We in America are nearer to the final triumph over poverty than ever before in the history of any land…We 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! 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? The Business Cycle

Out of the Great Depression grew a clamor for answers to why it was happening People were seeking answers…and 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 The Business Cycle

First…some 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 Macroeconomics

Inflation and Unemployment: – 4 – Inflation Unemployment Source: U.S. Bureau of the Census, The Statistics of the United States, 1957

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 Historical Cycles

The Business Cycle Trough Peak REAL GDP TIME Growth trend Peak Trough Contraction Expansion

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 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 long- term trend occurred during the Great Depression The Business Cycle

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.

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 The Business Cycle

Business Slumps Dates Duration (months) Percentage Decline in Real GDP Peak Unemployment Rate Aug. ‘29–Mar. ‘ % 24.9% May ‘37 –June ‘ Feb. ‘45 –Oct. ‘ Nov. ‘48–Oct. ‘ July ‘53–May ‘ Aug. ‘57–Apr. ‘ Apr. ‘60–Feb. ‘ Dec. ‘69–Nov. ‘ Nov. ‘73–Mar. ‘ Jan. ‘80–July ’ July ‘81–Nov. ‘ July ‘90–Feb. ‘ Mar. ‘01–Nov. ‘ Dec 07– ? ? ?

Financial Variables and the Business Cycle Financial variables, such as stock and bond prices, are procyclical and tend to be leading the business cycle The interest rate paid on short-term U.S. government bonds, known as Treasury bills, is both procyclical and lagging

Financial Variables and the Business Cycle (cont’d) The spread (difference in interest rates) between long-term and short-term government bonds is leading and procyclical, and it is a good predictor of recessions The spread between interest rates on corporate bonds and government bonds is countercyclical as companies are more likely to run out of money in recessions and thus have to pay higher interest rates for corporate bonds

FIGURE 8.6 Stock Prices,

FIGURE 8.7 Interest Rates on U.S. Treasury Bills,

FIGURE 8.8 Credit Spreads and Spreads Between Long and Short-Term Bonds, (a)

FIGURE 8.8 Credit Spreads and Spreads Between Long and Short-Term Bonds, (b)

Both Keynes and the Classical economists agreed that business cycles occur, but disagreed on whether they’re 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? A Model of the Macro Economy

The Macro Economy Internal market forces External shocks Policy levers DETERMINANTS Output Jobs Prices Growth International balances OUTCOMES MACRO ECONOMY The primary outcomes of the macro economy are output of goods and services (GDP), jobs, prices, economic growth, and international balances…Outcomes result from the interplay of internal market forces, external shocks, and policy levers

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 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 Macroeconomic Performance

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 doesn’t explain how the 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 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 Aggregate Demand and Supply

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 Aggregate Demand

REAL OUTPUT PRICE LEVEL 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 Aggregate Demand

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 Aggregate Supply

PRICE LEVEL REAL OUTPUT Aggregate supply

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 Macro Equilibrium

PRICE LEVEL REAL OUTPUT QEQE PEPE Aggregate demand Aggregate supply E D1D1 S1S1 P1P1 Macro equilibrium

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 Macro Failures

An Undesired Equilibrium PRICE LEVEL QEQE PEPE Aggregate demand Aggregate supply E Equilibrium output Full-employment output (Goal) QFQF P* F Where we’d like to be! Where we are!

An Undesired Equilibrium PRICE LEVEL QEQE PEPE Aggregate demand Aggregate supply E Equilibrium output QFQF P* F Goal: Desired price level Actual price level

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 Instability

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 AS and AD Shifts

Macro Disturbances F P* QFQF AS 0 PRICE LEVEL REAL OUTPUT (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL REAL OUTPUT (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 H Example: OPEC raises price of oil, Causing production costs to rise 9/11 affects physical and economic security; AD shifts left

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 Competing Theories of Short-Run Instability

Demand-Side Theories P* (b) Excessive demand AS 0 PRICE LEVEL REAL OUTPUT PRICE LEVEL REAL OUTPUT (a) Inadequate demand AS AD 1 E1E1 Q1Q1 AD 0 E0E0 QFQF AD 2 P2P2 Q2Q2 E2E2 E0E0 P* QFQF

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 Keynesian Theory

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 isn’t 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 Monetary 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? 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 Supply-Side Theories

AD 0 Q3Q3 P3P3 QFQF E0E0 AS 0 REAL OUTPUT PRICE LEVEL P0P0 AS 1 E3E3

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: Don’t interfere with the market; let markets self adjust Policy Strategies

There are a host of tools available –Classical laissez faire –Fiscal policy –Monetary policy –Supply-side policy –Trade policy Selecting 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 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 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 Policy Tools

International Business Cycles In a globalized economy, business cycles of many countries are correlated with those of the United States As financial markets throughout the world have become more integrated as well, the financial crisis in the United States during the fall of 2008 led to a global financial crisis and subsequently simultaneous economic contractions around much of the world

FIGURE 8.9 International Business Cycles,

International Comovements

International transmission mechanisms If these are similar between countries, what causes them to be similar? Closer together, more trade they do (Gravity model) more likely GDP will be affected in both countries Capital flows – depends on FDI, whether the country is a major financial market center. Wealth effects from 24/7 asset markets – e.g. stockmarkets tend to rise and fall in tandem

International business cycles  International in the sense that is there a “tipping point” such that if more than a certain number of countries go into recession, the world goes into recession.  Other point of view might be that certain type of event that causes a recession might make it more likely to be a global recession.  Examples: Great depression, Oil price shocks of the 70s, current Great recession. Counterexamples: South East Asian crisis, Debt crisis of the mid-1980s, Japan in the 1990s.

Could there be independent regional cycles? Could regional trade blocs promote independent business cycles? Economic logic – more trade and investment linkages between countries on same continent, more likely that regional business cycles will occur. Michael Artis (Univ of Manchester, UK) first to assert that there is an EU business cycle. Led to idea that maybe, like EU, other regional integration agreements should look to integrate further. Most research appears to show that indeed there is an EU cycle. Similarly there is a NAFTA cycle as well, but this is because US dominates NAFTA.

Shocks – symmetric vs asymmetric Symmetric vs asymmetric Across several countries vs just one country But can asymmetric shocks become symmetric?

Synchronization Another way to think of this is in terms of a concept from physics known as “synchronization”. This is like correlation except that we are looking at whether cycles are of the same periodicity, and are phased the same (i.e. move together through time).  Using this approach you can compare cycles between different countries and see how closely they behave through time.  Recent research tends to suggest that more synchronization comes from globalization than from regional trading blocs, but this can reverse if there is a major integration initiative going on.