Topic 7 Notes

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TRIMESTER 2 2023 ECON106/ECON406 Economics for Date: Thursday, 28 September 2023, 12:24 PM
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Management
Book: Topic 7 Notes
 Description

Notes for: National Income.

 Table of contents

Learning Objectives

Introduction and Readings

Macroeconomic Issues

Gross Domestic Product (GDP)

Economic Growth

Unemployment

Inflation

Balance of Payments

Introduction to the 'Circular Flow of Goods' Concept

Circular Flow of Income

National Income Accounting

National Income Accounting (Con't)

Limitations on National Income Accounting

Aggregate Output and Expenditure

Withdrawals and Injections Approach

Income and Expenditure Approach

The Multiplier and the Accelerator

Unemployment

Determinants of Business Cycles

 Learning Objectives

After completing this topic, you should be able to:

Understand the objectives of macroeconomic policymaking;

Understand the meaning of GDP, economic growth, unemployment and inflation;
Understand the concept of balance of payments;
Appreciate the circular flow of income;
Understand the concepts of inner flow, withdrawals and injections;
Appreciate the differences between intermediate and final goods;
Understand GDP at market prices;
Appreciate the concept of personal disposal income;
Understand what implicit deflators are in national accounting;
Appreciate the three methods of calculation of GDP;
Understand the significant omissions in the calculation of GDP;
Appreciate the difference between actual and potential GDP;
Understand marginal propensities to consume and withdraw;
Understand the income and expenditure approach to GDP determination;
Understand the withdrawals and injections approach to GDP determination;
Understand the multiplier and accelerator effects;
Understand aggregate demand and supply curves;
Appreciate the determinants of the level of unemployment;
Appreciate the factors contributing to the business cycle; and
Understand the accelerator principle.
 Introduction and Readings
In parallel with the Topic Notes:

Chapter 9 and 10, and the Appendix from your textbook (Sloman, Norris & Garret, 2014)

Reading 7.1 - Chapter 4 (Samuelson & Nordhaus, 2010)

recommended notes

Samuelson, P. A., & Nordhaus, W. D. (2010). Chapter 4: Overview of macroeconomics. In Macroeconomics (19th ed., pp. 65–83). Boston, MA: McGraw-Hill.

ISBN: 9780073344225

Reading 7.2 - RBA Economic Outlook (August, 2023)

recommended

Reserve Bank of Australia (RBA). (2023, August 1). Statement on Monetary Policy - Economic Outlook - August 2023. Retrieved 14 August 2023, from Reserve Bank of
Australia. Statement on Monetary Policy - Economic Outlook - August 2023 website: [Link]

Reading 7.3 - Chapter 9 (Hubbard, Glenn R. ; Garnett, Anne M. ; Lewis, Philip E. T. ; O'Brien, Anthony P., 2018b)

recommended notes

Hubbard, R. G., Garnett, A. M., Lewis, P., & O’Brien, A. (2018). Chapter 9: Aggregate expenditure and output in the short run. In Macroeconomics (4th ed., pp. 229–271).
Melbourne, Vic: Pearson.

Make your own notes to complement these topic notes.

Review questions at the end of chapter 9 and 10 of the textbook.
Try out the self-assessment multiple choice questions
 Macroeconomic Issues
Macroeconomics focuses on the activities of the economy as a whole. It is concerned with aggregate demand or the total amount of spending in the economy, the
aggregate supply or economy’s total output of goods and services and why total output fluctuates over time resulting in the business cycle. Macroeconomics
studies the determination of national output and its growth over time, the problems of recession, unemployment, inflation, the balance of international payments
and cyclical instability. Finally, microeconomics covers the policies adopted by governments to deal with all these problems.
 Gross Domestic Product (GDP)
Measurements of total income, total production and total expenditure are important for understanding the economic environment. Nominal GDP measures at
current prices the value of the flow of final goods and services produced over a year, while real GDP measures it after adjusting for inflation. The estimate of GDP
must not include non-productive transactions but it is necessary, where practicable, to impute the value of productive non-market transactions. Due to difficulties
in estimation, much productive non-market activity is not included. To avoid double counting only final output is included and intermediate goods are left out.

