ECN 111 Chapter 14 Lecture Notes
14.1 Business-Cycle Definitions and Facts
A. Dating Business-Cycle Turning Points
1. A standard definition of a recession is a decrease in real GDP that lasts for at least
two quarters (six months).
2. The NBER (National Bureau of Economic Research) uses a broader definition of
recession to date business-cycle turning points. It defines a recession as “a period of
significant decline in total output, income, employment, and trade, usually lasting from
six months to a year, and marked by widespread contractions in many sectors of the
economy.”
B. U.S. Business-Cycle History
The NBER has identified 32 complete cycles starting from a trough in December 1854.
1. Since 1854, the average length of an expansion is 35 months and the average length
of a recession is 18 months.
2. During the years since World War II, the average recession shortened to 11 months
and the average expansion lengthened to 59 months.
C. Recent Cycles
After a recession that ran from July 1990 to March 1991, the U.S. economy entered a
record-breaking expansion that lasted 120 months until March 2001.
14.2 Aggregate Supply
A. Aggregate Supply Basics
The quantity of real GDP supplied (Y), depends on: the quantity of labor employed, the
quantities of capital and human capital and the technologies they embody, the quantities
of land and natural resources used, and the amount of entrepreneurial talent available.
B. Aggregate Supply and Potential GDP
Along the aggregate supply curve, a change in the price level changes the quantity of
real GDP supplied and results in a movement along the aggregate supply curve. Along
the potential GDP line, when the price level changes, the money wage rate and the
money prices of other resources change to keep the real wage rate (and other real
prices) at the full-employment equilibrium level.
1. Why the AS Curve Slopes Upward
When the price level changes, three reactions create the positive relationship between
the price level and quantity of real GDP supplied:
a. Business Failure and Startup
Real GDP changes when the number of firms in business changes. If the price level
rises relative to costs, profits increase, the number of firms in business increases,
and the quantity of real GDP supplied increases.
b. Temporary Shutdowns and Restarts
The price level relative to costs is an influence on temporary shutdown decisions. If
the price level rises relative to costs, fewer firms will decide to shut down, so more
firms operate and the quantity of real GDP supplied increases.
c. Changes in Output Rate
When the price level rises and the money wage rate doesn’t change, the quantity of
labor demanded increases and production increases.
2. Production at a Pepsi Plant
Production at a Pepsi plant illustrates that when the price level falls, so that the real
wage rate rises, production decreases.
C. Changes in Aggregate Supply
1. Changes in Potential GDP
Anything that changes potential GDP changes aggregate supply and shifts the
aggregate supply (AS) curve.
2. Changes in Money Wage Rate and Other Resource Prices
The higher the money wage rate (or money prices of other resources), the higher are
firms’ costs and the smaller is the quantity that firms are willing to supply at each price
level. So an increase in the money wage rate decreases aggregate supply and shifts
the AS curve leftward.
14.3 Aggregate Demand
A. Aggregate Demand Basics
The quantity of real GDP demanded is the total amount of final goods and services
produced in the United States that people, businesses, governments, and foreigners plan
to buy: Y = C + I + G + X  M.
B. Aggregate Demand and the AD Curve
The quantity of real GDP demanded decreases when the price level rises so the
aggregate demand curve is downward sloping. The aggregate demand (AD) curve has a
downward slope for three reasons:
1. The Buying Power of Money
A rise in the price level lowers the buying power of money and decreases the quantity
of real GDP demanded.
2. The Real Interest Rate
When the price level rises, the demand for money increases, which increases the
nominal interest rate and, in the short run, also the real interest rate. The rise in the
real interest rate decreases consumption expenditure and investment.
3. The Real Prices of Exports and Imports
A rise in the U.S. price level encourages people to spend less on U.S.-made items and
more on foreign-made items.
C. Changes in Aggregate Demand
Other factors that influence aggregate demand and shift the AD curve are:
1. Expectations
a. An increase in expected future income increases the amount of consumption goods
(especially big-ticket items such as cars) that people plan to buy and increases
aggregate demand.
b. An increase in expected future inflation increases aggregate demand because
people decide to buy more goods and services before their prices rise.
c. Expectations of higher profits increase the investment that firms plan to undertake
and increase aggregate demand.
2. Fiscal Policy and Monetary Policy
a. A tax cut or an increase in either transfer payments or government purchases
increases aggregate demand.
b. A cut in the interest rate or an increase in the quantity of money increases
aggregate demand.
3. The World Economy
a. A rise in the foreign exchange rate decreases aggregate demand.
b. An increase in foreign income increases U.S. exports and increases U.S. aggregate
demand.
D. The Aggregate Demand Multiplier
The aggregate demand multiplier is an effect that magnifies changes in expenditure plans
and brings potentially large fluctuations in aggregate demand. When any influence on
aggregate demand changes expenditure plans, the change in expenditure changes
income; and the change in income induces a change in consumption expenditure.
14.4 Understanding the Business Cycle
A. Aggregate Demand Fluctuations
1. An increase in aggregate demand shifts the AD curve rightward and increases the
price level and real GDP. An expansion occurs.
2. A decrease in aggregate demand shifts the AD curve leftward and decreases the price
level and real GDP. A recession occurs
B. Aggregate Supply Fluctuations
Aggregate supply can fluctuate for two reasons. First, potential GDP grows at an uneven
pace, so even if we never departed from full employment, real GDP would cycle. During a
period of rapid technological change and capital accumulation, potential GDP grows
rapidly and is above its long-term trend. Second, a change in the money price of a major
resource, such as crude oil, is another source of change in aggregate supply.
1. A decrease in aggregate supply shifts the AS curve leftward. The price level increases
and real GDP decreases.
2. The combination of recession (falling real GDP) and inflation (rising price level) is
called stagflation.
C. Adjustment Toward Full Employment
1. An inflationary gap is a gap that exists when real GDP exceeds potential GDP and
that brings a rising price level. Workers demand higher wages, and firms, anxious to
maintain their employment and output levels in the face of a labor shortage, meet
those demands. As the money wage rate rises, aggregate supply decreases and the
aggregate supply curve shifts leftward, restoring real GDP to potential GDP.
2. A deflationary gap is a gap that exists when potential GDP exceeds real GDP and
that brings a falling price level. With a labor surplus, the money wage rate falls and the
aggregate supply curve shifts rightward, restoring real GDP to potential GDP.