BUSINESS CYCLES
AND ECONOMIC GROWTH
WHAT ARE BUSINESS CYCLES?
Alternating
periods of economic
growth & contraction.
Commonly
called “business
fluctuations” because they are
not easily predicted.
Expansion
Period of recovery
from a recession
Peak
Point where Real
GDP stops going up
Continues until a new
peak is reached
Recession
Period of decline in
Real GDP
Trough
Must decline for 2
consecutive quarters
Point where Real GDP
stops doing down
A severe recession can result in a DEPRESSION
Economic Conditions
High unemployment and major shortages
SLOW EXPANSION (BELOW 3%)
RESULTS IN GROWTH RECESSION



Unemployment may
not follow GDP
growth
Consumption fails to
increase significantly
Hint at when?
ESSENTIAL QUESTION: WHY ARE
MARKETS UNSTABLE? WHAT TO DO?
THEY ARE NOT!
 Classical View

THEY ARE SO!!
 Keynesian View

Say’s Law: supply
creates its own
demand
 If you build it, they
will come…
Markets inherently
UNSTABLE
 Insufficient demand
drags economy down


Classical Response
Laissez faire
 LR market self adjust



Keynesian Response
Govt intervenes
 SR Fiscal/Monetary
Policy

Keynes—In the long run, we are all dead.
CHECK FOR UNDERSTANDING…

What is the business cycle?
ONE MORE CHECK


Why aren’t Classical economists worried about
it?
Why are Keynesian economists worried about it?
BUSINESS CYCLES IN THE U.S.
The Great Depression
Worst and most prolonged economic downturn
 Marked by the stock market crash on
“BLACK TUESDAY” - October 29, 1929
 Between 1929 and 1933, GDP declined nearly 50%.
 Unemployment peaked at 24.9% (1933).
 Decade long depression ended with ramp up for WWII
World War II
U.S. economy returned to its growth trend
 Spending on wartime goods helped stimulate the
economy.
 Since then, the overall trend has been 3% growth.
A MODEL OF THE MACRO ECONOMY
DETERMINANTS
Internal
market
forces
Externa
l
shocks
Policy
levers
LO1
OUTCOMES
Output
Jobs
MACRO
ECONOMY
Prices
Growth
Internationa
l balances
MACROECONOMIC PERFORMANCE

Macro outcomes include:





LO1
Output - total 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
capacity.
International balances - international value of the
dollar; trade and payments balances with other
countries.
MACROECONOMIC PERFORMANCE

Determinants of macro performance include:
Internal market forces - population
growth, spending behavior,
intervention & innovation.
External shocks - wars, natural
disasters, trade disruptions, etc.
Policy levers - tax policy,
government policy, changes in the
availability of money, credit
regulation, etc.
LO1
BUSINESS CYCLE REMIX:
ARE THE PRESENTERS CONCERNED ABOUT THE
SR OR LR BUSINESS CYCLE?
Keynes and Friends…

In the long run, we’re all
dead.

Therefore, focus on SR
with policy changes
Say and Friends…

In the long run, economy
will self adjust… “supply
creates is own demand”

Therefore, laissez faire
AGGREGATE SUPPLY & DEMAND
Behind the Macro Model
AGGREGATE DEMAND AND SUPPLY

LO2
Any influence on macro outcomes must be
transmitted through supply or demand.
AGGREGATE DEMAND
Aggregate demand is 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
PRICE LEVEL (average price)
AGGREGATE DEMAND
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
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
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
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 foreigners buy
more U.S produced goods.

LO2
INTEREST-RATE EFFECT
With lower prices, consumers need to borrow less,
the demand for loans diminishes, so interest
rates drop.
 Lower interest rates encourages loan-financed
purchases.