Using GDP at current prices (nominal GDP) to examine the economy’s output over a number of years presents a problem as it includes the changes in real
production together with the changes in the prices of those goods and services. To overcome this problem a price index (GDP Implicit Deflator) is constructed and
used to deflate GDP at current prices so establishing GDP at constant prices (real GDP). GDP is a measure of economic activity but not social welfare. Many
variables which influence society’s wellbeing are not allowed for in the estimation of GDP. Changes in population are included by estimating GDP per capita.
 Economic Growth
The rate of economic growth is the percentage increase in real GDP over a year, also known as actual growth, while potential growth represents the rate at which
the economy could grow, based on the economy's capacity to produce. This can vary if there is an increase in resources (natural resources, labour or capital) or an
increase in efficiency due to advances in technology, people's skills or management.

The economy grows over time but at an uneven pace. Economic fluctuations or business cycles are of major concern. While there are high rates of growth in GDP
in some years there are falls in others. When GDP falls for at least two quarters the economy is said to be in recession. These fluctuations affect many types of
aggregate economic activity (sales, profit levels, investment) but most particularly the rate of inflation and unemployment. Business cycles are not regular in
severity or timing. Generally their recurrent fluctuations may be viewed as having four phases: (1) Upturn; (2) Expansion; (3) Peaking out; (4) Recession or
slowdown. Figure 7.1 illustrates, in a stylistic way, the business cycle.

Figure 7.1. The business cycle

Source: Sloman et al. (2014).

The long term output trend line in Figure 7.1 shows the trend of national output over time and has the same slope as the potential output line. The internal
composition of the economy influences the cyclical pattern. Faced with fluctuations in aggregate demand, competitive markets tend to adjust prices relatively
quickly and hence experience smaller fluctuations than monopolistic or oligopolistic markets where prices are relatively sticky. On the other hand, durable goods
industries tend to experience greater fluctuations than do non-durable goods industries. The cyclical pattern is also influenced by factors external to the economy,
for example new inventions and technological development. Finally, prevailing attitudes towards the economy (optimism - pessimism) become ‘self fulfilling
prophesies’ and shift the economy in one direction or the other. In the long run, the determinants of actual growth are growth in aggregate demand and growth in
potential output.
 Unemployment
The number of people unemployed represents 'those of working age who are without work, who want to work and who are available for work at current wage rates'.
The unemployment rate is the number of unemployed as a percentage of the labour force, which includes people employed and unemployed. The various stages
of the business cycle suggest that unemployment worsens during downswings (recessions) and improves during upswings (expansion), this is known as cyclical
unemployment. Other types of unemployment include seasonal unemployment (due to seasonal variations on production or sales), frictional unemployment
(associated with people moving from one job to other or moving into the labour force) and structural unemployment (long-term unemployment due to structural
factors in the economy, such as mismatch between the skills required by a particular job and the skills of workers who have lost their jobs in declining industries.

People self-esteem when they are unemployed is likely to fall and they are more likely to be affected by stress-related illness. Unemployment is also a concern due
to the costs it imposes on the economy. The economic cost of unemployment is estimated by the GDP gap, that is the difference between potential (full
employment) GDP and actual GDP. It is the goods and services not produced because there is unemployment. The burden of unemployment is spread unevenly
over various groups. Other effects of unemployment are losses in tax revenues for the government not only because unemployed people pay no income taxes and
receive benefits from the government, also they spend less money so pay less GST (Goods and Services Tax). Firms lose profits they could have made and other
workers receive a worse wage rate they might have earned.
 Inflation
Inflation is a persistent rise in the general level of prices of all goods and services. It reduces the purchasing power of money. The rate of inflation is the annual
percentage increase in the price level. The conventional view is that the rise in the general level of prices tends to be smallest when the GDP gap widens and
unemployment increases and vice versa. However in the mid 1970s the economy experienced a severe period of inflation during a deep recession. These events
are described as stagflation.

