Economic Environment

and Policy (EEP)

Session-6

Investment Multiplier
And Business Cycles

Dr. Tarun Das, Professor, IILM

Prof. Tarun Das, IILM EEP Session-6 1

Contents of this presentation
1. Investment function, investment
multiplier and accelerator
2. Numerical examples
3. Types of business cycles
4. Causes of business cycles
5. Macro variables and business
cycles

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 1.1 Investment Function and
Accelerator
Investment is the rate of change of
capital accumulation over time.
It = ∆ Kt = Kt – kt-1
Capital/output ratio (COR) = Kt / Yt
Incremental capital/output ratio (ICOR)
= ∆Kt / ∆Yt
Kt = w. Yt, where w = COR = ICOR
It = Kt – kt-1 = w (Yt – Yt-1) = w ∆Yt
The basic relationship between change of
output and volume of investment is known as
accelerator principle. The capital/output
ratio w is known as the accelerator.

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 1.2 Investment Multiplier
Investment multiplier is the ratio of
incremental income to incremental
investment.
Investment multiplier = ∆Yt / ∆It
Yt = Ct + It = α + β Yt +It
Or, Yt - β Yt = α + It
Or. (1- β ) Yt= α + It
Or, Yt = α / (1-β ) + 1/ (1-β ) It
Investment multiplier = ∆Yt / ∆It = 1/ (1-β )
= 1/ (1-MPC) = 1/ MPS.
Investment multiplier varies directly with
MPC and inversely with MPS.

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 2.1 Numerical Example: Multiplier
Problem-1: Given consumption function
C=50+0.75 Y or savings function S=-50+0.25 Y,
Estimate investment multiplier. If investment
rises by Rs.100 Crore, what is the increase of
income? How is additional income distributed
between savings and consumption?
Answer: Here, MPC=0.75, MPS=0.25
Investment multiplier = 1/ (1-MPC) = 1/ MPS
= 1/ 0.25 = 4.
If investment rises by Rs.100 Crore, income rises
by Rs.400 Crore. Then, consumption rises by
MPC*Y = 0.75*400 = Rs.300 Crore and savings
rises by Rs.100 Crore.

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 2.2 Numerical Example: ICOR
Problem-2: Given average real GDP growth
rate of 9% and average investment ratio of
36%, estimate ICOR. Assuming that ICOR
declines by 5% due to increase of
productivity, how much investment is
required if we plan for a growth of 10% per
annum?
Answer: ICOR = 36/9 =4.
If ICOR declines by 5%,
new ICOR=95% of 4 = 3.8
So required investment for a growth rate of
10% = 3.8 * 10 = 38%.

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 2.3 Equilibrium Income with
government
Problem-3: Let consumption depends on
disposable income and consumption
function is given by: C=50+0.75 (Y-T).
Further assume that average tax rate is
20% and govt maintains a balanced
budget. If domestic private investment
equals Rs.100 Crore, find out
equilibrium level of income,
consumption, savings and taxes.

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 2.4 Equilibrium Income with
government
Answer:T = 0.2 * Y= govt expenditure (G) as
govt maintains a balanced budget.
C=50+0.75(Y-T)=50+0.75(Y-0.2Y)
=50+0.6Y
Y=C+S+T=50+0.6Y+100+ 0.2Y
as S=I=100.
Or, Y= 150+0.8Y
Or, Y-0.8Y = 150. OR, Y=150/0.2=750.
T=0.2*750=150 =G
C=50+0.75 (750-150) = 500
S=Y-C-T=750-500-150=100
Check: Y=C+S+T=500+100+150=750
Y=C+I+G=500+100+150=750.

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 3.1 What is the Business Cycle?
• Business cycles are periodic but
irregular up-and-down
movements in economic activity:
such as real GDP, employment,
profits etc.
• Its timing is random, and to a
large degree, unpredictable.
• A business cycle is identified as a
sequence of four phases:
1.Recession,
2.Trough,
3.Boom,
4.Peak
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 3.2 Phases of Business Cycle
1.Contraction, Recession, Slum,
Depression (A slowdown in the pace
of economic activity); A recession
occurs if a contraction is severe
enough. A deep trough is called a
slump or a depression.
2.Trough (The lower turning point of a
business cycle, where a contraction
turns into an expansion);
3.Expansion, Prosperity, Boom (A
speedup in the pace of economic
activity);
4.Peak (The upper turning of a business
cycle, where an expansion turns into a
contraction).

