Chapter 8- The Business Cycle 2/25/2019 Chapter 8- The Business Cycle Objective – Students will be able to answer questions regarding the business cycle. SECTION 1 © 2001 by Prentice Hall, Inc.

The Business Cycle The United States’ GDP is not constant from year to year. Instead, the GDP grows most years and then shrinks in some years. The ups and downs in GDP over time is referred to as the business cycle.

The Business Cycle Illustrated:

The Business Cycle Illustrated: Peak temporary maximum in Real GDP. At this point the unemployment rate (u%) is probably below the natural rate of unemployment, and the inflation rate (π%) is probably increasing. Recession The contractionary phase of the business cycle. A period of decline in Real GDP accompanied by an increase in u%. To be classified as a recession, the economic decline must be at least 6 months long.

The Business Cycle Illustrated: Trough The bottom of the business cycle. The u% is probably high and π% is probably low. Recovery The phase of the business cycle where the economy is returning to full employment.

The Business Cycle Illustrated: Important note The various phases of the business cycle last for different amounts of time. In recent history, expansions have lasted years longer than have recessions. The Great Depression is the most notable example of a long recession/trough

The Business Cycle Illustrated: Causes Irregularity of Investment Changes in productivity Changes in total spending (aggregate demand) Durable goods manufacturing is most susceptible to the effects of the business cycle

The Business Cycle Illustrated: Business cycle has become less severe because of technological advancements in supply-chain management and structural changes in U.S. economy.

Section 1 Assessment Describe the four phases of the business cycle. 2. Describe the causes of the business cycle.

Summary: In a paragraph, describe what you have learned today.

Key to Macroeconomic Symbols GDPR – Real GDP (Output) C – Consumption IG – Gross Private Investment G – Government Spending XN – Net Exports (Exports – Imports) w- wages (primary cost of production) T – taxes DI – disposable income X – Exports M – Imports AD – aggregate demand SRAS – short-run aggregate supply LRAS – long-run aggregate supply PL – Price Level SRPC – short-run Phillips curve LRPC – long-run Phillips curve u% - unemployment rate π% - inflation rate SLF – Supply of loanable funds DLF – Demand for loanable funds r% - real interest rate MS – Money Supply MD – Money Demand ER – Excess Reserves i% - nominal interest rate DR – discount rate RR – reserve ratio OMO – open market operations (buying and selling gov’t bonds) FOREX – foreign exchange market D$ - demand for dollars in FOREX S$ - supply of dollars in FOREX $ - value of dollar in FOREX ↑ - increase ↓ - decrease → - shift right (increase) ← - shift left (decrease) .: - therefore Δ - change

Self-correcting economy: below full-employment (recession) Assume recessionary gap with flexible wages (w) u% ↑.: w↓ .: SRAS→.: GDPR↑ & PL↓.: u%↓ & π%↓ = SRPC← Self-correcting economy: above full-employment (inflation) Assume inflationary gap with flexible wages (w) u%↓ .: w↑ .: SRAS←.: GDPR↓ & PL ↑.: u%↑ & π%↑ = SRPC→ Expansionary fiscal policy on economy below full-employment (recession) Assume recessionary gap with sticky wages (note: DI = disposable income) T↓.: DI↑.: C↑.: AD→.: GDPR↑ & PL↑.: u%↓ & π%↑ = move up/left along SRPC OR G↑.: AD→.: GDPR↑ & PL↑.: u%↓ & π%↑ = move up/left along SRPC Contractionary fiscal policy on economy above full-employment (inflation) Assume inflationary gap T↑ .: DI↓.: C↓ .: AD← .: GDPR↓ & PL↓ .: u%↑ & π%↓ = move down\right along SRPC G↓ .: AD← .: GDPR↓ & PL↓ .: u%↑ & π%↓ = move down\right along SRPC Expansionary monetary policy on economy below full-employment (recession) Assume recessionary gap with sticky wages Fed buys bonds, DR↓, and/or RR↓ .: ER↑ .: MS→ .: i%↓ .: IG↑ .: AD→.: GDPR↑ & PL↑.: u%↓ & π%↑ = move up/left along SRPC Contractionary monetary policy on economy above full-employment (inflation) Fed sells bonds, DR↑, and/or RR↑ .: ER↓ .: MS ← .: i%↑ .: IG ↓ .: AD← .: GDPR↓ & PL↓ .: u%↑ & π%↓ = move down\right along SRPC

‘Crowding In’ of Gross Private Investment (effect of budget surplus) ‘Crowding Out’ of Gross Private Investment (effect of deficit spending) Assume Expansionary Fiscal Policy (G↑ and/or T↓ .: government budget moves toward deficit) deficit spending .: DLF → or SLF ← .: r%↑ .: IG ↓ (partially or completely offsets intended increase in AD) ‘Crowding In’ of Gross Private Investment (effect of budget surplus) Assume Contractionary Fiscal Policy (G↓ and/or T ↑ .: government budget moves toward surplus) budget surplus .: DLF ← or SLF→ .: r% ↓ .: IG↑ (partially or completely offsets intended decrease in AD) Expansionary Fiscal Policy Net Export Effect (counters policy) deficit spending .: DLF → or SLF ← .: r%↑ .: D$ → .: $↑ .: U.S. goods/services relatively expensive and foreign goods/services are relatively cheap .: X↓ and/or M↑ .: XN ↓ Contractionary Fiscal Policy Net Export Effect (counters policy) budget surplus .: DLF ← or SLF→ .: r% ↓ .: S$ → .: $↓ .: U.S. goods/services relatively cheap and foreign goods/services are relatively expensive .: X↑ and/or M↓ .: XN↑ Expansionary Monetary Policy Net Export Effect (reinforces policy) Fed buys bonds, DR↓, and/or RR↓ .: ER↑ .: MS → .: i%↓ .: S$ → .: $↓ .: U.S. goods/services relatively cheap and foreign goods/services are relatively expensive .: X↑ and/or M↓ .: XN↑ Contractionary Monetary Policy Net Export Effect (reinforces policy) Fed sells bonds, DR↑, and/or RR↑ .: ER↓ .: MS↓ .: i%↑ .: D$ → .: $↑ .: U.S. goods/services relatively expensive and foreign goods/services are relatively cheap .: X↓ and/or M↑ .: XN ↓