The Business Cycle

Chapter 8
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

The Business Cycle

We in America are nearer to the final triumph over poverty than ever before in the history of any landWe shall soon with the help of God be in sight of the day when poverty will be banished from this nation. President-elect Herbert Hoover, 1928 OOPS!
8-2

The Business Cycle

The Great Depression shook not only the foundations of the world economy but the self-confidence of the economics profession The search for explanations focused 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?
8-3

The Business Cycle

Out of the Great Depression grew a clamor for answers to why it was happening People were seeking answersand solutions! Thus, for the first time, emerged the concept of macroeconomics
Basic purpose of macroeconomics is to explain how and why economies grow and what causes recurrent ups and downs of the business cycle
8-4

Macroeconomics
Firstsome definitions:
Macroeconomics is the study of aggregate economic behavior of the economy as a whole The business cycle is the occurrence of alternating periods of economic growth and contraction

Macro theories try to explain the business cycle; economic policies try to control it

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Stable or Unstable?
Prior to the 1930s, macroeconomists thought there could never be a Great Depression
They believed a market-driven economy was inherently stable

Laissez faire: The doctrine of leave it alone; of non-intervention by government in the market mechanism seemed reasonable at the time
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The Self-Regulating Economy

According to the classical economists, the economy self-adjusts to deviations from its long-term growth trend Economic downturns were viewed as temporary setbacks, not permanent problems The cornerstones of classical optimism were flexible prices and flexible wages

8-7

Classical Theory
The optimistic views of the classical economists were summarized in Says Law: Supply creates its own demand
Whatever was produced would be sold All workers seeking employment would be hired

Unsold goods and unemployed labor could emerge, but both would disappear once people had time to adjust prices and wages
8-8

Classical Theory
There could be no Great Depression in the classical view of the world Yet, there was! Fifty, sixty, seventy years after the Great Depression, and the analyses that have taken place during that time, have presented a different picture than was first imagined at the time
8-9

Macro Failure
The Great Depression was (seemingly) a stunning blow to classical economists
Unemployment grew and persisted despite falling prices and wages The classical self-adjustment mechanism simply didnt (seem to) work

People seeking answers and solutions to the Depression were desperateand desperate people often are misled (intentionally or unintentionall

8-10

Inflation and Unemployment: 1900-1940

24 20 16 12 8 4 0 4 8 1900 1910 1920 1930 1940

Unemployment

Inflation

Source: U.S. Bureau of the Census, The Statistics of the United States, 1957

8-11

The Keynesian Revolution

John Maynard Keynes developed an alternate view of the macro economy, asserting that a market-driven economy is inherently unstable
Small disturbances in output, prices, or unemployment were likely to be magnified by the invisible hand of the marketplace The Great Depression was not a unique event, Keynes argued, but a calamity that would recur if we relied on the market mechanism to self-adjust
8-12

Government Intervention
In Keynes view, the inherent instability of the marketplace required government intervention
When the economy falters we cant afford to wait for some assumed self-adjustment mechanism but must intervene to protect jobs and income The government could do this by priming the pump: buying more output, employing more people, providing more income transfers, and making more money available
8-13

Historical Cycles
Upswings and downturns of the business cycle are gauged in terms of changes in total output Real GDP: The value of final output produced in a given period, adjusted for changing prices Changes in employment typically mirror changes in production The following slide depicts the stylized features of a business cycle
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The Business Cycle

Peak Peak Peak Trough Trough Growth trend

REAL GDP

TIME

8-15

The Business Cycle

An economic upswing (expansion) is an increase in the volume of goods and services produced An economic downturn (contraction) occurs when the volume of production declines Successive short-run contractions and expansions are the essence of business cycles

8-16

The Business Cycle

The dashed horizontal line across the graph on the following slide represents the long-term growth rate of the U. S. economy From 1929 through 2009, the U.S. economy has expanded at an average rate of 3% per year The most prolonged departure from the longterm trend occurred during the Great Depression
8-17

The Business Cycle in U.S. History

Source: U.S. Department of Commerce (2009)

From 1929 to 2009, real GDP increased at an average rate of 3 percent a year.
8-18

The Business Cycle

Recessions are periods when total output (real GDP) declines for two or more consecutive quarters A Growth recession is a period during which real GDP grows, but at a rate below the long-term trend of 3 percent In November 1982, the U.S. economy began an economic expansion that lasted over 7 years
During that period, real GDP increased over $1 Trillion and nearly 20 million new jobs were created As an aside, the Congress passed the Reagan tax cuts in July of 1981