Inflation erodes the purchasing power of money, so when people anticipate inflation they will try to protect themselves. When inflation is not fully anticipated some
people are hurt by it. Those who lose by unanticipated inflation include: creditors; fixed income groups and holders of fixed-dollar assets such as money. When
fully anticipated these losses are avoided by charging interest rates which fully reflect anticipated inflation, indexation of fixed incomes and by holding wealth in
variable-dollar assets such as real estate. Uncertainty about the rate of inflation makes it difficult for the economy to achieve full employment as businesses and
households are unable to correctly plan their spending, saving and borrowing activities. Therefore, price stability is one of the major goals of economic
management by governments. To measure the general level of prices in the economy, the most commonly used figure is the Consumer Price Index.

In general, people make mistakes when they forecast the rate of inflation so they cannot adapt fully to it. In that situation, the following problems appear and
become more serious as the rate of inflation reaches a higher level:

Redistribution: Income is transferred from those on fixed incomes and those in weak bargaining positions in the labour market to those with economic
power to gain large pay, rent or profit increases.
Uncertainty and lack of investment: Unanticipated inflation produces uncertainty in business because firms experience problems predicting costs and
revenues so reduce their rate of investment.
Balance of payments: The balance of payments deteriorates because exports become less competitive in world markets and imports become relatively
cheaper than domestic goods. This concept is analysed in the following subsection however note for now an x% shock to inflation reduces the value of the
exchange rate by the same x%.
Resources: Extra resources are used under inflation, for example, companies require specialised professionals such as accountants and financial experts
to cope with its effects.

Inflation can come from persistent rises in aggregate demand (demand pull inflation) or from persistent increases in the costs of production (cost-push inflation).
 Balance of Payments
The balance of payments account is the record of all transactions between a country and the rest of the world. This account is divided into the current account,
capital account and the financial account. Transactions of imports and exports of goods and services, payments and receipts of interest, and dividends are
recorded in the current account, transfers of money and capital from abroad are recorded in the capital account, while the financial account records investment
flows and changes in foreign exchange reserves. It is difficult to define an 'adequate' balance of payments however the balance is 'satisfactory' if an inward
investment flow is maintained without affecting other objectives seriously.

Governments try to: (1) maintain high and sustainable economic growth, (2) low unemployment, (3) low inflation and (4) a satisfactory balance of payments. To do
so, governments control several factors affecting these variables and pay attention to important relationships between the four objectives.
 Introduction to the 'Circular Flow of Goods' Concept
The macro economy can be represented in its most simple form as a flow of goods and incomes between producers and consumers, which we refer to as
households. Producers, or firms, provide goods and services which are demanded by households. Meanwhile households provide things that firms need: labour,
land, raw materials and capital. This causes a circular flow of incomes: households earn incomes from firms and firms earn incomes from households, so the
money circulates. Also, goods and services circulate, but in the opposite way because households supply factors to firms (receiving money for them), which use
them to produce and sell goods and services back to households. This is shown in Figure 7.2 below.

Figure 7.2. Simple representation of the circular flow of goods and incomes.

Source: Sloman et al. (2014).

 Circular Flow of Income
The governments' policy objectives are related to aggregate demand (AD), which is the total spending on goods and services made in the country, composed of:

1. Consumer spending on goods and services (C);

2. Investment expenditure by firms within the country (I);

3. Government spending on goods and services (G); and

4. Expenditure by foreign nationals on the country's goods and services (X) and expenditure on imports (M).

The aggregate demand equation is:

AD = C + I + G + X - M

where exports are X and imports, M.

