Ch. 14. The Business Cycle. Different theories of the business cycle Keynesian Monetarist Real Business Cycle Origins of and the mechanisms at work during the Great Depression Two Big Upfront Suggestions  You can use this chapter as a serious application chapter that uses a lot of background material on AS-AD and the deeper models that lie behind LAS, SAS, and AD. But it is not advisable to attempt to teach this chapter in its entirety unless you’ve laid the groundwork described in “Where we have been.”  You an also use this chapter ass a source of material on the U.S. economy during the 1990s and 2000s and the Great Depression. You can use most of what is in these parts of the chapter (parts 1, 4, and 5) any time after Chapter 23.

Business Cycle Patterns The business cycle is an irregular and nonrepeating up-and-down movement of business activity that takes place around a generally rising trend. http://www.nber.org/cycles.html Recessions are getting shorter. Expansions are getting longer. The advent of graphing calculators has meant that students are much more familiar with the notion of a cycle than they used to be. It is important to make sure that students understand that the business cycle is only a cycle in the sense that real GDP fluctuates around a trend, and it in no way resemble a sine curve. It is useful to look at data to get across the point that in the business cycle, both the amplitude and the frequency of the cycle are highly irregular, and that the movement of the graph is not always smooth. It is impressive to students to show them how the depth of recessions has tended to become less over time, and the length of expansions more. The contrast between pre and post 1940 is fairly striking; one way to explain it is to talk about the size of government and the extent of automatic stabilizers. Very few students will be able to guess correctly what proportion of wage earners paid income or payroll taxes in 1935; ask them, and then tell them the answer (less than 5 percent). The ideas of impulse and propagation mechanism are fairly intuitive, and the discussion in the text should get them across well; what students may need some help understanding is that there are alternative theories of what the impulses and mechanisms are, and that we will be looking at several alternatives.

The Role of Investment All theories of the business cycle agree that investment and the accumulation of capital play a crucial role. Recessions begin when investment slows and recessions turn into expansions when investment increases. Investment and capital are crucial parts of cycles, but are not the only important parts.

Cycle Patterns, Impulses, and Mechanisms The AS-AD Model All business cycle theories can be described in terms of the AS-AD model. Two business cycle theories Aggregate demand theories Real business cycle theory The text shows the students how the schools of macroeconomics relate to each other, discusses the different impulses and mechanisms stressed by each school, and presents a clear and non-judgmental account of the alternative views. You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it “hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic. You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics.

Aggregate Demand Theories of the Business Cycle Three types of AD theories Keynesian Monetarist Rational expectations It is worth quickly reviewing the AS-AD model, because this becomes the organizing principle for distinguishing between the alternative theories: all can be cast into the AS-AD framework, with the differences between them being what moves, how, and why. The Keynesian model is relatively straightforward and easy for students to grasp, being based on business sentiment shifts changing investment. Similarly, Monetarist theory is based on changes in the growth rate of money. An obvious question students will think of is why would the Fed change monetary policy in ways that produce a cycle? Point out that this may not be deliberate, but may be caused by miscalculations of what is going on in the economy, or changes in the relationship between monetary policy and aggregate demand arising from financial innovation or events elsewhere in the world. Rational expectations theories to a large extent broaden the Keynesian explanation by seeing the impulse as arising from unpredictable errors in forecasting aggregate demand, rather than fluctuations in investment alone.

AD Theories of Business Cycle Keynesian Theory Volatile expectations are the main source of business cycle fluctuations. Nominal wages are rigid downward, but not upward. Keynesian Impulse “Animal spirits” change radically in response to a small bit of new information. Expected future sales and expected future profits, which changes investment.

AD Theories of Business Cycle Keynesian Cycle Mechanism Changes in “animal spirits” lead to change in investment AD shifts a flat (or nearly so) SAS curve. Changes in I have multiplier effects e.g. as income rises, consumption rises, causing AD to shift further to the right, etc.

AD Theories of Business Cycle A Keynesian recession. Real wages and productivity should rise during a recession.

AD Theories of Business Cycle A Keynesian expansion. Real wages and productivity should fall during an expansion.

AD Theories of Business Cycle Monetarist Theory fluctuations in the quantity of money are the main source of business cycle fluctuations in economic activity. Monetarist Impulse The initial impulse is the growth rate of the money supply.

AD Theories of Business Cycle Monetarist Cycle Mechanism A change in the monetary growth rate that shifts the AD curve combined with an upward sloping SAS curve. An increase in the growth rate lowers interest rates and the value of the dollar, shifting AD rightward multiplier effects amplify the effect. A decrease in the monetary growth rate has opposite effects.

AD Theories of Business Cycle Recession phase of Monetarist business cycle. Real wages and productivity should rise during a recession.

Aggregate Demand Theories of the Business Cycle Expansion phase of monetarist business cycle. Real wages and productivity should fall during an expansion.

AD Theories of Business Cycle Rational Expectations Theories New classical theory Unanticipated fluctuations in AD are the main source of economic fluctuations. New Keynesian theory Unanticipated fluctuations in AD are the main source of economic fluctuations but also leaves room for anticipated fluctuations in AD to play a role.

AD Theories of Business Cycle A rational expectations business cycle recession.

AD Theories of Business Cycle Rational expectations expansion.