8-19

Business Slumps
Dates
Aug. 29Mar. 33 May 37 June 38 Feb. 45 Oct. 45 Nov. 48Oct. 49 July 53May 54 Aug. 57Apr. 58 Apr. 60Feb. 61 Dec. 69Nov. 70 Nov. 73Mar. 75

Duration (months)
43 13 8 11 10 8 10 11 16

Percentage Decline in Real GDP

53.4% 32.4 38.3 9.9 10.0 14.3 7.2 8.1 14.7

Peak Unemployment Rate

24.9% 20.0 4.3 7.9 6.1 7.5 7.1 6.1 9.0

Jan. 80July 80
July 81Nov. 82 July 90Feb. 91 Mar. 01Nov. 01 Dec 07

6
16 8 8 ?

8.7
12.3 2.2 0.6 ?

7.6
10.8 6.5 5.6 ?

8-20

A Model of the Macro Economy

Both Keynes and the Classical economists agreed that business cycles occur, but disagreed on whether theyre an appropriate target for government intervention In order to understand whether and how the government should try to control the business cycle, it is necessary to understand the origins of the business cycle
What causes the economy to expand and contract? What market forces dampen (self-adjust) or magnify economic swings?

8-21

The Macro Economy

DETERMINANTS
Internal market forces

OUTCOMES
Output Jobs

External shocks

MACRO ECONOMY

Prices Growth

Policy levers

International balances

The primary outcomes of the macro economy are output of goods and services (GDP), jobs, prices, economic growth, and international balancesOutcomes result from the interplay of internal market forces, external shocks, and policy levers
8-22

Macroeconomic Performance
Determinants of macro performance include:
Internal market forces - Population growth, spending behavior, intervention & innovation, etc. External shocks - Wars, natural disasters, terrorist attacks, trade disruptions, and so on Policy levers - Tax policies, government spending, changes in the availability of money, and regulation, for example

8-23

Macroeconomic Performance
Macroeconomic outcomes include:
Output - Value of goods and services produced (real GDP) 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 payment balances with other countries
8-24

Aggregate Demand and Supply

To determine which view of economic performance are valid, we need to examine the inner workings of the macro economy The previous slide tells us that macro outcomes depend on certain identifiable forces but doesnt explain how t eh forces and outcomes are connected The macro outcomes are the result of market transactions (supply & demand)
Any influence on macro outcomes must be transmitted through the interactions of supply or demand

8-25

Aggregate Demand and Supply

Economists have developed a simple model of how the economy works They use aggregate demand to refer to the collective behavior of all buyers in the market
Economists define aggregate demand as the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus To understand the concept, imagine that everyone is paid on the same day and with their incomes in hand, they enter the product market. The question then becomes: How much output will people purchase?

To answer the question we must know something about prices

If goods are cheap, people will be able to buy more with their given income High prices will limit both willingness and ability to buy
8-26

Aggregate Demand
The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices
The downward slope suggests that with a given (constant) income, at lower price levels people will buy more goods and services

8-27

Aggregate Demand

PRICE LEVEL

Aggregate demand

REAL OUTPUT

8-28

Aggregate Demand
Three reasons for the downward slope:
Real-balances effect - a change in the price level affects the purchasing power of money Foreign-trade effect - balance of trade depends on domestic price level relative to foreign Interest-rate effect - change in price level affects demand for loan-financed purchases

8-29

Aggregate Supply
Aggregate supply: 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 Two reasons for upward sloping curve:
The profit effect the primary reason for producing goods and services The cost effect cost pressures are minimal at low levels of output but intense as the economy approaches capacity

8-30

Aggregate Supply
Aggregate supply

PRICE LEVEL

REAL OUTPUT

8-31

Macro Equilibrium
Aggregate supply and demand curves summarize the market activity of the whole (macro) economy Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply Equilibrium is unique; it is the only price-level-output combination that is mutually compatible with aggregate supply and demand

8-32

Macro Equilibrium
Aggregate supply

PRICE LEVEL

P1 E PE

Macro equilibrium

Aggregate demand D1 QE S1

REAL OUTPUT

8-33

Macro Failures
Nevertheless, there are potential problems with macro equilibrium that may lead to disequilibrium:
Undesirability - the equilibrium price or output level may not satisfy policy goals Instability - even if the designated macro equilibrium is optimal, it may not last long