A two sector flow diagram illustrates the economic decisions of households and businesses. Households exchange their resources of land, labour and financial
capital for money payments in the form of wages, rents, interest and profits. This constitutes household income. Businesses view these payments as costs of
production incurred to produce and supply goods and services demanded by households. The money payments received by business for these goods and
services are equal to consumer spending by households. This interaction between the two sectors in the resource and goods and services markets comprises the
two aspects of the circular flow. In addition both households and businesses save part of their income or sales revenue, placing their savings in financial
institutions. The financial markets act as intermediaries between the savers and the borrowers in the economy. With the inclusion of a third sector, the
government, payments by government and government purchases of goods and services from businesses is included in the circular flow. The circular flow of
income and expenditure is illustrated in Figure 7.3.

Figure 7.3. The circular flow of income and expenditure.

Source: Sloman et al. (2014).

The inner flow is composed of firms' factor payments to households and payments from households to firms for goods and services consumed. Not all income
will pass through the inner flow since some is withdrawn. Withdrawals or leakages (W) represent incomes of households or firms that are not passed on to the
inner flow and include:

1. Net savings (S), incomes households save for the future;

2. Net taxes (T), taxes paid by people or companies minus benefits received from government;

3. Import expenditure (M), incomes used in consumption of imported goods and services or on goods and services using imported components.
So, total withdrawals are:

W=S+T+M

Part of the demand for firms' output comes from consumer expenditure and the rest is from sources outside the inner flow, known as injections (J). Injections
depend on:

1. Investment (I), money spent by firms on equipment, building up stocks of inputs, semi-finished or finished goods;

2. Government expenditure (G), on goods and services produced by firms;

3. Export expenditure (X), residents overseas buy exports of goods and services.

Total injections are:

J=I+G+X

So, aggregate demand (AD), total spending on output, is:

AD = Cd + J

In this case Cd represents consumer spending on domestically produced goods and services.
 National Income Accounting
National income accounting provides aggregate measures of what is happening in the economy and allows government and business decision makers to plan
better. The information assists public and private policy makers to assess the economy’s performance, identify problem areas and implement policies to improve
performance.

The main economic aggregate is Gross Domestic Product (GDP). When it is calculated as expenditure on final goods and services produced in the economy in a
year it is called the expenditure method. When it is calculated as income received and paid to the owners of resources used for production it is called the income
method. Or where GDP is calculated as the value of everything produced in the country during the year, it is called the product method.

The expenditure side of GDP is summarised as:

GDP = AD = C + I + G + X - M

Private Final Consumption (C), refers to household expenditure on durable and non-durable goods and services. It also includes some imputed household
expenditures. For example, an imputed rent on owner occupied dwellings.

Gross Private Investment (I) includes all final purchases of new plant and equipment by business firms including all construction (private gross fixed capital
formation). Changes in inventories are included to adjust for the difference between ‘sales’ and ‘production’ over the year. All such investment activity is termed
‘Gross Investment’. This is subdivided into Replacement Investment (to maintain the economy’s capital stock) and Net Private Investment (to add to the
economy’s capital stock). Growth in the economy’s capital stock (positive net private investment) contributes to growth in GDP.

General government consumption expenditure (G) relates to spending on goods and services by all levels of government excluding transfer payments.

Net exports (X - M), allows for foreign purchases of our exports and domestic purchases of goods produced overseas minus our imports.

The Australian GDP for the period 2015-16 measured using the expenditure method is presented below.

Table 7.1. Australian GDP: expenditure-based measure, 2015-16.

$ Billion
Final consumption expenditure
Households 941
General government 304
Gross fixed capital formation
Private 342
Public 73
Changes in inventories 0
Gross national expenditure 1,661
Exports less imports 0
Statistical discrepancy -1
Gross domestic product 1,660

Source: Australian Bureau of Statistics (ABS) (2017a).

The income side of GDP consists of payments of wages, salaries and supplements to workers (compensation of employees and gross mixed income); gross
operating surpluses including rent, interest, profit and residual payments to wages of executives; and indirect taxes on products and imports less subsidies. The
Australian GDP for the period 2015-16 measured using the income method is presented below.

Table 7.2. Australian GDP: income-based measure, 2015-16.

