports—is nonincome-determined spending because it does not come directly from household earned income.

It is important to make a distinction between income-determined and nonincome-determined spending. This is because nonincome-determined spending, when it is injected into the economy, is subject to a multiplier effect. An increase or decrease in nonincome-determined spending causes changes in output and employment that are far greater than the initial change in spending. An increase, for example, of $100 million in nonincome-determined expenditures will cause the economy to grow by much more than $100 million because of the multiplier effect.

TABLE 5.2 Effect on Total Output and Income from a Nonincome-Determined Spending Injection of $10,000,000

Why is there a multiplier effect? How does it work? Nonincome-determined spending is not part of the “basic circle” of the circular flow model. That is, it is spending that does not come from income earned from production that is taking place. Instead, it comes from outside the core circle of the economy, or is injected into the economy. Once the injection enters the economy, it becomes part of the basic circle and these dollars are spent over and over again.

Let's work through an example. Suppose that a developer borrows $10,000,000 to invest in building homes. As the homes are constructed, the developer uses the $10,000,000 to hire people and buy materials and other resources. This spending by the developer puts $10,000,000 into the economy that was not previously there. In other words, this investment injection of $10,000,000 initially creates $10,000,000 in output (the homes) and incomes.

People who receive the $10,000,000 in income from this injection will now take part of it and spend it—they can buy cars, go on vacation, eat in trendy restaurants—and use part for saving and taxes. We will assume that they spend $8,000,000. Since this $8,000,000 is “new” to the economy, it will result in $8,000,000 of new production and incomes. The income earners of the $8,000,000 will now take part of that, say $6,400,000, and spend it.

The process does not stop here but continues through the economy in a circular pattern, creating more output and income along the way. In the end, the initial injection of $10,000,000 in the economy creates a substantial amount of output and income. Table 5.2 illustrates this example of the multiplier process through several rounds. When this example is carried through enough successive rounds to approach a zero increase in the last round, and the output and income created in each round are summed, $50,000,000 in total output and income results. This means that the initial injection of $10,000,000 has been multiplied, or magnified, to $50,000,000 of output and income; there has been a multiplier effect equal to five times the initial change in spending.

Calculating the Multiplier Effect There is an easier way to calculate the multiplier effect than to go through each round of spending, as in Table 5.2. To do so, divide the initial change in nonincome-determined spending by the percentage of the additional income received by households that is not spent. Expressed as a formula, the multiplier effect is

In the preceding example, the initial change in nonincome-determined spending was $10,000,000 and households receiving that $10,000,000 as income spent $8,000,000, or 80 percent, and did not spend $2,000,000, or 20 percent. The households that received $8,000,000 in income spent $6,400,000, or 80 percent, and did not spend $1,600,000, or 20 percent, and so on. Accordingly, in this example, the initial change in nonincome-determined spending of $10,000,000 would be divided by 0.20, the percentage of additional income not spent in each round, to result in an answer of $50,000,000, the total change in output and income.⁸

The multiplier effect is dependent on how much is spent and not spent from each successive round of income and output that is created: The more that is spent, the greater the multiplier effect; the less that is spent, the smaller the multiplier effect. If households in the preceding example had spent only 75 percent and not spent 25 percent of each successive round of newly created income, the level of economic activity would have grown by $40,000,000 ($10,000,000/0.25 = $40,000,000) rather than $50,000,000.

The multiplier effect also applies when nonincome-determined expenditures are cut back. For example, a decrease in investment spending of $10,000,000, by the time it works its way through the economy, will cause the level of economic activity to decline by more than the initial $10,000,000 decrease.

The multiplier effect is frequently used in local impact studies. Sometimes colleges and universities, for example, will conduct economic studies and use a local multiplier to show how they bring positive economic benefits to a community. Students can be regarded as bringing injections into a local economy as they buy courses, housing, food, books, and such. In addition, multipliers are used to justify large public projects like stadiums. The case is frequently made that a new stadium brings more fans into an area, becomes a tourist magnet, encourages spending for hotels and food, and thus creates additional employment and income for the area.

