The Business Cycle

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The Business Cycle
Chapter 8
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Part 3: Cyclical Instability
Chpt. 8: The Business Cycle.
Chpt. 9: Aggregate Demand.
Part 4: Fiscal Policy.
Part 5: Monetary Policy.
Part 6: Supply Side.
Part 7: Global Macro.
2
Chpt. 8: The Business Cycle
1. Stable or Unstable?
2. Historical Cycles.
3. A Model of the Macro Economy.
4. Aggregate Demand and Supply.
5. Competing theories of short run
instability.
6. Taming the Cycle (Preview).
7. Long-Run Self-Adjustment.
3
1. Stable or Unstable?
5
Macroeconomics
The Business Cycle:
alternating periods of economic growth
and contraction.
6
The Business Cycle
REAL GDP (units per time period)
(Figure 8.2, pg. 148)
Peak
Growth trend
Peak
Peak
Trough
Trough
TIME
7
Macroeconomics
The Business Cycle:
alternating periods of economic growth
and contraction.
Macroeconomic theories try to explain
the business cycle,
Macroeconomic policies try to control it.
8
9
Recession 
GDP
10
Stable or Unstable?
Pre-1930s:
macro economists thought there could never
be a “Great Depression:”
“market-driven economies
are inherently stable,”
“government
intervention is
unnecessary.”
11
Classical Theory
Classical Theory = Laissez faire.
nonintervention by government in the
market mechanism.
12
A Self-Regulating Economy
Classical theory:
the economy “self-adjusts” to deviations
from its long-term growth trend.
Because of…
flexible prices, and …
flexible wages.
13
A Self-Regulating Economy
Unsold goods and unemployed labor
would disappear as soon as people
had time to adjust prices and
wages.
14
A Self-Regulating Economy
The Classical view of the macro
economy was summarized in Say’s
Law.
According to Say’s Law, supply
creates its own demand:
15
And then…
16
The Great Depression
17
The Great Depression
18
The Great Depression
19
The Great Depression
20
The Great Depression
21
Macro Failure
The Great Depression was a stunning
blow to classical economists.
Unemployment grew and persisted
despite falling prices and wages.
22
Inflation and Unemployment:
1900-1940
(Figure 8.1, pg. 147)
24
20
Unemployment
16
12
8
4
0
–4
Inflation
–8
1900
1910
1920
1930
1940
23
The Keynesian Revolution
British economist, John Maynard
Keynes developed an alternate view
of the macro economy.
24
Inherent Instability
“Market-driven economies are inherently
unstable.”
Disturbances in output,
prices, or unemployment are
likely to be magnified by
the invisible hand of the
marketplace.
25
1. Stable or Unstable?
26
Government Intervention
In Keynes’ view, the inherent
instability of the marketplace
required government intervention.
27
2. Historical Cycles
28
Historical Cycles
Swings in the business cycle are
gauged in terms of changes in total
output (real GDP).
The historical growth path of the
U.S. economy:
not a smooth rising trend,
very erratic.
29
REAL GDP (units per time period)
The Business Cycle
Peak
Growth trend
Peak
Peak
Trough
Trough
TIME
30
The Business Cycle in U.S. History
(Figure 8.3, pg. 148)
31
The Great Depression
The Great Depression was the
most prolonged departure from the
long-term growth-path.
Between 1929 and 1933, real GDP
contracted a total of nearly 30%.
In 1939, GDP per capita was lower
than it had been in 1929.
32
The Great Depression
Times are
hard, son…
33
World War II
World War II ended the Great
Depression by greatly increasing
the demand for goods and services.
Real GDP grew an unprecedented
19% in 1942.
34
The Postwar Years
There have been 11 recessions
since 1944.
Recession:
a decline in real GDP,
for at least two or more consecutive
quarters.
35
Recent History
The economy experienced a growth
recession during the 1980s.
Growth recession:
a period during which real GDP grows,
but …
at a rate below the long-term trend of
3 percent.
36
The Business Cycle in U.S. History
(Figure 8.3, pg. 148)
37
The 1980s
Growth recession:
the economy expands too slowly.
Recession:
real GDP actually contracts.
38
The 1980s
In November 1982,
the U.S. economy
began an expansion
that lasted over 7
years.
39
The 1990s and 2000
The 1990s started with a recession
in July 1990 that officially ended in
February 1991.
From 1992 through the fall of 2000,
total output kept increasing and
unemployment fell to a low of 3.9
percent.
40
The 1990s and 2000
The economy experienced a
brief recession in 2001
which was extended by the
9/11 terrorist attacks.