$ Billion
Compensation of employees 807
Gross operating surplus and mixed income
 Non-financial corporations 275
Financial corporations 90
General government 37
Gross mixed income* 281
Total factor income 1,489
Taxes less subsidies on production and imports 170
Statistical discrepancy 0
Gross domestic product 1,660

*= Gross mixed income includes dwellings owned by persons.

Source: Australian Bureau of Statistics (ABS) (2017a).

 National Income Accounting (Con't)
Finally, the product method of measuring GDP uses value added which is the extra value that each firm in each sector of the economy adds to an item. Other items
included in the account to obtain GDP are: (1) Government services are included with the wages and salaries paid to workers for providing those services; (2)
Rental value (imputed) of properties used by people who use their own property rather than rent it; and (3) Indirect taxes and subsidies, paid or received for goods
and services. The Australian GDP for the period 2015-16 measured using the product method is presented below.

Table 7.3: Australian GDP: product-based measure, 2015-16.

$ Billion
Agriculture, forestry and fishing 36
Mining 114
Manufacturing 99
Electricity, gas, water and waste services 43
Construction 134
Wholesale trade 65
Retail trade 72
Accommodation and food services 39
Transport, postage and warehousing 78
Information media and telecommunications 47
Financial and insurance services 146
Rental, hiring and real estate services 50
Professional, scientific and technical services 103
Administrative and support services 45
Public administration and services 89
Education and training 78
Health care and social assistance 112
Arts and recreation services 14
Other services 30
Ownership of dwellings 148
Gross value added at basic prices 1,543
Taxes less subsidies on products 111
Statistical discrepancy 6
Gross domestic product 1,660

Source: Australian Bureau of Statistics (ABS) (2017a).

Several related national accounting concepts include:

Gross National Expenditure: sum of private final consumption, gross private investment and government spending (GNE = C + I + G);
National Turnover of Goods and Services: total annual flow of goods and services in the economy (NT = GDP + Imports or GNE + exports);
Gross Domestic Product at Factor Cost: return to the owners of factors of production (GDPfc = GDP – indirect taxes + subsidies);
Domestic Factor Incomes: that part of value added which accrues to the owners of factors of production after allowing for fixed capital consumption (DFI
= GDPfc – depreciation);
National Income: income received by the country’s residents allowing for domestically generated income paid to overseas residents and overseas
generated income paid to our residents (NI = GDP – (net income paid overseas + depreciation);
National Disposable Income: income in the hands of the country’s residents allowing for net overseas transfers (NDI = NI – net overseas transfers);
Household Income: total income received in a given period by normal residents;
Household Disposable Income: total income received by normal residents net of direct taxes, fees, fines, consumer debt interest and unrequited transfers
overseas;
Net Domestic Product: value of the economy’s output after allowing for consumption of fixed capital.
 Limitations on National Income Accounting
It should be stressed that GDP is by no means synonymous with a nation’s economic welfare. Four important reasons for this are as follows:

Only market activity is included in GDP

Work done in the home and by do-it-yourselfers certainly contributes to the nation’s wellbeing but it is not measured in the GDP because it has no price tag.

An important implication of this exclusion is seen when we try to compare the GDPs of developed and less developed countries. International GDP comparisons
are vastly misleading when the two countries differ greatly in the fraction of economic activity that each conducts in organised markets.

This fraction is relatively large in Australia and relatively small in the less developed countries so when we compare their respective measured GDPs we are not
comparing the same economic activities at all. Many things that get counted in the Australian GDP are not counted in the GDPs of less developed nations.

GDP places no value on leisure

As a country gets richer, one thing that happens is citizens consume more and more leisure time so there is an ever widening gap between official GDP and some
true measure of national wellbeing that would include leisure. For this reason, growth in GDP systematically understates the growth in national wellbeing. But there
are also reasons why the GDP overstates how well off we are. These are considered next.

