Economic

Development
Module 2

Prepared by:
Cristeta A. Baysa, DBA
Oct 2020

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 Module 2: Business Cycle and Foundations of Aggregate Demand
Overview:
Heraclitus once said, “Change is the only thing that is constant.”. This certainly applies
to national economies.

Every nation’s economy fluctuates between periods of expansion and contraction.

Module Objectives:
After successful completion of this module, you should be able to:
 Demonstrate understanding in the basic concepts of development economics.
 Discuss the components to compute the National Income
 Identify the different cycles in business and how it can be addressed through
government policies
 Discuss the different components/ approaches in solving the national income
 Use the concept of multipliers to determine country’s output
Course Materials:
The Business Cycle
The business cycle model shows how a nation’s real GDP fluctuates over time, going
through phases as aggregate output increases and decreases. Over the long-run, the
business cycle shows a steady increase in potential output in a growing economy.

Phases and turning points of the Business Cycle

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Output Gaps in the Business Cycle
The output gap is the difference between actual output and potential output in the
business cycle. Potential output is what a nation could be producing if all of its
resources were being used efficiently. In the business cycle model, a nation’s potential
output at any given time is represented as the long-run growth trend.
Output gaps exist whenever the current amount that a nation is producing is more or
less than potential output. In the business cycle model, whenever the business cycle
curve is above the growth trend that means an economy is experiencing a positive
output gap. Whenever the business cycle curve is below the growth trend that means
the economy is experiencing a negative output gap.
When actual output is above the potential output, aggregate demand has grown faster
than aggregate supply, causing the economy to overheat. Overheating in this instance
means output is occurring at an unsustainably high level, at which the unemployment
rate is lower than the natural rate of unemployment. Eventually, the business cycle will
reach a peak and enter a recession.
When actual output is below the potential output, aggregate demand or aggregate
supply have fallen, causing a fall in employment and output. When a negative output
gap exists, the unemployment rate will be higher than the natural rate of unemployment.
Eventually, the business cycle will reach a trough and enter a recovery and expansion.
Potential output in the business cycle
Potential output is also called full-employment output. Potential output is the level of real
GDP that would be produced if all resources are used efficiently. For example, if labor is
used efficiently, the actual rate of unemployment will be equal to the natural rate of
unemployment. When there is a positive output gap, an economy is producing beyond
its long-run potential and the unemployment rate will be lower than the NRU. During a
recession, real GDP falls below its potential and the unemployment rate is higher than
the NRU.
The actual unemployment rate is different than the natural rate of unemployment, at
different points along the business cycle, because cyclical unemployment changes
along the business cycle. Cyclical unemployment increases due to reduced output
during recessions, and cyclical unemployment decreases due to increased output
during expansions.

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The business cycle model shows the fluctuations in a nation’s aggregate output and
employment over time. The model shows the four phases an economy experiences
over the long-run: expansion, peak, recession, and trough. The business cycle curve is
represented by the solid line in the model shown in Figure 1, and the growth trend is
represented by the dashed line in Figure 1.
Output gaps are represented by the difference between actual output. During an
expansion, the business cycle line is above the growth trend. During a recession, the
business cycle is below the growth trend.
The Production Possibilities Curve (PPC)
Fluctuation experienced in the business cycle can also be illustrated using the
production possibilities curve (PPC), as in Figure 2.

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In the PPC above we can observe the following:
A country producing its full employment level of output is at a point on its PPC, such as
point Y. When a country approaches a peak in its business cycle, output temporarily
expands beyond the full employment level to a point such as point Z, and there is a
positive output gap. This is unsustainable as unemployment is below its natural rate and
resource scarcity will ultimately cause output to fall. A fall in output below potential
output causes a recession and a movement to a point inside the PPC, such as point X,
resulting in a negative output gap. A recovery occurs when an economy that is
producing inside its PPC due to a recession sees its output start to increase again, such
as from point X to point Y.
Common misperceptions
An expansion is not necessarily economic growth. When an economy is recovering from
a recession, it is in the expansion phase of the business cycle, but it is not experiencing
economic growth. Economic growth occurs when the potential and actual output of a
nation increases over time. That growth is either shown by the dashed, upward-sloping
trend line (the growth trend) in the business cycle model, or by an outward shift of the
PPC.
An economy can produce beyond its full employment level of output. Resources can be
overutilized, such as workers working very, very long hours. However, as any student
who has ever pulled an all-night study session for an exam knows, you can’t sustain
that kind of effort for long.
Consumption and Investment Expenditure
Kindly copy the link and paste it on the browser.
https://youtu.be/N9VIsauE0RA
Government Expenditure
Government spending or expenditure includes all government consumption, investment,
and transfer payments. In national income accounting, the acquisition by governments
of goods and services for current use, to directly satisfy the individual or collective
needs of the community, is classed as government final consumption expenditure.
Government acquisition of goods and services intended to create future benefits, such
as infrastructure investment or research spending, is classed as government investment
(government gross capital formation). These two types of government spending, on final
consumption and on gross capital formation, together constitute one of the major
components of gross domestic product.

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Government spending can be financed by government borrowing, or taxes. Changes in
government spending is a major component of fiscal policy used to stabilize the
macroeconomic business cycle.
Foreign Expenditure
Foreign Expenditure means an expenditure in the Currency of any country other than
the Member Country for goods, works or services supplied from the territory of any
country other than the Member Country.
Multiplier Model
The basic idea behind the multiplier model is that—up to the limit set by “full
employment” or potential GDP the actual level of employment and output depends on
the state of aggregate demand (AD). A shortfall in aggregate demand will push an
economy into recession; an increase in AD can pull the economy back up to potential.
The multiplier represents the ratio of the overall increment of real GDP to the increment
of some independent expenditure variable,1 for example investment (where the
increment can be positive or negative, i.e. a decrement). Where the multiplier is greater
than one, the “extra” change in aggregate expenditure is accounted for by an induced
change in consumption. In all cases, the possibility of a positive multiplier effect rests on
the assumption that there are unused resources—that is, the economy is operating
short of full employment. If the economy is already at full employment, any increase in
one category of real expenditure must be offset by a reduction in some other category
or categories of real expenditure, or in other words the multiplier is necessarily zero.
Activities/ Assessments:
1) Why does unemployment rise during the recession phase of the business cycle?
2) What is the difference between a recession and a depression?
3) If a country is producing beyond its production possibilities curve, what phase of the
business cycle is it most likely experiencing?

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