13e
Chapter 08:
The Business Cycle
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
The Business Cycle
• Macroeconomics explains how and why
economies grow and what causes the recurrent
ups and downs known as the business cycle.
• Business cycle: alternating periods of
economic growth and contraction.
• We focus on three central questions:
– 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
Learning Objectives
• 08-01. Know the major macro outcomes and
their determinants.
• 08-02. Know why the debate over macro
stability is important.
• 08-03. Know the nature of aggregate
demand (AD) and aggregate supply (AS).
• 08-04. Know how changes in AD and AS
affect macro outcomes.
8-3
Stable or Unstable?
• Prior to the 1930s, conventional wisdom was a
market-driven economy, which was inherently
stable.
– Business cycles (ups and downs in the economy)
were short-lived, and the market seemed to correct
(regulate) itself.
– There was no need for government intervention –
that is, the prevailing view dictated a policy of
laissez faire..
• Laissez faire: the doctrine of “leave it alone,” of
nonintervention by government in the market
mechanism.
8-4
A Self-Regulating Economy
• Classical economics: the economy “selfadjusts” to any deviations from its long-term
growth trend.
– In this view, wages and prices are flexible.
– If there are excess goods, the producer can
• Lower prices and sell more, eliminating excess goods.
• Decrease output and lay off workers. Laid-off workers
compete for jobs by asking for lower wages. At lower
wages, firms will hire more workers.
– This is the essence of Say’s Law.
8-5
A Self-Regulating Economy
• Say’s Law: supply creates its own demand.
– Whatever was produced would be sold.
– All workers who sought employment would be
hired.
– This would occur because people have time to
adjust prices and wages downward.
• The economy therefore is self-regulating.
8-6
Macro Failure
• The self-adjustment mechanism did not
work during the Great Depression.
– John Maynard Keynes analyzed the situation
and concluded that self-adjustment could not
occur because of “an insufficiency of effective
demand.”
– He asserted that a market-driven economy was,
in fact, inherently unstable.
• He concluded that the government must
intervene by increasing aggregate demand.
8-7
Government Intervention
• For an underperforming economy, Keynes
proposed that the government intervene to
–
–
–
–
By more output.
Employ more people.
Provide more income transfers.
Make more money available.
• For an overheated economy, Keynes proposed
the opposite.
– Higher taxes.
– Spending reductions.
– Reduce availability of money.
8-8
Business Cycle
• The four parts of a modern
business cycle are
– The peak, where GDP
maximizes.
– Recession, where GDP
declines.
– The trough, where GDP
minimizes.
– Recovery, where GDP
increases.
• These are variations
around a growth trend
that slopes upward.
8-9
Terms Associated with the
Business Cycle
• Economic growth: real GDP grows faster
than 3%. Expansion.
• Growth recession: real GDP grows, but
slower than 3%. The economy expands too
slowly.
• Recession: real GDP contracts (for two or
more consecutive quarters).
• Depression: an extremely deep recession.
8-10
The Great Recession of 2008-2009
• A recession began as falling home and stock
prices sapped consumer wealth and
confidence. This was coupled with a credit
crisis.
– Sales plummeted and GDP contracted.
– Unemployment reached 10.1%.
• The Great Recession reached its trough in
August 2009, but economic growth since that
time has been so sluggish that unemployment
remains high (over 9% in 2011).
8-11
A Model of the Macro Economy
• Macro outcomes:
– Output: real GDP.
– Jobs: levels of employment and unemployment.
– Prices: CPI and inflation.
– Growth: year-to-year expansion of GDP.
– International balances: value of the dollar;
trade balances.
8-12
A Model of the Macro Economy
• Determinants of macro performance:
– Internal market forces: population growth,
spending behavior, invention and innovation.
– External shocks: wars, natural disasters,
terrorist attacks, trade disruptions.
– Policy levers: tax policy, government spending,
changes in the availability of money, regulation.
8-13
The Crucial Controversy
• Most controversial is whether the policy levers
are effective and necessary.
– Keynes said “yes.”
– Classical economists said “no.”
• Also controversial is whether pure, marketdriven economies are inherently stable or
unstable.
– Keynes said “unstable.”
– Classical economists said “stable.”
8-14
Aggregate Demand and Supply
• The forces of supply and demand are at
work in the macro economy.
– Any influence on macro outcomes must be
transmitted through supply or demand.
• The macro model shows how the macro
economy works, and it consists of
aggregate demand and aggregate supply.