In summary, changes in nonincome-determined spending, such as investment spending, government and foreign purchases, and household expenditures from transfer payments or borrowing, will cause changes in economic activity that are a multiple of the initial change in spending.

Application 5.3, “Ripples through the Economy,” provides three examples of the multiplier effect. The first deals with slumps experienced in western Pennsylvania because of coal and steel; the second with rewards from attracting conventions and sporting events to a city; and the third with recent problems in the auto industry. Keep in mind that the multiplier effect applies to both increases and decreases in spending.

APPLICATION 5.3

A Word about Inflation

We must be careful to understand that it is not always to the benefit of the economy to encourage more spending. When the economy expands, the full production-full employment level of output sets a limit on how far spending can cause production and employment to increase. If spending continues to grow when the economy is at or close to the full production-full employment level of output, demand-pull inflation may result.

TEST YOUR UNDERSTANDING

Inflation may occur if injections into the spending stream are greater than leakages when the economy is at or near full employment. Too much spending through investment, household borrowing, exporting, and/or government expenditures, or too little saving, importing, and/or taxing could cause prices to rise.

A Word about Expectations

Earlier we noted that expectations of a recession might induce businesses to cut back investment spending in anticipation of a decline in sales. Expectations of a recession could also cause households to increase their saving because they fear possible job losses. Such actions prompted by the fear of a recession can actually trigger a recession. Fear-induced increases in saving bring about a greater leakage from the spending stream, and a reduction in investment lessens this injection into the spending stream. As saving is increased and investment is reduced, the resulting decrease in spending causes output, employment, and income to fall, and the economy slips into a recession.

Expectations can also cause or worsen inflation. If households and businesses expect prices to rise, they may try to beat the price increases by buying now what they want and need in the future. This surge in spending may serve only to cause or worsen the inflation that is feared.

It is important to maintain good, positive expectations about the economy. Recovery from a recession is more difficult when households and businesses are unwilling to spend because they are pessimistic about the prospects of recovery. Controlling inflation is more difficult if households and businesses believe that prices will continue to go up in the future and that they will be penalized for postponing their expenditures.

You can check your knowledge of the impact of spending, leakages, injections, the multiplier, the full employment ceiling, and expectations on the economy by completing Test Your Understanding, “Changes in Economic Activity.”

MACROECONOMIC PREDICTORS AND POLICIES

Chapters 4 and 5 have provided a wealth of basic information about the macroeconomy, from data to key terminology to an understanding of the forces that impact how the economy behaves. You now know the indicators of good and bad health in the economy and how that is defined. The constant coverage of economic conditions by the media and the expressions that are used should make you smart about evaluating that coverage.

Part of the interest in economic conditions is in predicting the future, or where the economy is headed. Is it moving into or out of a recession or a recovery? Some of the economic data we have examined give the state of the economy: unemployment and GDP figures, for example. Other data, such as consumer spending and interest rates serve more as predictors. When consumers are fearful of times ahead and cut back on their spending, it has a negative impact on economic activity. Likewise, an increase in interest rates makes investment spending less profitable and inclines businesses toward postponement. The list of predictors, however, is not limited to these data as people also watch many other indicators such as changes in business inventories and measures of consumer confidence. You might enjoy Application 5.4, “Unconventional Indicators of Economic Health,” which gives some of the more unique and quirky predictors that various people have found.

Regardless of where the economy is moving, the goals continue to be full employment, price stability, and full production and economic growth. Since total spending is the fundamental driver of production and employment and sometimes price levels, policies have been designed to affect spending in the economy.

Fiscal policy modifies spending by changing government taxes, transfer payments, and purchases of goods and services. Fiscal policy can increase spending to redirect the economy into an expansion or decrease spending to slow it down. The workings of this strategy for influencing the economy will be discussed in the next chapter.