8-34

An Undesired Equilibrium
Aggregate demand Aggregate supply

PRICE LEVEL

PE P*

Where we are! Where wed like to be! F

Equilibrium output QE QF

Full-employment output (Goal)

8-35

An Undesired Equilibrium
Aggregate demand Aggregate supply

PRICE LEVEL

Actual price level PE P* E Goal: Desired price level

Equilibrium output QE QF

8-36

Instability
Macroeconomic equilibrium changes whenever the aggregate supply and/or demand curves shift Business cycles are likely to result from recurrent shifts of aggregate supply and demand curves

8-37

AS and AD Shifts
Shifts in aggregate supply can be caused by changes in costs of production due to import prices, natural disasters, changed tax policies, or other events Shifts in aggregate demand can be caused by changes in export demand, expectations, taxes, or other events

8-38

Macro Disturbances
(a) Supply shifts AS1 AS0 AD0 G F
PRICE LEVEL
PRICE LEVEL

(b) Demand shifts AS0

P1 P*

P* P2

F H
AD0 AD1

Q1 QF
REAL OUTPUT

Q2 Q F
REAL OUTPUT

Example: OPEC raises price of oil, Causing production costs to rise

9/11 affects physical and economic security; AD shifts left

8-39

Competing Theories of Short-Run Instability

Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them The AS/AD Model does not really settle the question of who is right! It does, however, provide a framework for comparing the different theories, of which there are several:
Demand-side theories, such as Keynesian and Monetary, emphasize aggregate-demand shifts Supply-side theories center on shifts in supply
8-40

Demand-Side Theories
(a) Inadequate demand AS (b) Excessive demand AS0

PRICE LEVEL

PRICE LEVEL

P2 P*

E2

P*

E0 E1 AD0 AD1 Q1 QF
REAL OUTPUT

E0
AD2 AD0

QF Q2
REAL OUTPUT

8-41

Keynesian Theory
Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment Advocated increasing government spending a rightward AD shift to move the economy toward full employment

8-42

Monetary Theories
Monetary Theories emphasize the role of money in financing aggregate demand Money and credit affect ability and willingness to buy goods and services If credit isnt available or is too expensive consumers reduce spending and businesses curtail investment Excessive aggregate demand may cause inflation Both Keynesians and monetarists theories emphasize the potential of aggregate-demand shifts to alter macro outcomes
8-43

Supply-Side Theories
Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well Might producers be unwilling to supply more goods at current prices?
Could this be a result of greed? Rising costs? Resource shortages? Government taxes and regulation?

8-44

Supply-Side Theories
Supply-side economists believe that the real problem is that high rates of taxation and heavy regulation reduce the incentive to work, to save, and to invest. What is needed is not a demand stimulus but better incentives to stimulate supply. Increases in aggregate supply move us closer to goals of price stability and full employment

8-45

Supply-Side Theories
AS1

AS0
PRICE LEVEL

P3
P0

E3

E0

AD0

Q3

QF

REAL OUTPUT

8-46

Long-Run Self Adjustment

Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations They assert a long-run aggregate supply curve anchored at the natural rate of output (QN)
Flexible prices (and wages) enable the economy to maintain the natural rate of output QN

8-47

The Natural Rate of Output

AS

PRICE LEVEL

P2 P1 AD2 AD1 QN REAL OUTPUT

Fluctuations in aggregate demand affect the price level but not real output.
8-48

Short vs. Long-run Perspectives

The long-run aggregate supply curve is likely to be vertical at QN The short-run aggregate supply curve is likely to be upward-sloping Both aggregate supply and aggregate demand influence short-run macro outcomes

8-49

Policy Strategies
Only three strategy options for macro policy:
Shift the aggregate demand curve: Use policy tools that affect total spending Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output Laissez-faire: Dont interfere with the market; let markets self adjust

8-50

Selecting Policy Tools

There are a host of tools available that we will be covering in more detail in later chapters:
Classical laissez faire Fiscal policy Monetary policy Supply-side policy Trade policy

We will start with a brief introduction to each here

8-51

Policy Tools
The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

8-52

Policy Tools
Monetary policy: The use of money and credit controls to influence macroeconomic outcomes Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

8-53

Policy Tools
Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve

8-54

The Business Cycle

End of Chapter 8
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.