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.

4 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. Fix These Sections (5-6) (redundant

5 1. Stable or Unstable?

6 Macroeconomics The Business Cycle: alternating periods of economic growth and contraction.

7 The Business Cycle (Figure 8.2, pg. 148) Trough Peak REAL GDP (units per time period) TIME Growth trend 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.

9

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 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:

16 And then…

17 The Great Depression

18 The Great Depression

19 The Great Depression

20 The Great Depression

21 The Great Depression

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: (Figure 8.1, pg. 147) – 4 – 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 1. Stable or Unstable?

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 REAL GDP (units per time period) TIME Growth trend Peak Trough

31 The Business Cycle in U.S. History (Figure 8.3, pg. 148)

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.

33 The Great Depression 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 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 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 The latest recession started in the 4 th quarter of 2007 and lasted until June 2009.

42 3. A Model of the Macro Economy

43 A Model of the Macro Economy Keynes and Classical economists agreed that business cycles occur. They disagreed on whether they’re an appropriate target for government intervention.

44 Macroeconomic Performance Determinants of macro performance include: Internal market forces - population growth, spending behavior, intervention & innovation. External shocks - wars, natural disasters, trade disruptions, etc. Policy levers - government policy: tax policy, changes in the availability of money, credit regulation, etc. LO1

45 Macroeconomic Performance Macro outcomes include: Output - total value of goods and services produced. 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 payments balances with other countries. LO1

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 MACRO ECONOMY LO1

47 Internal market forces DETERMINANTS A Model of the Macro Economy MACRO ECONOMY LO1 The MACRO ECONOMY:

48 A Model of the Macro Economy External shocks Policy levers DETERMINANTS OutputJobsPricesGrowth 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 OutputJobsPricesGrowth 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) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) QEQE PEPE Aggregate demand Aggregate supply 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) PRICE LEVEL (average price) Aggregate demand LO2

56 Aggregate Demand The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices. LO2

57 Aggregate Demand REAL OUTPUT (quantity per year) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) Aggregate demand LO2

65 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?

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) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) 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) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) D1D1 S1S1 QEQE PEPE Aggregate demand Aggregate supply P1P1 E LO3

76 Macro Equilibrium PRICE LEVEL (average price) REAL OUTPUT (quantity per year) QEQE PEPE Aggregate demand Aggregate supply 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) PRICE LEVEL (average price) QEQE PEPE Aggregate demand Aggregate supply E Equilibrium output Full-employment output QFQF P* F LO3 Desired price 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

81 An Undesired Equilibrium PRICE LEVEL (average price) Aggregate demand Aggregate supply QEQE PEPE E Equilibrium output Desired price level QFQF P* F 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) F P* QFQF AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 H LO3

84 The Business Cycle (Figure 8.2, pg. 148) Trough Peak REAL GDP (units per time period) TIME Growth trend 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) F P* QFQF AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 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) F P* QFQF AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 H LO3

89 Macro Disturbances F P* QFQF AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 H LO3

90 5. Competing Theories of Short-Run Instability (& Corresponding Remedies) Demand-Side Theories. Keynesian (& fiscal policy). Monetarist (& monetary policy). Supply-Side Theories

91 Competing Theories of Short-Run Instability Macro controversies and debate focus on the (shape of the) AS and AD curves… …AND THE POTENTIAL TO SHIFT THEM..... LO3

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

93 Demand-Side Theories P* (b) Excessive demand AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Inadequate demand AS AD 1 E1E1 Q1Q1 AD 0 E0E0 QFQF AD 2 P2P2 Q2Q2 E2E2 E0E0 P* QFQF 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 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Inadequate demand AS AD 1 E1E1 Q1Q1 AD 0 E0E0 QFQF AD 2 P2P2 Q2Q2 E2E2 E0E0 P* QFQF 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 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Inadequate demand AS AD 1 E1E1 Q1Q1 AD 0 E0E0 QFQF AD 2 P2P2 Q2Q2 E2E2 E0E0 P* QFQF LO3

98 A Model of the Macro Economy External shocks Policy levers DETERMINANTS OutputJobsPricesGrowth International balances OUTCOMES The MACRO ECONOMY 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) AD 0 Q3Q3 P3P3 QFQF E0E0 AS 0 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) P0P0 AS 1 E3E3 LO3

101 Supply-Side Theory External shocks Policy levers DETERMINANTS OutputJobsPricesGrowth International balances OUTCOMES The MACRO ECONOMY 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

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

106 Classical Laissez Faire The laissez-faire approach requires no tools. The economy naturally self-adjusts to full employment. LO3

107 Fiscal Policy (Demand-Side) Fiscal policy (Keynesian): government alteration of macroeconomic outcomes through the adjustment of: taxing, and … spending. The government can shift the AD curve to the right by: spending more money, or … cutting taxes. LO3

108 Monetary Policy (Demand-Side) Monetary policy: the influence macroeconomic outcomes through the adjustment of the: money/credit supply. The government can shift the AD curve to the right by Lowering interest rates to stimulate demand: Encourages consumers and businesses to borrow and spend more. LO3

109 Supply-Side Policy Supply-side policy seeks to shift the aggregate supply curve. Supply-side policy is the use of: tax incentives, deregulation, and… other mechanisms …in order to … BRING PRODUCTION COSTS DOWN in order to increase the ability and willingness to produce goods and services. (to increase supply) 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 (Q N ) by fundamental determinants. LO3

113 REAL OUTPUT(quantity per year) PRICE LEVEL (average price) The “Natural” Rate of Output (Figure 8.12, pg. 162) QNQN AS AD 1 P1P1 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) PRICE LEVEL (average price) The “Natural” Rate of Output QNQN AS AD 2 AD 1 P2P2 P1P1 LO3

117 REAL OUTPUT(quantity per year) PRICE LEVEL (average price) The “Natural” Rate of Output QNQN AS AD 1 AD 2 P1P1 P2P2 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?

120 Three Basic Policy Strategies Policy Strategy #1: Shift the aggregate demand curve – find and use policy tools that: stimulate total spending, …or… restrain total spending. “Demand-Side Policy.” Fiscal or monetary. LO3

121 Three Basic Policy Strategies Policy Strategy #2: Shift the aggregate supply curve – find and implement policy levers that: reduce the costs of production: …or that otherwise … stimulate more output at every price level. “Supply-Side Policy.” LO3

122 Three Basic Policy Strategies Policy Strategy #3: Laissez-faire – Don’t interfere with the market; let markets self adjust. “Classical Policy.” LO3

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved The Business Cycle End of Chapter 8