Unit 8 The Business Cycle The Top 5 Concepts Macroeconomics Unit 8 The Business Cycle The Top 5 Concepts

Introduction In this unit you learn about the factors which influence the slope and position of the demand and supply curves. You are also exposed to the main economic theories about the demand and supply curves. When the economy is at equilibrium, everything is not always OK. In this unit you will begin to understand that our economy moves through cycles and those cycles may not always be at a desirable level of output.

Business Cycles The United States economy has had frequent periods of growth and decline in its history. The periods of growth and decline are called business cycles. Business cycles are alternating periods of economic growth and contraction. In this chapter we will discuss the causes of business cycles and some of the theories that economists use to explain cycle changes.

Concept 1: Classical View of Business Cycles General belief of classical or laissez-faire economists prior to 1930s was that the economy was inherently stable. The economy at times “self-adjusts” to deviations from long-term growth. Short periods of output declines and layoffs may occur, but the economy would correct itself. A key component of the classical theory was that wages and prices were flexible.

Concept 1: Classical View of Business Cycles Flexible prices refers to the belief that when demand for goods and services slows, the prices will drop until demand rises again. Flexible wages refers to the belief that as demand falls and more workers are laid off, the increased competition for jobs will cause wages to fall. More workers can then be hired for lower wages. The classical view of the macro economy is stated in Say’s Law: supply creates its own demand. The view stated that whatever was produced will be sold.

Concept 1: Classical View of Business Cycles Say’s law further stated that all workers who sought employment will be employed. Unsold goods and unemployed labor could occur, but adjustments to wages and prices would eventually eliminate them. The Great Depression proved the classical theory wrong.

Concept 2: Keynesian View of Business Cycles John Maynard Keynes was a British economist whose theories were popular during the 1930s and beyond. Keynes believed that a market-driven economy is inherently unstable. Changes in output, prices, or unemployment would be magnified by the invisible hand. Keynes believed that an economy can’t rely upon the market mechanism to correct the problem.

Concept 2: Keynesian View of Business Cycles Keynes believed that government intervention was needed to control the instability of a market economy. If the economy slows down, the government should buy more output, employ more people, increase income transfers, and make more money available. If the economy overheats, then the role of government is to slow the economy down by increasing taxes, reducing government spending, and by making money less available.

Business Cycles A recession is a decline in total output (real GDP) for two or more consecutive quarters. A growth recession is a period in which real GDP grows, but at a rate below the long-term trend of 3 percent. Recent recessions: 1990 – 1991, 2001. The economy of 2002 – 2003 was considered to be in a growth recession.

Concept 3: Aggregate Demand Aggregate demand (AD) is the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus. AD reflects the behavior of all buyers in the marketplace. The AD curve indicates how the real value of purchases varies with the average level of prices.

Aggregate Demand Curve PRICE LEVEL (average price) REAL OUTPUT (quantity per year) A line graph showing the aggregate demand curve. The line slopes downward and to the right.

Concept 3: Aggregate Demand The downward slope and angle of the AD curve is explained by three factors: The real-balances effect The foreign-trade effect The interest-rate effect

Real-Balances Effect The real-balances effect refers to the real value of money. The real value of money is determined by how many goods and services each dollar will buy. Periods of high inflation and/or high prices reduce your ability to purchase goods and services. Periods of low inflation and/or price reductions increase your ability to purchase goods and services. The real-balances effect then is dependent upon changes in average prices. As inflation declines the AD curve would shift to the right as more output is consumed.

Foreign-Trade Effect The foreign-trade effect refers to the relative price of imports compared to the price of U.S. produced goods. If U.S. produced goods prices are rising, more imports will be purchased. If U.S. produced goods prices are falling, more domestic goods will be purchased. Consumers in other countries also buy more U.S. exports when the prices fall, and buy less when the prices increase.

Interest-Rate Effect Prices of goods and services tend to affect the demand for money. As prices fall, the demand for money is lower. Why? Because goods and services cost less, therefore less borrowing is needed. When the demand for money is lower, interest rates fall. Lower interest rates eventually produce more borrowing to purchase goods and services. This process is known as the Interest-Rate Effect.

Concept 4: Aggregate Supply Aggregate supply (AS) is 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. Producers of goods and services determine how much they are willing to supply by the price they receive, along with their costs and production capabilities. The AS curve indicates the varying levels of output producers will supply at different price levels.

Aggregate Supply Curve PRICE LEVEL (average price) REAL OUTPUT (quantity per year) A line graph of the aggregate supply curve. The line slopes upward and to the right.

Concept 4: Aggregate Supply The AS curve slopes upward because of: The Profit Effect The Cost Effect

The Profit Effect Producers can only make a profit on the goods and services they sell if the prices they receive are greater then the costs to produce the good or service. The rate of output, or the amount of product that sellers will produce, will increase when the price level rises. This is the profit effect.

Cost Effect Many costs associated with producing a good or service are not constant. The cost of renting a building may remain the same regardless of output, but the price of labor may increase if more people are employed or more overtime is paid. The cost effect refers to the increase in costs as output is increased. At high rates of output cost pressures are very high which leads to the supply curve bending straight up. Examples of cost pressures include paying overtime wages and expedited shipping costs.