Monetary policy focuses on changing borrowing and, to a lesser degree, saving, or the injections and leakages that flow through financial institutions. This policy falls into the domain of the Federal Reserve, whose actions can change interest rates and the amount of funding available for loans. The Federal Reserve can create conditions that encourage borrowing and spending by households and businesses, or tighten credit and discourage borrowing and spending. The Federal Reserve, loan making, interest rates, and monetary policy are covered in Chapters 7 and 8.

APPLICATION 5.4

Strong opinions and disagreements exist about which policies are best for dealing with problems in the macroeconomy. Various points of view on the proper method for reaching objectives or dealing with problems in the macroeconomy will be covered in the upcoming macroeconomic chapters.

Summary

1. Market economies, such as that of the United States, are constantly experiencing expansions and contractions in their levels of real GDP. These recurring upswings and downswings in production are called business cycles. Business cycles affect not only output but also employment and income. Business cycles have four phases: recovery, peak, recession, and trough. The length of time in each phase and its intensity differ from cycle to cycle.
2. There are several theories about the causes of economic fluctuations. These different theories are based on differing sets of assumptions and variables.
3. Changes in total, or aggregate, spending on new goods and services cause changes in economic activity. An increase in total spending increases output, employment, and income, and the economy grows until it reaches full employment. A decrease in total spending decreases output, employment, and income, and the economy contracts. Total spending is the spending by the household, business, government, and foreign sectors together.
4. Household spending on new goods and services, called personal consumption expenditures, is fairly stable as it increases from year to year, and is greater than the combined purchases of businesses, government units, and foreign buyers. Most household spending originates from income earned from producing goods and services. Households can also make purchases from borrowed funds and transfer payments, which are labeled nonincome-determined spending because they do not come from household earned income. These nonincome-determined expenditures are injections into the spending stream. In addition to buying goods and services, households can use income for saving or paying taxes, which are leakages from the spending stream.
5. The purchase of new goods such as machinery and equipment by businesses is called investment spending and is a form of nonincome-determined spending. Of the major components of total spending, investment is the least stable and a major source of fluctuations in output, employment, and income. Investment spending is influenced by profit expectations that are affected by the outlook for future economic activity and the interest rate for borrowing funds. Investment spending is an injection into the spending stream: Increases in investment spending stimulate the level of economic activity, and reductions in investment spending lead to reductions in output, employment, and income. Business saving and taxes are leakages from the spending stream.
6. Government can influence spending in three areas: the purchase of goods and services, transfer payments, and taxes on households and businesses. Government purchases of goods and services are a form of nonincome-determined spending and are direct injections into the spending stream. Transfer payments provide injections, and taxes are a leakage.
7. Expenditures by U.S. buyers on imported goods and services are leakages from the spending stream. Purchases of exported U.S. goods and services by foreign buyers are injections and classified as nonincome-determined expenditures. Net exports is exports minus imports and indicates whether the foreign sector had a net positive or negative impact on total spending. Net exports has tended to be negative over the past few decades.
8. Leakages from the spending stream include saving and paying taxes by households and businesses as well as purchases of imports. Injections include household spending from borrowing and transfer payments, business investment spending, government purchases of goods and services, and purchases of exports.
9. If all leakages from the spending stream equal all injections, the level of economic activity will continue unchanged. If leakages exceed injections, spending decreases, and the level of economic activity falls. If injections are greater than leakages, the spending stream expands, and the level of economic activity grows.
10. An increase or decrease in nonincome-determined household expenditures, investment spending, government purchases, or foreign spending leads to a multiple increase or decrease in the levels of output, employment, and income. The multiplier effect is calculated by dividing the initial change in nonincome-determined spending by the percentage of additional income received by households that is not spent.
11. If the economy is operating at or near full employment, increases in spending may lead to demand-pull inflation rather than to increases in output and employment. For this reason, increasing total spending does not always cause the economy to expand.
12. Expectations can influence total spending and therefore complicate the job of stabilizing the economy. Because of the effect of expectations on spending, fears can cause self-fulfilling prophecies: The fear of a recession can lead to a recession, and the fear of inflation can lead to inflation.
13. The objectives of full production and economic growth, full employment, and stable prices can be accomplished through increasing or decreasing total spending. Fiscal policy influences total spending through changes in government purchases of goods and services, transfers, and taxes. Monetary policy influences spending through changes in the interest rate and money supply, or changes in lending and borrowing.

