McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved The Business Cycle Chapter...

McGraw-Hill/Irwin

©2008 The McGraw-Hill Companies, All Rights Reserved

The Business Cycle

Chapter 8

2

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.

3

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.

5


6

Macroeconomics

The Business Cycle:

alternating periods of economic growth and contraction.

7

The Business Cycle

(Figure 8.2, pg. 148)

Trough

Peak

RE

AL

GD

P (

units

per

tim

e pe

riod)

TIME

Growth trendPeak

Peak

Trough

8

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.

10

Recession

GDP

11

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.”

12

Classical Theory

Classical Theory = Laissez faire.

nonintervention by government in the market mechanism.

13

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.

14


Unsold goods and unemployed labor would disappear as soon as people had time to adjust prices and wages.

15


The Classical view of the macro economy was summarized in Say’s Law.

According to Say’s Law, supply creates its own demand:

16

And then…

17

The Great Depression

18


19


20


21


22

Macro Failure

The Great Depression was a stunning blow to classical economists.

Unemployment grew and persisted despite falling prices and wages.

23

Inflation and Unemployment: 1900-1940

(Figure 8.1, pg. 147)

24

20

16

12

8

4

0

– 4

– 8

1900 1910 1920 1930 1940

Inflation

Unemployment

24

The Keynesian Revolution

British economist, John Maynard Keynes developed an alternate view of the macro economy.

25

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.

26


27

Government Intervention

In Keynes’ view, the inherent instability of the marketplace required government intervention.

28

2. Historical Cycles

29

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.

30

The Business Cycle

Trough

Peak

RE

AL

GD

P (

units

per

tim

e pe

riod)

TIME

Growth trendPeak

Peak

Trough

31

The Business Cycle in U.S. History

(Figure 8.3, pg. 148)

32


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.

33


Times are hard, son…

34

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.

35

The Postwar Years

There have been 11 recessions since 1944.

Recession:

a decline in real GDP,

for at least two or more consecutive quarters.

36

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.

37

The Business Cycle in U.S. History

(Figure 8.3, pg. 148)

38

The 1980s

Growth recession:

the economy expands too slowly.

Recession:

real GDP actually contracts.

39

The 1980s

In November 1982, the U.S. economy began an expansion that lasted over 7 years.

40

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.

41

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.

42

3. A Model of the Macro Economy

46

A Model of the Macro Economy

(Figure 8.4, pg. 151)

Internal market forces

External shocks

Policy levers

DETERMINANTS

Output

Jobs

Prices

Growth

International balances

OUTCOMES

MACROECONOMY

LO1

47

Internal market forces

DETERMINANTS


MACROECONOMY

LO1

The MACRO ECONOMY:

48


External shocks

Policy levers

DETERMINANTS

Output

Jobs

Prices

Growth


OUTCOMES

The MACRO ECONOMY:

LO1

The Market:Internal Market Forces

Supply & Demand

Gov’t Intervention

49


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

50

4. Aggregate Demand and Supply

Aggregate Demand.

Aggregate Supply.

Macro Equilibrium.

Macro Failures.

51


External shocks

Policy levers

DETERMINANTS

Output

Jobs

Prices

Growth


OUTCOMES

The MACRO ECONOMY:

LO1


AS & AD

Gov’t Intervention

52

Aggregate Demand and Supply

Any influence on macro outcomes… (output,

jobs,

prices,

growth,

international balances)…

…must be transmitted through supply or demand.

LO2

53

AS & AD Drive the Business Cycle

(Figure 8.7, pg. 156)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

REAL OUTPUT (quantity per year)

QE

PE

Aggregatedemand

Aggregatesupply

E

LO3

54

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

55

Aggregate Demand

(Figure 8.5, pg. 153)


PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

LO2

58

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

59

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

60

Aggregate Demand

(Figure 8.5, pg. 153)


PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

LO2

61

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

62

Aggregate Demand

(Figure 8.5, pg. 153)


PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

LO2

63

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

64

Aggregate Demand

(Figure 8.5, pg. 153)


PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

LO2

66

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

67

Aggregate Supply

(Figure 8.6, pg. 155)

PR

ICE

LE

VE

L (a

vera

ge p

rice)


Aggregate supply

LO2

68

Two reasons explain the upward slope of the aggregate supply curve:

The profit effect.

The cost effect.

Aggregate Supply

LO2

69

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

70

Aggregate Supply

(Figure 8.6, pg. 155)

PR

ICE

LE

VE

L (a

vera

ge p

rice)


Aggregate supply

LO2

71

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

72

Aggregate Supply

(Figure 8.6, pg. 155)

PR

ICE

LE

VE

L (a

vera

ge p

rice)


Aggregate supply

LO2

73

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?

