Model Answer
0 min readIntroduction
The business cycle, characterized by alternating periods of economic expansion and contraction, is a fundamental feature of market economies. These fluctuations in national income and employment are significantly influenced by changes in aggregate demand. A key driver of aggregate demand is autonomous expenditure – spending that is independent of income levels. Understanding the relationship between these two is crucial for effective macroeconomic policy formulation. This answer will examine how shifts in autonomous expenditure initiate and amplify the business cycle through the multiplier effect.
Understanding Key Concepts
Business Cycle: The business cycle refers to the fluctuations in economic activity that an economy experiences over a period of time. These fluctuations typically involve stages of expansion, peak, recession, and trough. These cycles are not regular in length or intensity.
Autonomous Expenditure: Autonomous expenditure represents the components of aggregate demand that are not directly influenced by the current level of national income. These include investment (I), government spending (G), and net exports (X-M). Changes in these components initiate shifts in the aggregate demand curve.
The Relationship: Autonomous Expenditure and the Business Cycle
Changes in autonomous expenditure are a primary driver of fluctuations in the business cycle. An increase in autonomous expenditure, such as increased government spending or business investment, leads to an initial increase in aggregate demand. However, the impact on national income is magnified through the multiplier effect.
The multiplier effect states that an initial change in autonomous expenditure leads to a larger change in national income. This is because the initial spending creates income for others, who then spend a portion of that income, creating further income, and so on. The size of the multiplier (k) is determined by the marginal propensity to consume (MPC). The formula is: k = 1 / (1 - MPC).
Illustrative Example
Suppose the MPC is 0.8. This means that for every additional rupee of income, individuals spend 80 paise and save 20 paise. If the government increases spending by ₹100 crore (autonomous expenditure), the initial increase in aggregate demand is ₹100 crore. This leads to an increase in income of ₹100 crore. Those who receive this income spend 80% (₹80 crore), which becomes income for others. This process continues, with each round of spending being 80% of the previous round. The total increase in national income will be:
₹100 + ₹80 + ₹64 + ... = ₹100 / (1 - 0.8) = ₹500 crore
Therefore, a ₹100 crore increase in government spending leads to a ₹500 crore increase in national income.
Stages of the Business Cycle and Autonomous Expenditure
- Expansion: During an expansion, autonomous expenditure typically increases due to rising business confidence, increased investment, and potentially expansionary fiscal policy.
- Peak: As the economy reaches its peak, autonomous expenditure may begin to level off or even decline, signaling a potential slowdown.
- Recession: A decline in autonomous expenditure, often triggered by a fall in investment or consumer confidence, can initiate a recession.
- Trough: During a trough, government intervention through increased autonomous expenditure (fiscal stimulus) can help to jumpstart the economy and initiate a recovery.
Limitations and Considerations
While autonomous expenditure is a significant driver, other factors also influence the business cycle, including monetary policy, supply shocks, and global economic conditions. The effectiveness of fiscal policy (changes in autonomous expenditure) can be limited by factors such as crowding out and time lags.
Conclusion
In conclusion, changes in autonomous expenditure play a crucial role in initiating and amplifying the business cycle. The multiplier effect demonstrates how an initial change in autonomous spending can have a magnified impact on national income. Understanding this relationship is vital for policymakers seeking to stabilize the economy and mitigate the effects of economic fluctuations. However, it’s important to acknowledge that autonomous expenditure is not the sole determinant of the business cycle and that other factors also contribute to its dynamics.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.