Concept 5: Macro Equilibrium The aggregate supply and demand curves represent the market activity of the whole economy. Macro equilibrium occurs at the point at which AD and AS cross. At this point, the combination of price level and real output is compatible with both buyers and sellers.

Macro Equilibrium Aggregate Supply PRICE LEVEL (average price) Equilibrium Point Aggregate Demand REAL OUTPUT (quantity per year) A line graph showing the aggregate demand and supply curves and the equilibrium point.

Concept 5: Macro Equilibrium The macro equilibrium point is unique, but it is generally not a constant point. Changes in the determinants of demand and supply will cause the AD and AS curves to shift. For example an increase production costs can shift the AS curve to the left. An increase in consumer income can shift the AD curve to the right. Changes in prices will cause movements along the AD and AS curves.

Concept 5: Macro Equilibrium There are two potential problems with Macro Equilibrium: Undesirability – The price and output choices may not satisfy our macroeconomic goals; we may not be at full employment GDP output or the inflation rate is too high. Instability – Macro disturbances may change the equilibrium point. A change in any determinants can cause a shift in AD or AS which can change the equilibrium point.

An Undesired Equilibrium Point Aggregate Demand Aggregate Supply Price Level (average price) E PE QE F PF QF Equilibrium Output Full employment A graph of the aggregate demand and supply curves indicating an equilibrium rate of output below the level of output necessary for full employment Real Output (quantity per year)

Undesired Equilibrium Point The preceding chart illustrates a macro equilibrium point that is not desired. At point E, average prices are higher and the quantity of output is not sufficient to reach full employment output. A rightward shift of the AS curve to intersect the demand curve at point F would produce lower prices and higher output. The new macro equilibrium point would be at full employment output.

Short-Run Instability Most economic theories concentrate on shifting the AD and/or AS curves to correct economic problems. Classical theorists believed that the economy would naturally gravitate towards full employment. If the economy was not at full employment, then prices and wages fall until full employment is restored.

Short-Run Instability – Demand-Side Theories Keynes believed that inadequate aggregate demand would cause persistently high unemployment. Government policies should be directed at increasing aggregate demand to reduce unemployment. Increased government spending, decreasing taxes, or increasing transfer payments are ways to increase AD; shift AD right. Decreased government spending, higher taxes, or decreasing transfer payments are ways to decrease AD; shift AD left.

Short-Run Instability – Demand-Side Theories Monetary theory is another economic theory used to change aggregate demand. Increasing the supply of money by reducing interest rates and changing bank reserve requirements, can cause AD to shift right. Decreasing the supply of money by increasing rates, changing bank reserve requirements, can cause AD to shift left.

Short-Run Instability – Supply-Side Theory The basis of supply-side theory is that economic downturns may be caused by an inadequate amount of aggregate supply. As a result, inflation and/or unemployment may result from inadequate AS. The focus is to shift AS to the right. Government’s role is to reduce taxes and regulation, invest in infrastructure, increase human capital investment, and provide incentives for capital investment. These steps will shift AS to the right.

Short-Run Instability – Eclectic Explanations Eclectic explanations for economic problems are based upon the assumption that the problems may be both AD and AS based. Since the problems likely occurred because of AD and AS failures, the solutions must adjust both the AD and AS curves. Therefore eclectic theorists use both demand side and supply side policies to correct economic problems.

Long-Run Self-Adjustment Classical and monetary theorists believe that the long-run AS curve is vertical. This means that shifts in AD would only affect price, not output. There is considerable disagreement as to whether or not this is true. The important concept may be to concentrate economic policies on the short-run to maintain stability. In the short-run there is general agreement that the AS curve is upward sloping and shifts in the AS curve will produce changes in prices and output.

Economic Policy and Theory – An Overview Classical Theory – Laissez-faire and the natural gravitation towards full employment. Flexible wages and prices. Fiscal Policy – The use of government taxes and spending to alter macroeconomic outcomes. This is Keynesian policy. Monetary Policy – The use of money and credit controls to influence macroeconomic outcomes. In the U.S., monetary policy is controlled by the Federal Reserve.

Economic Policy and Theory – An Overview. Supply-Side Policy – The use of tax incentives, regulation or deregulation, infrastructure and human capital investment, and other mechanisms to increase the ability and willingness to produce goods and services. Trade Policy – Not a basic economic theory but often used with other theories. Changing trade barriers like tariffs and quotas can increase/decrease the supply of goods and can affect the price. Lower priced imported goods can reduce inflationary price pressures domestically.

Economic Policy and Theory – An Overview Eclecticism – Mixing both demand-side and supply-side policies to solve economic problems. This theory recognizes that both AD and AS may cause problems. Solutions to economic problems use both demand side and supply side tools.

Summary Business cycles, Say’s law, classical view and Keynesian view. Recession and growth recession. Aggregate demand, AD curve. Real-balances, foreign-trade, interest-rate effect. Aggregate supply, AS curve. Profit effect, cost effect. Macro equilibrium and problems. Full Employment GDP.

Summary AD shifts, AS shifts. Short-run instability theories: Keynesian, Monetary, Supply-side, Eclectic. Fiscal Policy, monetary policy, supply-side policy. Eclecticism.