74

Macro Equilibrium

Macro equilibrium is unique:

the only combination of price and output …

compatible with both: aggregate demand

and …

aggregate supply.

LO3

75

Macro Equilibrium

(Figure 8.7, pg. 156)

PR

ICE

LE

VE

L (a

vera

ge p

rice)


D1 S1QE

PE

Aggregatedemand

Aggregatesupply

P1

E

LO3

77

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

78

An Undesired Equilibrium

(Figure 8.8, pg. 157)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

QE

PE

Aggregatedemand

Aggregatesupply

E

Equilibriumoutput Full-employment output

QF

P*F

LO3

Desiredprice level

79

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 full-employment GDP …

… we have failed to achieve the full employment goal.

LO3

80

Undesirability

Similar problems may arise when the equilibrium price level is inflationary.

(Figure 8.10, pg. 160)LO3

82

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

83

Macro Disturbances

(Figure 8.11, pg. 161)

FP*

QF

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


(b) Demand shifts

AD0

AD1

FP*

QF

AD0

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


(a) Supply shiftsAS1

GP1

Q1

P2

Q2

H

LO3

84

The Business Cycle

(Figure 8.2, pg. 148)

Trough

Peak

RE

AL

GD

P (

units

per

tim

e pe

riod)

TIME

Growth trendPeak

Peak

Trough

85

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

86

Macro Disturbances

(Figure 8.11, pg. 161)

FP*

QF

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


(b) Demand shifts

AD0

AD1

FP*

QF

AD0

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)



GP1

Q1

P2

Q2

H

LO3

87

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

88

Macro Disturbances

(Figure 8.11, pg. 161)

FP*

QF

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


(b) Demand shifts

AD0

AD1

FP*

QF

AD0

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)



GP1

Q1

P2

Q2

H

LO3

90

5. Competing Theoriesof

Short-Run Instability(& Corresponding Remedies)

Demand-Side Theories.Keynesian (& fiscal policy).

Monetarist (& monetary policy).

Supply-Side Theories

92

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

94

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

95


(Figure 8.10, pg. 160)

P*

(b) Excessive demand

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


PR

ICE

LE

VE

L (a

vera

ge p

rice)


(a) Inadequate demand

AS

AD1

E1

Q1

AD0 AD0

E0

QF

AD2

P2

Q2

E2

E0P*

QF

LO3

96

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.

Interest rates ↓, $ supply ↑ = AD increase.LO3

97


(Figure 8.10, pg. 160)

P*

(b) Excessive demand

AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)


PR

ICE

LE

VE

L (a

vera

ge p

rice)


(a) Inadequate demand

AS

AD1

E1

Q1

AD0 AD0

E0

QF

AD2

P2

Q2

E2

E0P*

QF

LO3

98


External shocks

Policy levers

DETERMINANTS

Output

Jobs

Prices

Growth


OUTCOMES

The MACROECONOMY

LO1


99

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

100

Supply-Side Theories

(Figure 8.11, pg. 161)

AD0

Q3

P3

QF

E0

AS0


PR

ICE

LE

VE

L (a

vera

ge p

rice)

P0

AS1

E3

LO3

101

Supply-Side Theory

External shocks

Policy levers

DETERMINANTS

Output

Jobs

Prices

Growth


OUTCOMES

The MACROECONOMY

LO1


102

Eclectic Explanations

Eclectic explanations of macro failure draw from both the demand-side and the supply-side of the economy.

LO3

103

6. Taming the Cycle(Summary & preview of things to come…)

104

Taming the Cycle

The real challenge for macro theory is to determine which curves or shifts best represents the reality of macro failure.

105

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

110

Trade Policy

(Also:International trade and money flows can be changed to shift the aggregate demand and/or the aggregate supply curve.)

LO3

111

7.Long-Run Self-Adjustment.

112

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 long-run aggregate supply curve that is anchored at the natural rate of output (QN) by fundamental determinants.

LO3

113

REAL OUTPUT(quantity per year)

PRIC

E LE

VEL

(ave

rage

pric

e)

The “Natural” Rate of Output

(Figure 8.12, pg. 162)

QN

AS

AD1

P1

LO3

114


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.

115

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

116


PRIC

E LE

VEL

(ave

rage

pric

e)


QN

AS

AD2

AD1

P2

P1

LO3

117


PRIC

E LE

VEL

(ave

rage

pric

e)


QN

AS

AD1

AD2

P1

P2

LO3

118

Short vs. Long-run Perspectives

Short-run AS:likely to be upward-sloping.

Long-run AS:likely to be vertical.

LO3

119


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?

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved The Business Cycle Chapter...

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