LO2

The Aggregate
Demand curve shifts
in response to changes
in overall spending
habits in the economy



Internal Mkt Forces
External Shocks
Policy Levers
PRICE LEVEL (average price)
SHIFTS IN AGGREGATE DEMAND
AD2
AD1
REAL OUTPUT (quantity per year)
Reduced Income Tax
Increases Output & Price
Level
CHECK FOR UNDERSTANDING
1.
2.
3.
4.
5.
What does aggregate
mean?
What two variables
interact in the market
mechanism behind the
macro model?
What is the relationship
between the two variables
as it relates to the
aggregate demand curve?
Provide one reason for the
shape (slope) of the
aggregate demand curve.
What is the main reason
for shifts in the aggregate
demand curve?
1.
2.
3.
4.
5.
Total
Real Output (GDP) and
Price Level (measure of
inflation)
Indirect Relationship (As
price level rises, the
quantity of real output
demanded falls)
Real balances effect,
foreign trade effect,
interest rate effect
Changes in overall
spending
PRACTICE WITH AGGREGATE DEMAND
Curve shifts as a result of changes in spending
PRICE LEVEL (average price)

C
E
A
D
B
REAL OUTPUT (quantity per year)
AGGREGATE SUPPLY

LO2
Aggregate supply is the total quantity of output
producers are willing and able to supply at
alternative price levels in a given time period,
ceteris paribus.
PRICE LEVEL (average price)
AGGREGATE SUPPLY
Aggregate supply
REAL OUTPUT (quantity per year)
LO2
AGGREGATE SUPPLY

Two reasons explain the upward slope of the
aggregate supply curve:
The profit effect.
The cost effect.
LO2
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
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.

LO2
COST EFFECT

LO2
Cost pressures are minimal at low rates of output
but intensify as the economy approaches
capacity.

The Aggregate Supply
curve shifts in
response to changes in
overall cost of inputs
/ production



Internal Mkt Forces
External Shocks
Policy Levers
PRICE LEVEL (average price)
SHIFTS IN AGGREGATE SUPPLY
AS2
AS1
REAL OUTPUT (quantity per year)
Increases in Corporate Taxes
Raise Price Level, Reduce Output
CHECK FOR UNDERSTANDING
1.
2.
3.
4.
What is the
relationship between
the two variables as it
relates to the
aggregate supply?
What is the primary
reason for the shape of
the AS curve?
Why does the slope of
the curve change as
output increases?
What is the main
reason for shifts in the
aggregate supply
curve?
1.
Direct Relationship
(As price level rises,
the quantity of real
output supplied
increases)
2.
Profit effect
3.
Cost effect
4.
Changes in cost of
inputs/production
MACRO EQUILIBRIUM

LO3
Macro equilibrium is the combination of price
and output that is compatible with both
aggregate demand and aggregate supply, i.e.
buyers’ and sellers’ intentions.
PRICE LEVEL (average price)
MACRO EQUILIBRIUM
Aggregate
supply
P1
E
PE
Aggregate
demand
D1
QE
S1
REAL OUTPUT (quantity per year)
LO3
MACRO EQ. PROBLEM SET RECAP
1.
Businesses feel good
about the economy
and decide to
increase spending.
a.
b.
c.
Shift AS or AD?
Eq PL?
Eq rGDP?
MACRO EQ. PROBLEM SET RECAP
2.
A sudden burst in
technology makes
production more
efficient.
a.
b.
c.
Shift AS or AD?
Eq PL?
Eq rGDP?
MACRO EQ. PROBLEM SET RECAP
3. The cost of oil, a
major input,
increases.
a.
b.
c.
Shift AS or AD?
Eq PL?
Eq rGDP?
MACRO EQ. PROBLEM SET RECAP
4. The government
decides to increase
personal income
taxes.
a.
b.
c.
Shift AS or AD?
Eq PL?
Eq rGDP?
MACRO EQ. PROBLEM SET RECAP
5. The stock market
collapses and
investors lose
billions.
a.
b.
c.
Shift AS or AD?
Eq PL?
Eq rGDP?
MACRO FAILURES

There are 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
UNDESIRABILITY
Full-employment GDP is 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.