Key Terms and Concepts

Business cycles

Recovery

Peak

Recession

Trough

Total, or aggregate, spending

Personal consumption expenditures

Income-determined spending

Transfer payments

Nonincome-determined spending

Injections into the spending stream

Financial institutions

Leakages from the spending stream

Investment spending

Retained earnings

Saving–borrowing relationship

Government purchases of goods and services

Exports

Imports

Net exports

Multiplier effect

Expectations

Fiscal policy

Monetary policy

Review Questions

1. Identify the four phases of a business cycle and describe the changes in economic activity that occur during each phase.
2. What is the basic cause of a recession?
3. What is the difference between income-determined spending and nonincome-determined spending? What are the different types of nonincome-determined spending? Why are all nonincome-determined expenditures injections into the spending stream?
4. Changes in the level of economic activity are related to changes in the spending of households, businesses, government units, and buyers in the foreign sector.
   1. How do personal consumption expenditures, investment spending, government purchases of goods and services, and net exports compare in terms of relative size and stability?
   2. How are personal consumption expenditures affected by taxes, transfer payments, saving, and borrowing?
   3. How is investment spending affected by changes in the interest rate?
   4. Why are government expenditures on goods and services a direct injection and government expenditures on transfer payments not a direct injection into the spending stream?
   5. What effects do transactions in the foreign sector have on domestic levels of output, employment, and income?
   6. Under what circumstances would an increase in total spending lead primarily to an increase in output, and when would it lead primarily to an increase in prices?
5. Identify the various leakages from and injections into the spending stream in a circular flow model of the economy. What is the relationship between leakages and injections when the level of economic activity is expanding, contracting, or remaining unchanged? What role do financial institutions play in the relationship between leakages and injections?
6. What is the multiplier effect, and how is it related to nonincome-determined spending and the circular flow of economic activity? What happens to the multiplier effect when the percentage of additional earned income not spent increases? Why does this happen?
7. In each of the following cases, calculate the change that occurs in the level of output as a result of the multiplier effect.
   1. Government purchases of goods and services increase by $600 million, and 20 percent of additional income received is not spent.
   2. Household spending from borrowing declines by $1 billion, and 30 percent of additional income received is not spent.
   3. Investment spending increases by $800 million, and 75 percent of additional income received is spent.
   4. Investment spending increases by $20 billion at the same time that U.S. net exports decrease by $15 billion, and 60 percent of additional income received is spent.
   5. Household purchases from transfer payments increase by $500 million when the economy is at full employment, and two-thirds of additional income received is spent.
   6. (Be careful.) Government purchases decrease by $200 million and transfer payments increase by $100 million when people are spending 75 percent of income received.
8. Take a large sheet of paper and construct a circular flow model that illustrates all of the leakages and injections in the macroeconomy.