Real Business Cycle Theory technological change creating random fluctuations in productivity is the source of the business cycle. The RBC Impulse The impulse in RBC theory is the growth rate of productivity that results from technological change. The RBC approach distinguishes itself from the other theories by positing that fluctuations have their origins in real phenomena, not money, business sentiments, or rational expectations not being fulfilled. Intuitively, it is appealing to students: they are all aware of technical progress, and it is intuitively a very small step to acceptance that the pace of technological change varies, and so does the pace of productivity change, and that will produce fluctuations in the demand for capital and labor. The only difficulty with this is that it is much easier to grasp intuitively in terms of fluctuations in the rate at which these things change than in the absolute shifts in curves that we translate it into when we simplify to talking in terms of levels and a fixed potential GDP rather than fluctuations about trend growth. It may be helpful for students to first expound on the ideas intuitively in terms of trend growth rates and fluctuations about them, and then remind students that in order to simplify, we take out the trend growth and talk about the business cycle as though it was fluctuations about a fixed potential GDP in a static economy. There is a potential for confusion here, but it applies to all discussions about the business cycle, which in reality is fluctuations about trend growth, but which in order to be able to use the AS-AD framework we have simplified to a static situation.

Real Business Cycle Theory The RBC Mechanism Two immediate effects follow from a change in productivity Investment demand changes The demand for labor changes

Real Business Cycle Theory The capital and labor markets in a real business cycle recession.

Real Business Cycle Theory A decrease in productivity lowers firms’ profit expectations and decreases both investment and labor demand

Real Business Cycle Theory The interest rate falls.

Real Business Cycle Theory The lower real interest rate lowers the return from current work so the supply of labor decreases.

Real Business Cycle Theory Employment falls by a large amount and the real wage rate falls by a small amount. Labor productivity decreases.

Real Business Cycle Theory Money in RBC plays no role in the RBC theory; RBC theory emphasizes that real things, not nominal or monetary things, cause business cycles. Cycles and Growth The shock that drives the cycle in RBC is the same force that generates economic growth. RBC concentrates on its SR consequences: growth theory concentrates on its long-term consequences.

The Great Depression In early 1929 unemployment was at 3.2 percent. In October the stock market fell by a third in two weeks. In 1930, the price level fell by about three percent and real GDP declined by about nine percent. Over the next three years real GDP declined 29% price level fell 24% Unemployment peaked at 25% Major transfer programs nonexistent. Take a few moments in class to describe various facts about the Great Depression and its impact. Strive to reinforce your students’ understanding of the importance of this watershed event. The fact that real GDP fell by about 30 percent from 1929 to 1933 is impressive, but in an abstract fashion. Emphasize the unemployment rate, because it is easy for students to identify with unemployment. Point out that the unemployment rate peaked at between 20 to 25 percent for several years and averaged over 10 percent for the decade of the 1930s. To really bolster what these unemployment rates mean, remind the students that an unemployment rate of 25 percent means that one out of every four workers is unemployed. Ask them to imagine what it must have been like to be unemployed at that time, especially because this was an era with no major transfer programs such as unemployment compensation. Indeed, discuss with the students that at the time there were sincere doubts whether the capitalist system would continue; many people looked to other forms of economic organization—socialism, communism, or fascism—as answers to the Great Depression. Continue by describing how the Great Depression still affects our economy today. In particular, such institutions as Social Security, federal insurance for bank deposits, and unemployment compensation were initiated during the 1930s. Perhaps more importantly, the idea that the federal government should take an active role in the nation’s economy matured during this decade. These features are so common that it is hard to envision their absence. But in a real way, we owe their presence — whether for good or bad — to the Great Depression!

The Great Depression The 1920s were a prosperous era but as they drew to a close increased uncertainty affected investment and consumption demand for durables. The stock market crash of 1929 heightened uncertainty. The uncertainty caused investment to fall, which decreased AD and real GDP in 1930. Until 1930, the Great Depression was similar to an ordinary recession.  Many economists, even younger ones, and especially older ones, were initially attracted to macroeconomics because at one point in their lives, they were personally touched by the plight of welfare recipients. They thought that the best way to lessen their burden was to reduce the unemployment rate, so they became economists. If you are one of these economists, share your motivation with your students. This sort of interest can become contagious and enhance students’ enthusiasm for learning the material. This chapter and the next (which deals with macroeconomic policy) is an excellent opportunity to point out the importance of macroeconomics. People’s lives are adversely affected by recessions and slow economic growth. There are lots of examples you can give: some people are forced on welfare; some college students can’t find jobs for long periods after graduating; indeed, some families are unable to send their children to college at all; and some older workers are forced to retire well before they would like while others are forced to keep working longer than they had planned. All these costs could be avoided if the nation could eliminate recessions and slow growth. Ask the students if this state of affairs is possible. And do not be afraid to offer your opinion.

The Great Depression Why the Great Depression Happened Some economists think that the decrease in investment was the primary cause that decreased aggregate demand and created the depression. Other economists (notably Milton Friedman & monetarists) assert that inept monetary policy was the primary cause of the decrease in aggregate demand.

The Great Depression Unprecedented number of bank failures Bank failures led to bank panics and more failures. Huge contraction in the money supply that was not offset by the Federal Reserve. Difficult to borrow money.

The Great Depression Can It Happen Again? Four reasons make it less likely that another Great Depression will occur Bank deposit insurance Fed as lender of last resort. Taxes and government spending Multi-income families Students will often think that another Great Depression is very unlikely to happen. Get some data from, e.g., the World Bank’s Web site, and show them what happened to real GDP in parts of the former Soviet Union in the early 1990s, and in some of the South East Asian economies in 1998. If you want to take the time, you can have an interesting discussion on the topic of how, for example, Indonesia’s real GDP can fall 25 percent but reported unemployment hardly change (without unemployment compensation, people cannot afford to be unemployed; the two million or so who did lose jobs became either self-employed or unpaid family workers). The business cycle has very real impacts on people’s lives, and although not as dramatic, the impacts in the United States are just as real. Asking students if they know anyone who lost a job or had their hours reduced during the recession is always a worthwhile exercise just after one.