‘Bads’ as well as ‘goods’ get counted in GDP

Suppose there is a natural disaster—such as the bushfires that razed much of Victoria in the summer of 2009. Surely the wellbeing of the nation was diminished
by this catastrophe. People were killed; many homes, businesses, and resorts were destroyed; soot covered cities and towns miles from the fire. Yet the disaster
may well have caused GDP to rise. Consumer spending to clean up and replace lost possessions added to Cd. Rebuilding and repairing the damaged homes,
stores, and businesses added to investment, I. Extra government spending for disaster relief and cleanup added to G. Yet no one would think that the nation was
better off for its higher GDP.

Ecological costs are not netted out of GDP

Many of the activities in a modern industrial economy that produce goods and services also have undesirable side effects on the environment. Automobiles
provide enjoyment and a means of transportation but they also despoil the atmosphere. Factories pollute rivers and lakes while manufacturing valuable
commodities. Almost everything seems to produce garbage which creates the problem of what to do with it. None of these ecological costs are deducted from
GDP in an effort to give us a truer measure of the net increase in economic welfare that our economy produces. Is this foolishness? Not if we remember the job
that national income statisticians are trying to do: they are measuring the economic activity conducted through organised markets, not national welfare.
 Aggregate Output and Expenditure
As discussed in the previous topic, according to the Keynesian model output in the economy is determined by the amount that people spend throughout the
economy. Accordingly, aggregate demand represents the aggregate expenditure on: i) consumption of domestically produced goods, ii) investment, iii)
government purchases, and iv) net exports.

AD = E = C + I + G + X - M = Cd + J

Figure 7.4 presents the aggregate output and aggregate expenditure line, which increases with income.

Figure 7.4. Expenditure-Income.

Source: Stiglitz et al. (2014).

In Figure 7.4, the 45° line defines the points where expenditure is equal to output (income), which are the points of possible equilibrium. The intersection of the
aggregate expenditure line with the 45° output (income) line defines the particular point of equilibrium for this level of spending (income or Real Output (GDP)
equal to Y0).

National income is equal to national output, which represents that when a good or service is purchased, the money paid for it eventually will become someone's
income as wages, interest payments or profits. Therefore:

GDP = National Income = Y

Firms produce only what they expect to sell, in consequence, the total output produced by firms will equal the total demand for output. Therefore, in the equilibrium
aggregate expenditure (E) must equal aggregate output (GDP), which is also equal to the national income:

E = GDP = Y
 Withdrawals and Injections Approach
The Keynesian analysis of output and employment is explained by changes in injections (J) and withdrawals (W). If J does not equal W, a disequilibrium exists, so
changes in GDP and employment are needed to restore the equilibrium. If there is an increase in injections, aggregate demand (Cd + J) increases and firms use
more labour and other resources and pay more income to households and hence GDP increases. Household consumption also increases so firms sell more and
the rise in incomes (or GDP) and employment has a non-unity, multiple effect, known as the multiplier effect. The equilibrium is restored when withdrawals
increase to equal injections. That is, families save more, pay more taxes or demand more imports.

This process can be summarised as:

J>W → GDP ↑ → W ↑ until J = W

In the same way, if injections fall, GDP and employment decrease again with a multiplier effect:

J<W → GDP ↓ → W ↓ until J = W

The withdrawals curve slopes upward, because W increases if GDP increases however injections such as investment, government expenditure and exports which
are only slightly affected by GDP are a horizontal straight line with increases represented by upward shifts in that line. Figure 7.5 illustrates this approach:

Figure 7.5. The withdrawals and injections approach.

Source: Sloman et al. (2014).

In Figure 7.5 withdrawals and injections are equal at point x. If injections exceed withdrawals then firms, who are faced with increased demand, produce more to
restore the equilibrium. Alternatively, if withdrawals exceed injections, firms face deficits in demand so produce less.
 Income and Expenditure Approach
Recalling Figure 7.4, national income can be represented by a 45º line from the origin because it must be spent on domestically produced goods (Cd) or withdrawn
(W) from the circular flow. Alternatively, aggregate demand (AD) is equal to aggregate expenditure (E) which represents total spending on domestic firms'
products and services which is consumption on domestic goods (Cd), plus the amount of injections in the economy (J). Figure 7.6 illustrates this approach in
terms of J and W.

