Chapter 08:The Business Cycle

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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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?

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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.

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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.

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A Self-Regulating Economy• Classical economics: the economy “self-

adjusts” 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.

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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, market-driven economies are inherently stable or unstable.– Keynes said “unstable.”– Classical economists said “stable.”

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 full-employment GDP.

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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 full-employment GDP.

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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.

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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.

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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.

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Demand-Side Theories

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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.

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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.

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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.