Discussion Questions

1. Figure 5.1 shows that since 1985, business cycles in the U.S. economy have had long recovery and relatively short recession phases. Why do you think this has happened? Do you think this pattern is typical of what we can expect from the economy in the future?
2. Suppose the economy were in a recession and someone said to you, “If we simply started producing more, the recession and unemployment problems would go away.” How would you evaluate this statement?
3. Personal consumption expenditures grow at a relatively constant rate over time, while investment spending fluctuates widely. What reasons might explain why personal consumption expenditures are more stable than investment spending?
4. Suppose the economy is in a recession and a member of Congress sponsors a bill to limit imports of vehicles, clothing, and other manufactured goods. The bill, if passed into law, would allegedly ensure that some of the dollars currently leaving the spending stream for imports would instead be spent on domestic products, thereby increasing output, employment, and income, and reversing the recession. Is this bill a realistic solution to reversing the recession? How would you vote for this bill if you were in Congress?
5. Expectations play an important role in determining the level of economic activity and how the level of activity will change. What events might cause people to expect a recession? What events might cause people to expect inflation? What could be done to make the economy more predictable and help stabilize expectations?
6. Do you think there will be a positive or negative impact on economic activity as the United States pursues more “green” efforts? Consider a move toward more fuel-efficient vehicles and buildings in your answer.
7. The multiplier effect is larger or smaller depending on whether households spend more or less of their additional income. What effect might the expectation of a recession have on the multiplier? What effect might the expectation of inflation have on the multiplier?
8. Fiscal and monetary policies are designed to influence the level of economic activity through their impacts on total spending. Using the circular flow model, identify the leakages and injections each of these policies affects.

Critical Thinking Case 5

¹ The terms recession and depression do not have the same meaning. A recession is a downswing in economic activity. The Great Depression was a historical event in the 1930s when the United States and other economies experienced sharp reductions in output and increases in unemployment.

² Economic Report of the President (Washington, DC: U.S. Government Printing Office, 2012), Table B-1; numbers are preliminary.

³ The numbers in Figure 5.5 as well as Figures 5.7, 5.10, and 5.12 are given in real terms. That is, the numbers are adjusted for price increases, or inflation.

⁴ We are simplifying the saving–borrowing relationship by assuming that 100 percent of borrowed funds are spent. While this may not always be true, it does allow us to understand the impact of this important relationship. To be precise, we would compare saving with spending from borrowing.

⁵ Economic Report of the President, 2012, Table B-29. Number is preliminary.

⁶ We are being careful to compare the amount put into the spending stream through government purchases and transfers with the amount taken from the spending stream through taxes. This is because not all transfer payments are used to purchase goods and services, and not all taxes are paid with money that would have been spent. When households receive transfer payments, a portion of what they receive from the government may be saved. When households pay taxes, part of that payment may come from money that would have been used for personal consumption expenditures, and part may come from money that would have been saved. For this reason, assessing the impact of government expenditures and taxes becomes somewhat complex. Let us illustrate with the following example.

Suppose that the government taxes households $100 billion and uses that money to purchase $100 billion of goods and services. Suppose also that $70 billion of that tax is paid with dollars that households would have used for personal consumption expenditures, and $30 billion is paid with dollars they would have saved. Because of this, the tax of $100 billion reduces household spending by only $70 billion. Thus, the net effect of the tax of $100 billion and the expenditure program of $100 billion is to enlarge the spending stream by $30 billion, and the economy grows. In this example, if the government wanted the effect of its spending and taxes to be neutral, it would spend $70 billion and tax $100 billion.

This example could be further complicated by assuming that out of the $100 billion in government expenditures, only $50 billion is spent for the purchase of goods and services and that the other $50 billion goes for transfer payments. The $50 billion spent on goods and services goes directly into the spending stream, but part of the $50 billion in transfers could go into savings. If households saved $15 billion and spent $35 billion, then only $85 billion of the government's total expenditures would go into the spending stream.

⁷ Economic Report of the President (Washington, DC: U.S. Government Printing Office, 2012), Table B-1. Numbers are preliminary.

⁸ Be careful when calculating the multiplier effect to always express the percentage of additional income not spent as a decimal. That is, if 20 percent of additional income is not spent, then the multiplier effect is determined by dividing the initial change in nonincome-determined spending by 0.20, not by 20.