Figure 7.6. The income and expenditure approach.

Source: Sloman et al. (2014).

In Figure 7.6 aggregate expenditure and GDP are equal at point z. If aggregate expenditure exceeds GDP there is excess demand in the economy, so firms produce
more to restore equilibrium. Because part of the extra income is withdrawn (saved, taxed or spent on imports), aggregate expenditure rises less quickly than
income so the slopes of the curves are different. Alternatively, if GDP exceeds aggregate expenditure, there is insufficient demand in the economy so firms
decrease production to restore equilibrium.
 The Multiplier and the Accelerator
According to the Keynesian analysis of output and employment, if injections (J) do not equal withdrawals (W), changes in GDP and employment will restore the
equilibrium. GDP will increase if injections rise or withdrawals fall, but GDP will increase by more than the rises in injections or falls in withdrawals, this is known
as the multiplier effect. This can be represented by the multiplier k, where:

Therefore, the multiplier k is defined as the number of times by which a rise in GDP exceeds the rise in injections that caused it.

The size of the multiplier depends on the size of the marginal propensity to withdraw (mpw), which is the proportion of an increase in GDP that is withdrawn from
the circular flow of income:

The less is withdrawn, the larger is the increase in GDP so the k multiplier varies inversely with mpw, where:

1
k= mpw

Another way to understand this is through the marginal propensity to consume domestically produced goods (mpcd), which represents the proportion of GDP spent
on domestically produced goods. Given people must either withdraw money or spend it on consumption it follows:

mpw + mpcd = 1

or mpw = 1 - mpcd

So, the multiplier (k) equals:

1
k=
(1-mpcd)

In the case of investment level, it tends to be more unstable than other components in the aggregate demand. In a boom the rise in investment could be several times the
increase in GDP, while in a recession investment almost disappear. This is due to the accelerator theory which states that the level of investment tends to fluctuate dramatically
because it depends on the rate of change of GDP.

The multiplier and accelerator interact and feed on each other, because an increase in GDP causes a rise in investment, which becomes an injection into the circular flow
causing a multiplied rise in GDP.
 Unemployment
Unemployment when the economy is at full employment is of two types: frictional and structural unemployment. Frictional unemployment occurs when people
leave their job to look for a better one. Structural unemployment comes from fundamental changes in the demand for labour and in the kinds of jobs available as
the economy evolves and changes. The existence of frictional and a certain amount of structural unemployment implies there is a natural rate of unemployment
towards which the economy automatically moves. The amount of unemployment at full employment will differ from country to country, depending on the structure
and efficiency of the labour market and the level of unemployment benefits and training opportunities, among others.

In addition to frictional and structural factors some unemployment in the economy is attributable to the business cycle, especially when a recession occurs. The
economic cost of business cycle unemployment is known as the GDP gap. It is the difference between potential GDP (at full employment) and actual GDP.
 Determinants of Business Cycles
Keynesians aim to answer the following two questions:

1) Why do booms and recessions persist for a period of time?

Time lags: After changes in injections and withdrawals, the complete variations in GDP, output and employment take time to be reflected.

'Bandwagon effects': Expectations about the economic conditions affect people's expenditure behaviour.

2) Why do booms and recessions come to an end?

Ceilings and floors: Actual output can grow more rapidly than the potential output until they are equal. Also, there is a minimum level of consumption that people tend
to maintain.

Echo effects: Durable consumer goods and capital equipment after some times require to be replaced.

The accelerator: For investment to continue rising, consumer demand must rise at a faster rate, otherwise investment will decrease and the boom will break.

Random shocks: Expectations of firms, governments and consumers can be affected by national or international political, social or natural events, which will affect
aggregate demand.

Changes in government policy: Governments will follow contractionary or expansionary policies according to the period in the business cycle. In a boom a government
will be concerned about inflation and balance of payments deficit, while in a recession it will try to address unemployment and lack of growth.