Growth resumed in 2002
and accelerated through
2005.
The latest recession started
in the 4th quarter of 2007
and lasted until June 2009.
41
3. A Model of the
Macro Economy
42
A Model of the Macro Economy
(Figure 8.4, pg. 151)
DETERMINANTS
Internal
market
forces
External
shocks
OUTCOMES
Output
Jobs
MACRO
ECONOMY
Prices
Growth
Policy
levers
LO1
International
balances
46
A Model of the Macro Economy
The MACRO ECONOMY:
DETERMINANTS
Internal
market
forces
MACRO
ECONOMY
LO1
47
A Model of the Macro Economy
The MACRO ECONOMY:
DETERMINANTS
OUTCOMES
The Market:
External
shocks
Internal Market Forces
Output
Jobs
Prices
Policy
levers
Growth
Supply & Demand
Gov’t Intervention
LO1
International
balances
48
A Model of the Macro Economy
The crucial macro controversy:
are pure, market-driven economies
inherently stable or unstable?
Keynes and Classical economists:
agreed that business cycles occur.
disagreed on whether they’re an
appropriate target for government
intervention.
LO1
49
4. Aggregate Demand
and Supply
Aggregate Demand.
Aggregate Supply.
Macro Equilibrium.
Macro Failures.
50
A Model of the Macro Economy
The MACRO ECONOMY:
DETERMINANTS
OUTCOMES
The Market:
External
shocks
Internal Market Forces
Output
Jobs
Prices
Policy
levers
Growth
AS & AD
Gov’t Intervention
LO1
International
balances
51
Aggregate Demand and Supply
Any influence on macro outcomes…
(output,
jobs,
prices,
growth,
international balances)…
…must be transmitted through supply or
demand.
LO2
52
AS & AD Drive the Business
Cycle
PRICE LEVEL (average price)
(Figure 8.7, pg. 156)
Aggregate
supply
E
PE
Aggregate
demand
QE
REAL OUTPUT (quantity per year)
LO3
53
Aggregate Demand
Aggregate demand:
the total quantity of output…
demanded at alternative price levels …
in a given time period …
ceteris paribus.
It is used to refer to the collective
behavior of all buyers in the
marketplace.
LO2
54
Aggregate Demand
PRICE LEVEL (average price)
(Figure 8.5, pg. 153)
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
55
Aggregate Demand
Three separate reasons explain the
downward slope of the aggregate
demand curve:
The real-balances effect.
The foreign-trade effect.
The interest-rate effect.
LO2
58
Real-Balances Effect
The real value of money is
measured by how many goods and
services your money will buy.
Your cash balances are worth more
when the price level falls so that
you can buy more with them.
LO2
59
Aggregate Demand
PRICE LEVEL (average price)
(Figure 8.5, pg. 153)
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
60
Foreign-Trade Effect
Consumers can buy either foreign
or domestically produced goods.
When the U.S. price level falls:
Americans buy fewer foreign
produced goods, and…
they & foreigners buy more U.S
produced goods.
LO2
61
Aggregate Demand
PRICE LEVEL (average price)
(Figure 8.5, pg. 153)
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
62
Interest-Rate Effect
With lower prices:
consumers need to borrow less, so…
the demand for loans diminishes, so…
interest rates drop.
Lower interest rates encourages
loan-financed purchases.
LO2
63
Aggregate Demand
PRICE LEVEL (average price)
(Figure 8.5, pg. 153)
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
64
Aggregate Supply
Aggregate supply:
the total quantity of output producers
are willing and able to supply …
at alternative price levels …
in a given time period, …
ceteris paribus.
LO2
66
Aggregate Supply
(Figure 8.6, pg. 155)
PRICE LEVEL (average price)
Aggregate supply
REAL OUTPUT (quantity per year)
LO2
67
Aggregate Supply
Two reasons explain the upward
slope of the aggregate supply curve:
The profit effect.
The cost effect.
LO2
68
Profit Effect
Changing price levels will affect the
profitability of supplying goods.
We expect the rate of output to
increase when the price level rises.
LO2
69
Aggregate Supply
(Figure 8.6, pg. 155)
PRICE LEVEL (average price)
Aggregate supply
REAL OUTPUT (quantity per year)
LO2
70
Cost Effect
Costs go up as output expands.
Producers are willing to supply
additional output only if prices rise at
least as far as costs.
Cost pressures are minimal at low
rates of output, but …
intensify as the economy approaches
capacity.