LO3
UNDESIRABILITY
Recessionary Gap:
 If macro equilibrium is below full-employment
GDP, then we have failed to achieve the full
employment goal.

LO3
PRICE LEVEL (average price)
AN UNDESIRED EQUILIBRIUM
Aggregate
demand
PE
Aggregate
supply
E
F
P*
Equilibrium
output
QE
LO3
Full-employment output
QF
UNDESIRABILITY
Inflationary Gap:
 Similar problems may arise when the
equilibrium price level is inflationary.


LO3
Inflation is an increase in the average level of prices
of goods and services.
PRICE LEVEL (average price)
AN UNDESIRED EQUILIBRIUM
Aggregate
demand
PE
Aggregate
supply
E
Desired
price level
F
P*
Equilibrium
output
QE
LO3
QF
INSTABILITY

Macroeconomic equilibrium changes whenever
the aggregate supply and/or demand curves shift.

Macro Model Determinants:
Policy Levers
 External Shocks
 Internal Market Forces


LO3
Short Run vs. Long Question Revisited…
EXAMPLE OF INSTABILITY…

Government Shutdown!
CHECK FOR UNDERSTANDING
1.
2.
3.
When does Macro
Equilibrium occur?
What two major
policy goals might
Macro Equilibrium
conflict with?
Is Macro
Equilibrium stable?
Why or why not?
1.
When AD/AS
intersect
2.
Full Employment
(Potential Full
Employment
Output) & Preferred
Price Level
SR-no, AD or AS can
shift
LR-perhaps…but in
the long run…
3.
COMPETING THEORIES OF SHORT-RUN
INSTABILITY

Economists AGREE to DISAGREE

What is the shape of AD/AS curve?
Horizontal
 Vertical
 Steeply/gently sloped


LO3
Do policy options exist to shift either curve?
DEMAND-SIDE THEORIES

Keynesian and Monetary theories are the two
basic demand-side theories.

LO3
Both theories emphasize the potential of AD shifts to
alter macro outcomes
DEMAND-SIDE THEORIES
AS
P*
E1
E0
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)
KEYNESIAN THEORY



LO3
Problem: deficiency of
spending
Effect: depress
economy (high
unemployment)
Solution: Government
spending substitute
for consumers
PRICE LEVEL (average price)
Inadequate demand
AS
P*
E1
E2
AD2
AD1
Q
1
QF
REAL OUTPUT (quantity per year)
MONETARY THEORIES

LO3
Money and credit affect the ability and
willingness of people to buy goods and services.

Problem: TIGHT MONEY (high interest rates)

Effect: Consumers cut purchases/businesses cut
investment

Solution: Manage money supply carefully
(“Goldilocks” interest rates)
PRICE LEVEL (average price)
SUPPLY-SIDE THEORIES
Decrease in AS
AS2
AS1
E2
P3
Increases in AS
Closer to P* & FE
E1
P*
Suppliers impacted by
taxes, regulations, etc.
AD0
Q3
QF
REAL OUTPUT (quantity per year)
LO3
Increase Inflation & UE
CHECK FOR UNDERSTANDING
1.
2.
3.
4.
What two theories
explain shifts of the
AD that cause Macro
failures?
What do Keynsians
consider the cause of
Macro failures?
What do Monetarists
consider the cause of
Macro failures?
What problems might
cause a supply side
Macro failure?
1.
Keynesian theory &
Monetary theory
2.
Inadequate Demand
3.
Tight Money (reducing
investment or
spending)
4.
High taxes, onerous
regulations
LONG-RUN SELF ADJUSTMENT
FOCUS=INSTITUTIONAL CONSTRAINTS NOT FLUCTUATIONS

Monetarists focus: institutional constraints
limit LR output
Short Run profit effect dominate with increases in
output
 Long Run cost effect minimizes increase in output


LO3
Shape: Vertical AS means shifting AD impacts
prices but NOT output in LR.
PRICE LEVEL (average price)
THE “NATURAL” RATE OF OUTPUT
AS
P2
P1
AD2
AD1
QN
REAL OUTPUT(quantity per year)
LO3
SHORT VS. LONG-RUN PERSPECTIVES
The long-run aggregate supply curve is likely to
be vertical.
 The short-run aggregate supply curve is likely to
be upward-sloping.