8-15
Aggregate Demand
• Aggregate demand (AD): the total quantity of
output (real GDP) demanded at alternative
price levels in a given time period, ceteris
paribus.
– The collective behavior of all buyers in the
marketplace.
– It comprises all goods and services.
• AD slopes downward; people will buy more
goods and services at lower price levels, and
vice versa.
8-16
Aggregate Demand (AD)
• Why does AD slope downward?
– Real balances effect: the cash you hold is
worth more when the price level falls, so you
can buy more.
– Foreign trade effect: lower price levels in the
United States convince customers to buy more
American goods and fewer foreign goods.
– Interest rate effect: lower interest rates
promote more borrowing and more spending.
8-17
Aggregate Supply
• Aggregate supply (AS): 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.
– The collective behavior of all suppliers (sellers) in
the marketplace.
– It comprises all goods and services.
• AS slopes upward; suppliers will bring more
goods and services to market at higher price
levels, and vice versa.
8-18
Aggregate Supply (AS)
• Why does AS slope upward?
– Profit effect: if there is no change in the cost of
operating a business, rising prices will improve
profits, and suppliers will bring more products to
the market.
– Cost effect: cost increases make producing
products more expensive. Producers will be willing
to supply more only if prices also rise to cover those
added costs.
• At high rates of output (near productive capacity), costs
rise steeply and AS steepens sharply.
8-19
Macro Equilibrium
• AS and AD summarize the
market activity of the
macro economy.
• Macro equilibrium: the
combination of price level
and real output that is
compatible with both AD
and AS.
– Where AD and AS intersect.
– … at PE and QE.
8-20
Macro Failures
• Let QF be the goal of
full-employment GDP.
• The equilibrium
output QE is
undesirable; it does
not reach our macro
goal.
• Also, AD and AS can
shift, meaning that any
equilibrium can be
unstable.
8-21
AS Shifts
• AS will shift left if
– Business costs rise.
– Business taxes rise.
– Natural disaster occurs.
• AS will shift right if
– Business costs fall.
– Business taxes fall.
– Bounteous harvests occur.
• On the graph, AS shifts
left away from fullemployment GDP.
8-22
AD Shifts
• AD will shift left if
– Sending decreases.
– Expectations get worse.
– Taxes increase.
• AD will shift right if
– Spending increases.
– Expectations improve.
– Taxes decrease.
• On the graph, AD shifts left
away from fullemployment GDP.
8-23
Short-Run Instability:
Competing Theories
• Classical economists believe the economy will
self-regulate and gravitate toward full
employment.
• Keynes and his followers do not believe this.
They believe the economy might get worse
without government intervention.
• In addition, there are controversies about the
shape of AS and AD and the potential to shift
these curves.
8-24
Keynesian Theory
• This is a demand-side theory.
• A recession originates with a deficiency of
spending.
– AD is too far to the left.
– Policy: increase government spending to shift AD
back to the right.
• Inflation originates with an excess in spending.
– AD is too far to the right.
– Policy: increase taxes to shift AD back to the left.
8-25
Monetary Theory
• This is also a demand-side theory.
– Emphasizes the role of money in financing AD.
• “Tight” money might cause AD to shift too far
to the left.
– Policy: increase money supply and lower interest
rates to shift AD back to the right.
• “Easy” money might cause AD to shift too far to
the right.
– Policy: decrease money supply and raise interest
rates to shift AD back to the left.
8-26
Demand-Side Theories
8-27
Supply-Side Theory
• A shift in AS to the left causes output and
employment to decrease and inflation to
increase.
– This problem cannot be corrected by shifting AD.
• Shift AD right and unemployment falls but inflation
worsens.
• Shift AD left and inflation is reduced but unemployment
rises.
– Policy: devise ways to shift AS back to the right.
8-28
Long-Run Self-Adjustment
• Advocates argue that short-run instability is
not as important as the long-run trend in
economic growth.
– Relies on the view that the economy can self-adjust.
– Once it adjusts to a short-run deviation, the
economy will return to its long-run growth path.
• There is a “natural” rate of output determined
by institutional factors.
8-29
Short- and Long-Run Perspectives
• We live in the short run.
– Short-run variations affect our current economic
situation.
– We call on government to “fix” short-run problems
– now!
– Implemented policies take effect in the short-run.
– In the short run, AS slopes upward.
• The macro model we will use to describe policy
implementation will have an upward-sloping
AS curve.
8-30