LO2
71
Aggregate Supply
(Figure 8.6, pg. 155)
PRICE LEVEL (average price)
Aggregate supply
REAL OUTPUT (quantity per year)
LO2
72
AD & AS Review
1. The macro economy:
1. Determinants?
2. Outcomes?
2. AD & AS: what 2 variables are on the axes?
3. Explaining AD:
1. The real balances effect?
2. The foreign trade effect?
3. The interest rate effect?
4. Explaining AS:
1. Profit effect?
2. Cost effect?
73
Macro Equilibrium
Macro equilibrium is unique:
the only combination of price and
output …
compatible with both:
aggregate demand
and …
aggregate supply.
LO3
74
Macro Equilibrium
PRICE LEVEL (average price)
(Figure 8.7, pg. 156)
Aggregate
supply
P1
E
PE
Aggregate
demand
D1
QE
S1
REAL OUTPUT (quantity per year)
LO3
75
Macro Failures
Two potential problems with macro
equilibrium:
Undesirability –
the equilibrium price or output level may not
satisfy our macroeconomic goals.
Instability –
even if the designated macro equilibrium is
optimal, it may not last long.
LO3
77
An Undesired Equilibrium
PRICE LEVEL (average price)
(Figure 8.8, pg. 157)
Aggregate
demand
PE
Aggregate
supply
E
Desired
price level
F
P*
Equilibrium
output
Full-employment output
QE
LO3
QF
78
Undesirability
Full-employment GDP:
the total market value of final goods and
services that could be produced in a given
time period at full employment.
It represents potential GDP.
If macro equilibrium is below fullemployment GDP …
… we have failed to achieve the full
employment goal.
LO3
79
Undesirability
Similar problems may arise when the
equilibrium price level is inflationary.
(Figure 8.10, pg. 160)
LO3
80
Instability
Macroeconomic equilibrium changes
whenever the AD and/or AS curves
shift.
Business cycles:
result from recurrent shifts of aggregate
supply and demand curves.
LO3
82
Macro Disturbances
(a) Supply shifts
AS1
AS0
AD0
P1
P*
G
F
Q 1 QF
REAL OUTPUT (quantity per year)
LO3
(b) Demand shifts
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(Figure 8.11, pg. 161)
AS0
P*
P2
F
H
AD0
AD1
Q2 Q F
REAL OUTPUT (quantity per year)
83
The Business Cycle
REAL GDP (units per time period)
(Figure 8.2, pg. 148)
Peak
Growth trend
Peak
Peak
Trough
Trough
TIME
84
AD Shifts
A decrease in AD:
reduces real output and …
reduces the price level.
This can be caused by:
changes in expectations,
higher taxes,
decreased export demand,
other events.
LO3
85
Macro Disturbances
(a) Supply shifts
AS1
AS0
AD0
P1
P*
G
F
Q 1 QF
REAL OUTPUT (quantity per year)
LO3
(b) Demand shifts
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(Figure 8.11, pg. 161)
AS0
P*
P2
F
H
AD0
AD1
Q2 Q F
REAL OUTPUT (quantity per year)
86
AS Shifts
A decrease in AS:
reduces real output, and …
raises the price level (inflation).
This can be caused by:
higher production costs,
natural disasters,
changes in tax policies,
higher import prices,
expectations,
other events.
LO3
87
Macro Disturbances
(a) Supply shifts
AS1
AS0
AD0
P1
P*
G
F
Q 1 QF
REAL OUTPUT (quantity per year)
LO3
(b) Demand shifts
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(Figure 8.11, pg. 161)
AS0
P*
P2
F
H
AD0
AD1
Q2 Q F
REAL OUTPUT (quantity per year)
88
5. Competing Theories
of
Short-Run Instability
(& Corresponding Remedies)
Demand-Side Theories.
Keynesian (& fiscal policy).
Monetarist (& monetary policy).
Supply-Side Theories
90
Demand-Side Theories
Demand-side theories:
Keynesian:
Remedy = Fiscal Policy,
Monetary:
Remedy = Monetary Policy.
Both theories emphasize the potential of
aggregate-demand shifts to alter macro
outcomes.
LO3
92
Keynesian Theory (Demand Side)
Keynes’ view:
a deficiency of spending would tend to
depress an economy:
inadequate AD…
…persistently high unemployment
Fiscal Policy:
The Gov't can correct this by shifting AD through
taxing and spending policies.
Consumer taxes ↓ or Gov’t Spending ↑ = AD ↑ (right shift).
LO3
94
Demand-Side Theories
(Figure 8.10, pg. 160)
AS
P*
E0
E1
AD0
AD1
Q
QF
1
REAL OUTPUT
(quantity per year)
LO3
(b) Excessive demand
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(a) Inadequate demand
AS0
P2
P*
E2
E0
AD2
AD0
QF Q2
REAL OUTPUT (quantity per year)
95
Monetary Theories (Demand Side)
Money and credit:
affect the ability and willingness of people to buy
goods and services (demand).
