The Business Cycle Chapter 8 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. The Business Cycle • Basic purpose of macroeconomics is to explain how and why economies grow and what causes recurrent ups and downs – How stable is a market-driven economy? – What forces cause instability? – What, if anything, can the government do to promote steady economic growth? 8-2 Macroeconomics • Macroeconomics: The study of aggregate economic behavior, of the economy as a whole • Business cycle: Alternating periods of economic growth and contraction • Macro theories try to explain the business cycle, economic policies try to control it 8-3 Stable or Unstable? • Prior to the 1930s, macroeconomists thought there could never be a Great Depression • They believed a market-driven economy was inherently stable • Laissez faire: The doctrine of “leave it alone,” of nonintervention by government in the market mechanism 8-4 Classical Theory • According to the classical view, the economy “self-adjusts” to deviations from its long-term growth trend – a self-regulating economy • The cornerstones of classical optimism were flexible prices and flexible wages 8-5 Classical Theory • Say’s Law: Supply creates its own demand – Whatever was produced would be sold – All workers seeking employment would be hired • Unsold goods and unemployed labor could emerge, but both would disappear once people had time to adjust prices and wages 8-6 Macro Failure • The Great Depression was a stunning blow – Unemployment grew and persisted despite falling prices and wages – The classical self-adjustment mechanism simply didn’t work 8-7 Inflation and Unemployment: 1900-1940 24 20 Unemployment 16 12 8 4 0 Inflation –4 –8 1900 1910 1920 1930 1940 Source: U.S. Bureau of the Census, The Statistics of the United States, 1957 8-8 The Keynesian Revolution • John Maynard Keynes developed an alternate view of the macro economy, asserting that a market-driven economy is inherently unstable – Small disturbances in output, prices, or unemployment were likely to be magnified by the invisible hand of the marketplace 8-9 Government Intervention • In Keynes’ view, the inherent instability of the marketplace required government intervention – We can’t afford to wait for some assumed selfadjustment mechanism – Must intervene to protect jobs and income 8-10 Historical Cycles • Upswings and downturns of the business cycle are gauged in terms of changes in total output • Real GDP: The value of final output produced in a given period, adjusted for changing prices • Changes in employment typically mirror changes in production 8-11 The Business Cycle Peak Growth trend REAL GDP Peak Peak Trough Trough TIME 8-12 The Business Cycle • An economic upswing (expansion) is an increase in the volume of goods and services produced • An economic downturn (contraction) occurs when the volume of production declines • Successive short-run contractions and expansions are the essence of business cycles 8-13 The Business Cycle • Recession: A decline in total output (real GDP) for two or more consecutive quarters • Growth recession: A period during which real GDP grows, but at a rate below the long-term trend of 3 percent 8-14 The Business Cycle in U.S. History Source: U.S. Department of Commerce (2009) From 1929 to 2009, real GDP increased at an average rate of 3 percent a year. 8-15 Business Slumps Dates Duration (months) Percentage Decline in Real GDP Peak Unemployment Rate Aug. ‘29–Mar. ‘33 43 53.4% 24.9% May ‘37 –June ‘38 13 32.4 20.0 Feb. ‘45 –Oct. ‘45 8 38.3 4.3 Nov. ‘48–Oct. ‘49 11 9.9 7.9 July ‘53–May ‘54 10 10.0 6.1 Aug. ‘57–Apr. ‘58 8 14.3 7.5 Apr. ‘60–Feb. ‘61 10 7.2 7.1 Dec. ‘69–Nov. ‘70 11 8.1 6.1 Nov. ‘73–Mar. ‘75 16 14.7 9.0 Jan. ‘80–July ’80 6 8.7 7.6 July ‘81–Nov. ‘82 16 12.3 10.8 July ‘90–Feb. ‘91 8 2.2 6.5 Mar. ‘01–Nov. ‘01 8 0.6 5.6 Dec 07– ? ? ? 8-16 A Model of the Macro Economy • Both Keynes and the Classical economists agreed that business cycles occur, but disagreed on whether they’re an appropriate target for government intervention • Need to understand origins of the business cycle 8-17 Macroeconomic Performance • Macro outcomes include: – – – – – Output - Value of goods and services produced Jobs - Levels of employment and unemployment Prices - Average price of goods and services Growth - Year-to-year expansion in production International balances - International value of the dollar; trade and payments balances with other countries 8-18 Macroeconomic Performance • Determinants of macro performance include: – Internal market forces - Population growth, spending behavior, intervention & innovation, etc. – External shocks - Wars, natural disasters, terrorist attacks, trade disruptions, and so on – Policy levers - Tax policy, government spending, changes in the availability of money, and regulation, for example 8-19 The Macro Economy DETERMINANTS OUTCOMES Internal market forces Output Jobs External shocks MACRO ECONOMY Prices Growth Policy levers International balances 8-20 Aggregate Demand and Supply • Any influence on macro outcomes must be transmitted through supply or demand • Aggregate demand: The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus 8-21 Aggregate Demand • The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices • The downward slope suggests that with a given (constant) income, at lower price levels people will buy more goods and services 8-22 PRICE LEVEL Aggregate Demand Aggregate demand REAL OUTPUT 8-23 Aggregate Demand • Three reasons for the downward slope: – Real-balances effect - a change in the price level affects the purchasing power of money – Foreign-trade effect - balance of trade depends on domestic price level relative to foreign – Interest-rate effect - change in price level affects demand for loan-financed purchases 8-24 Aggregate Supply • Aggregate supply: The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus • Two reasons for upward sloping curve: – The profit effect – The cost effect 8-25 Aggregate Supply PRICE LEVEL Aggregate supply REAL OUTPUT 8-26 Macro Equilibrium • Aggregate supply and demand curves summarize the market activity of the whole (macro) economy • Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply 8-27 Macro Equilibrium PRICE LEVEL Aggregate supply P1 E Macro equilibrium PE Aggregate demand D1 QE S1 REAL OUTPUT 8-28 Macro Failures • Potential problems with macro equilibrium: – Undesirability - the equilibrium price or output level may not satisfy policy goals – Instability - even if the designated macro equilibrium is optimal, it may not last long 8-29 An Undesired Equilibrium PRICE LEVEL Aggregate demand PE Aggregate supply E F P* Equilibrium output QE Full-employment output QF 8-30 An Undesired Equilibrium PRICE LEVEL Aggregate demand PE Aggregate supply E Desired price level F P* Equilibrium output QE QF 8-31 Instability • Macroeconomic equilibrium changes whenever the aggregate supply and/or demand curves shift • Business cycles are likely to result from recurrent shifts of aggregate supply and demand curves 8-32 AS and AD Shifts • Shifts in aggregate supply can be caused by changes in costs of production due to import prices, natural disasters, changed tax policies, or other events • Shifts in aggregate demand can be caused by changes in export demand, expectations, taxes, or other events 8-33 Macro Disturbances (a) Supply shifts (b) Demand shifts AS1 AS0 AS0 P1 P* G F PRICE LEVEL PRICE LEVEL AD0 P* P2 F H AD0 AD1 Q1 QF REAL OUTPUT Q2 QF REAL OUTPUT 8-34 Competing Theories of Short-Run Instability • Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them • Demand-side theories, such as Keynesian and Monetary, emphasize aggregate-demand shifts • Supply-side theories center on shifts in supply 8-35 Demand-Side Theories (a) Inadequate demand (b) Excessive demand AS0 P* PRICE LEVEL PRICE LEVEL AS E0 E1 E2 P2 P* E0 AD2 AD0 AD0 AD1 Q1 QF REAL OUTPUT QF Q2 REAL OUTPUT 8-36 Keynesian Theory • Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment • Advocated increasing government spending – a rightward AD shift – to move the economy toward full employment 8-37 Monetary Theories • Monetary Theories emphasize the role of money in financing aggregate demand • Money and credit affect ability and willingness to buy goods and services • If credit isn’t available or is too expensive consumers reduce spending and businesses curtail investment 8-38 Supply-Side Theories • Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well • Increases in aggregate supply move us closer to goals of price stability and full employment 8-39 Supply-Side Theories AS1 PRICE LEVEL AS0 E3 P3 E0 P0 AD0 Q3 QF REAL OUTPUT 8-40 Long-Run Self Adjustment • Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations • They assert a long-run aggregate supply curve anchored at the natural rate of output (QN) – Flexible prices (and wages) enable the economy to maintain the natural rate of output QN 8-41 The “Natural” Rate of Output PRICE LEVEL AS P2 P1 AD2 AD1 QN REAL OUTPUT Fluctuations in aggregate demand affect the price level but not real output. 8-42 Short vs. Long-run Perspectives • The long-run aggregate supply curve is likely to be vertical at QN • The short-run aggregate supply curve is likely to be upward-sloping • Both aggregate supply and aggregate demand influence short-run macro outcomes 8-43 Policy Strategies • Shift the aggregate demand curve: Use policy tools that affect total spending • Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output • Laissez-faire: Don’t interfere with the market; let markets self adjust 8-44 Selecting Policy Tools • There are a host of tools available: – – – – – Classical laissez faire Fiscal policy Monetary policy Supply-side policy Trade policy 8-45 Policy Tools • The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment • Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes 8-46 Policy Tools • Monetary policy: The use of money and credit controls to influence macroeconomic outcomes • Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services 8-47 Policy Tools • Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve 8-48 The Business Cycle End of Chapter 8 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.