LO3
COMPROMISE: 3 Part aggregate supply curve
TAMING THE CYCLE

The real challenge for macro theory is to
determine which curves or shifts best represents
reality.
THREE BASIC POLICY STRATEGIES
Shift aggregate demand curve – find and use
policy tools that stimulate or restrain total
spending.
 Shift the aggregate supply curve – find and
implement policy levers that reduce the costs of
production or otherwise stimulate more output at
every price level.
 Laissez-faire – Don’t interfere with the market;
let markets self adjust.

LO3
SPECIFIC POLICY OPTIONS

There are a host of policy tools for any given
AS/AD strategy:





LO3
Classical laissez faire.
Fiscal policy.
Monetary policy.
Supply-side policy.
Trade policy.
CHECK FOR UNDERSTANDING
1.
2.
3.
4.
What group focuses
primarily on long run
perspectives?
How does the profit
effect govern the AS in
the short run?
How does the cost
effect govern the AS in
the long run?
What three policies
strategies exist to
manage the business
cycle?
1.
Monetarists
2.
Short Run increases in
production
3.
Long run production
cannot be increased
4.
Shift AS, shift AD or
do nothing (laissezfaire)
MACRO EQ. ADDITIONAL PROBLEMS
1. OPEC lowers the
price of oil.
a.
b.
c.
d.
Shift AS or AD?
Eq PL?
Eq rGDP?
Unemployment?
MACRO EQ. ADDITIONAL PROBLEMS
2. The “Buy American”
movement gains
increased power in
the US.
a.
b.
c.
d.
Shift AS or AD?
Eq PL?
Eq rGDP?
Unemployment?
MACRO EQ. ADDITIONAL PROBLEMS
3. The government
increases taxes to
pay down our
national debt.
a.
b.
c.
d.
Shift AS or AD?
Eq PL?
Eq rGDP?
Unemployment?
MACRO EQ. ADDITIONAL PROBLEMS
4. Consumers choose to
increase their
savings rate.
a.
b.
c.
d.
Shift AS or AD?
Eq PL?
Eq rGDP?
Unemployment
ADDITIONAL QUESTIONS…

The horizontal range
of the AS curve
reflects:
An overheated
economy
b) An economy that is
experiencing high
levels of inflation
c) An economy that is
near capacity
d) An economy with
fairly high levels
unemployment

Say’s law argues that:
a)
a)
b)
c)
d)
Cyclical instability
requires government
intervention
In the long run we’re
all dead
Consumers will
never increase
spending during
periods of recession
Unsold goods will
eventually sell at
lower prices via the
market mechanism
ADDITIONAL QUESTIONS…

The shape of the AD
curve is influenced by
all but which of the
following:
Real balances effects
b) Cost effects
c) Interest rate effects
d) Foreign trade effects
a)

Recessions are
characterized by:
Increases in real
GDP
b) Low levels of
unemployment
c) Two quarters of
declining real GDP
d) High levels of
inflation
a)
AP MACRO COOK OFF
LAYERS OF SPENDING…

Cook Off Rules
Groups of 2
 Due Fri, October 11th
 Creatively Depict AE
p.186-191
1 paragraph typed design
explanation
 Must Be Edible
2 points for participation
 4 points for winner!



Class Vote Based on
• Accuracy
• Creativity
• Taste
FRIEDRICH HAYEK (1899-1992)



Prominent classical (or
Neoliberal) economist
Winner of the 1974
Nobel in Economics
Argued for recovery
from Great Depression
with increased
PRIVATE investment
NOT government
spending