If credit (the ability to get money) isn’t
available/too expensive:
consumers cut back on credit purchases and
businesses cut back on investment (demand ↓).
Monetary theory:
shifting AD by adjusting the money supply
through credit controls.
LO3
Interest rates ↓, $ supply ↑ = AD increase.
96
Demand-Side Theories
(Figure 8.10, pg. 160)
AS
P*
E0
E1
AD0
AD1
Q
QF
1
REAL OUTPUT
(quantity per year)
LO3
(b) Excessive demand
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(a) Inadequate demand
AS0
P2
P*
E2
E0
AD2
AD0
QF Q2
REAL OUTPUT (quantity per year)
97
A Model of the Macro Economy
The MACRO
ECONOMY
DETERMINANTS
OUTCOMES
Output
External
shocks
The Market:
Internal Market
Forces
Jobs
Prices
Policy
levers
Growth
International
balances
LO1
98
Supply-Side Theory
Decreases in AS cause inflation and
higher unemployment.
Expectations ↓ or costs ↑ = AS↓ (left shift).
Supply Side policy:
Gov’t policies shift the aggregate supply curve
by changing the costs of doing business :
Lower business costs = ↑ AS (rightward shift).
(“Trickle-down” theory.)
LO3
99
Supply-Side Theories
PRICE LEVEL (average price)
(Figure 8.11, pg. 161)
AS1
AS0
E3
P3
E0
P0
AD0
Q3
QF
REAL OUTPUT (quantity per year)
LO3
100
Supply-Side Theory
The MACRO
ECONOMY
DETERMINANTS
OUTCOMES
Output
External
shocks
The Market:
Internal Market
Forces
Jobs
Prices
Policy
levers
Growth
International
balances
LO1
101
Eclectic Explanations
Eclectic explanations of macro
failure draw from both the demandside and the supply-side of the
economy.
LO3
102
6. Taming the Cycle
(Summary & preview of things to come…)
103
Taming the Cycle
The real challenge for macro theory
is to determine which curves or
shifts best represents the reality
of macro failure.
104
SUMMARY - Specific Policy Options
There are a host of specific policy
tools for any given AS/AD strategy:
Classical laissez faire:
Take no action – economy will self adjust.
Fiscal policy (AD) (Keynesian approach):
Gov’t taxing & spending adjustments.
Monetary policy (AD).
Money supply/credit adjustments:
Supply-side policy (AS).
Taxing, regulatory adjustments:
LO3
105
Trade Policy
(Also:
International trade and money flows
can be changed to shift the aggregate
demand and/or the aggregate supply
curve.)
LO3
110
7.Long-Run SelfAdjustment.
111
Long-Run Self Adjustment
Some economists argue that short-run
fluctuations in real output or prices are
meaningless in the long-run.
They assert that there is a vertical longrun aggregate supply curve that is
anchored at the natural rate of output
(QN) by fundamental determinants.
LO3
112
The “Natural” Rate of Output
PRICE LEVEL (average price)
(Figure 8.12, pg. 162)
AS
P1
AD1
QN
REAL OUTPUT(quantity per year)
LO3
113
Long-Run Self Adjustment
Why vertical…?
In the short-run:
Higher prices yield higher profits and
prompt producers to produce more.
…But…
In the long run:
Rising costs catch up to prices and
eliminate the incentive to produce more.
Output reverts to its natural rate.
114
Classical/Monetarist View
A vertical long-run AS curve means:
aggregate-demand shifts:
affect prices in the long-run,
…but …
do not affect output in the long-run.
LO3
115
PRICE LEVEL (average price)
The “Natural” Rate of Output
AS
P2
P1
AD2
AD1
QN
REAL OUTPUT(quantity per year)
LO3
116
PRICE LEVEL (average price)
The “Natural” Rate of Output
AS
P1
P2
AD1
AD2
QN
REAL OUTPUT(quantity per year)
LO3
117
Short vs. Long-run Perspectives
Short-run AS:
likely to be upward-sloping.
Long-run AS:
likely to be vertical.
LO3
118
Long-Run Self Adjustment
A vertical long-run AS curve implies:
that the economy will adjust itself back
to full employment output in the long run.
People & firms will adjust wages and prices
downward in response to a drop in demand.
Question?
How long will the long run be?
…and…
Should we wait for the natural
adjustment, or take action?
119
The Business Cycle
End of Chapter 8
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
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