mcgraw-hill/irwin ©2008 the mcgraw-hill companies, all rights reserved the business cycle chapter 8
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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.
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.
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
A Self-Regulating Economy
Unsold goods and unemployed labor would disappear as soon as people had time to adjust prices and wages.
15
A Self-Regulating Economy
The Classical view of the macro economy was summarized in Say’s Law.
According to Say’s Law, supply creates its own demand:
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.
27
Government Intervention
In Keynes’ view, the inherent instability of the marketplace required government intervention.
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
32
The Great Depression
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.
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.
38
The 1980s
Growth recession:
the economy expands too slowly.
Recession:
real GDP actually contracts.
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.
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
A Model of the Macro Economy
MACROECONOMY
LO1
The MACRO ECONOMY:
48
A Model of the Macro Economy
External shocks
Policy levers
DETERMINANTS
Output
Jobs
Prices
Growth
International balances
OUTCOMES
The MACRO ECONOMY:
LO1
The Market:Internal Market Forces
Supply & Demand
Gov’t Intervention
49
A Model of the Macro Economy
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
A Model of the Macro Economy
External shocks
Policy levers
DETERMINANTS
Output
Jobs
Prices
Growth
International balances
OUTCOMES
The MACRO ECONOMY:
LO1
The Market:Internal Market Forces
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
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)
REAL OUTPUT (quantity per year)
(b) Demand shifts
AD0
AD1
FP*
QF
AD0
AS0
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
(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)
REAL OUTPUT (quantity per year)
(b) Demand shifts
AD0
AD1
FP*
QF
AD0
AS0
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
(a) Supply shiftsAS1
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)
REAL OUTPUT (quantity per year)
(b) Demand shifts
AD0
AD1
FP*
QF
AD0
AS0
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
(a) Supply shiftsAS1
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
Demand-Side Theories
(Figure 8.10, pg. 160)
P*
(b) Excessive demand
AS0
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
(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
Demand-Side Theories
(Figure 8.10, pg. 160)
P*
(b) Excessive demand
AS0
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
PR
ICE
LE
VE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
(a) Inadequate demand
AS
AD1
E1
Q1
AD0 AD0
E0
QF
AD2
P2
Q2
E2
E0P*
QF
LO3
98
A Model of the Macro Economy
External shocks
Policy levers
DETERMINANTS
Output
Jobs
Prices
Growth
International balances
OUTCOMES
The MACROECONOMY
LO1
The Market:Internal Market Forces
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
REAL OUTPUT (quantity per year)
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
International balances
OUTCOMES
The MACROECONOMY
LO1
The Market:Internal Market Forces
102
Eclectic Explanations
Eclectic explanations of macro failure draw from both the demand-side and the supply-side of the economy.
LO3
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
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
Long-Run Self Adjustment
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
REAL OUTPUT(quantity per year)
PRIC
E LE
VEL
(ave
rage
pric
e)
The “Natural” Rate of Output
QN
AS
AD2
AD1
P2
P1
LO3
117
REAL OUTPUT(quantity per year)
PRIC
E LE
VEL
(ave
rage
pric
e)
The “Natural” Rate of Output
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
Long-Run Self Adjustment
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?
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