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 3.3 Different phases of business
cycles
variable
Peak

Contraction
Expansion

Trough

Time
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 3.4 Business Cycles are Irregular

• In many ways, the term “business cycle”

is misleading.
• “Cycle” seems to imply that there is
some regularity in the timing and
duration of upswings and downswings in
economic activity.
• Most economists, however, do not think
so.
• For describing the swings in economic
activity, therefore, many modern
economists prefer the term “short-run
economic or business fluctuations” to
“business cycle.”
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 3.5 Types of Business Cycles
• Main types of business cycles have
been named after their exponents.
• The Kitchin inventory cycle (3–5 years)
— after Joseph Kitchin,
• The Juglar fixed investment cycle (7–11
years) — after Clement Juglar,
comprising four stages:
1. expansion = rise in production and
prices, and low interests rates.
2. crisis = stock exchanges crash and
several companies become bankrupt.
3. recession = decrease in price and in
output, high interests rates.
4. recovery= stocks recover thanks to the
fall in prices and incomes.
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 3.6 Types of Business Cycles
• The Kuznets infrastructural investment
cycle (15–25 years) — after Simon
Kuznets, Nobel Laureate,
• The Kondratieff industrial wave or
innovation cycle (45–60 years) — after
Nikolai Kondratieff.
• The Forrester generation cycles (200
years) - after Jay Wright Forrester.
• The Toffler civilization cycles (1000-
2000 years) - after Alvin Toffler.

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 4.1 Business Cycle (BC)
variables
• Business cycles are generally measured
by movements or growth rates of real
GDP, capital and investment.
• The four primary economic fluctuations
are secular trend (T), business cycle (C),
seasonal (S), and random (R).
• Multiplicative Model: V=T*C*S*R
• Additive Model: V=T+C+S+R

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 4.2 Measurement of Business
Cycles-
Trend in Real GDP in USA in 1955-
2005

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 4.3 Log Real GNP and Trend

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 4.4 Deviations from Trends in Log
GNP

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4.5 Figure depicts fluctuations in GNP and
consumption. Observe how peaks and
troughs align and how upturns and
downturns coincide.

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 5.1 Causes of Business Cycles
• Just as there is no regularity in the timing
of business cycles, there is no reason why
cycles should occur at all.
• Business cycles occur due to some
disturbances, which pull the economy
above full employment or push it below.
• Inflationary booms are generated by surges
in private or public spending.
• Similarly, a wave of optimism or feel good
factors cause consumers to spend more
than usual and firms to build up new
capacities than necessary.

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 5.2 Causes of Business Cycles
• Recessions or depressions can be caused
by the same forces working in reverse
directions.
• A substantial cut in government spending
or a wave of pessimism among
consumers and firms may cause the
output of all types of goods and services
to fall.
• Another possible cause of recessions and
booms is monetary policy.
• A firm faced with high interest rates may
decide to postpone building a new
factory.
• Households may be lured by cheap
housing loans, and construction activities
may boom.
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 5.3 Political Theory of Business
Cycles
• The partisan theory of business cycle
suggests that cycles result from the
successive elections of administrations
with different policy regimes.
• Regime A adopts expansionary policies,
resulting in growth and inflation, but is
voted out of office when inflation
becomes unacceptably high and hurts
everybody.
• The replacement, Regime B, adopts
contractionary policies reducing inflation
and growth, and the downwards swing of
the cycle. It is voted out of office when
unemployment is too high, being replaced
by Party A.

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 6.1 Co-movement of variables
• Many economic indicators move together
during business cycles. During an
expansion, not only output rises, but also
employment and profits rise.
• Construction, retail and financial services
also rise, and inflation may rise if the
expansion is too brisk.
• Conversely, during recession, outputs of
goods and services falls, employment falls,
construction falls, and prices of consumer
goods and wages also fall.
• Recession is a period when a broad range of
economic indicators falls for a sustained
period, roughly at least half a year.

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 6.2 Cyclical behavior of macro economic
variables and BC indicators
According to Direction of change: variables
can be classified as procyclical,
countercyclical or acyclical.
• Procyclical- Variables have positive
correlation. They usually increase during
booms and decrease during recessions.
Consumption, investment and employment
are strongly procyclical.
• Countercyclical- Variables have negative
correlation. Unemployment is countercyclical.
• Acyclical- Variables have zero correlation,
implying no systematic relationship to the
business cycle . capital stock is acyclical.

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 6.3 Cyclical behavior of macro economic
variables and BC indicators
According to Timing of Occurrence:
variables can be classified as leading,
coincident or lagging variable.
Leading Indicator: which occurs ahead of the
occurrence of business circle variable.
Coincident Indicator: which move up and down
along with the business cycle variable.
Lagging Indicator: which follow the business
cycle variable after some time lag.

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 6.4 Leading Indicators
• New employment
• New orders for consumer durable goods
• Stock Index
• New orders for plant and equipment
• Building permits for private houses
• Deliveries by Companies
• Index of consumer confidence
• Index of business confidence
• Inflation
• Money growth rate (M2)

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 6.5 Coincident Indicators

• Nonagricultural employment
• Index of industrial production
• Personal income
• Manufacturing and trade sales

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 6.6 Lagging Indicators

• Wage rates
• Rate of inflation
• Consumer credits
• Lending rates
• Outstanding loans

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 6.7 Cross Classification of Indicators
Items Direction of Time of
change occurrenc
e
Industrial output procyclical coincident

Capacity procyclical coincident

utilization
Employment procyclical coincident

Unemployment countercyclica coincident

l
Inflation rate procyclical lagging
Corporate
Prof. Tarun Das, IILM profits procyclical
EEP Session-6 coincident29
 Thank you
Have a Good Day

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