Slide 17-1 Copyright © 2000 Addison Wesley Longman, Inc. CHAPTER 17 The Business Cycle Chapter 34 in Economics Michael Parkin ECONOMICS 5e

Slide 17-2 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Distinguish among the different theories of the business cycle Explain the Keynesian and monetarist theories of the business cycle Explain the new classical and new Keynesian theories of the business cycle

Slide 17-3 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain real business cycle theory Describe the origins of and the mechanism at work during two recent recessions Describe the origins of and the mechanisms at work during the Great Depression

Slide 17-4 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Distinguish among the different theories of the business cycle Explain the Keynesian and monetarist theories of the business cycle Explain the new classical and new Keynesian theories of the business cycle

Slide 17-5 Copyright © 2000 Addison Wesley Longman, Inc. Cycle Patterns, Impulses, and Mechanisms The business cycle is an irregular and nonrepeating up-and-down movement of business activity that takes place around a generally rising trend and that shows great diversity.

Slide 17-6 Copyright © 2000 Addison Wesley Longman, Inc. Some Business Cycle Patterns

Slide 17-7 Copyright © 2000 Addison Wesley Longman, Inc. Cycle Patterns, Impulses, and Mechanisms Business Cycle Patterns There is no simple explanation for the causes of the business cycle. There is no way of forecasting when the turning points will come.

Slide 17-8 Copyright © 2000 Addison Wesley Longman, Inc. Cycle Patterns, Impulses, and Mechanisms Cycle Impulses and Mechanisms 1) The economy is like a tennis ball. An outside force changes its direction 2) It also resembles the day to night cycle. No force causes the change

Slide 17-9 Copyright © 2000 Addison Wesley Longman, Inc. Cycle Patterns, Impulses, and Mechanisms Cycle Impulses and Mechanisms 3) Finally, it resembles a rocking horse: Some outside force has to begin the rocking. The cycle continues without any new force being applied. The rocking (cycle) eventually dies unless a new force is applied.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Cycle Patterns, Impulses, and Mechanisms The Central Role of Investment and Capital Recessions begin when investment in new capital slows down. Possibly due to diminishing returns Expansions begin when investment in new capital speeds up.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Distinguish among the different theories of the business cycle Explain the Keynesian and monetarist theories of the business cycle Explain the new classical and new Keynesian theories of the business cycle

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle There are three types of aggregate demand theories. These include: 1) Keynesian Theory 2) Monetarist Theory 3) Rational Expectations Theories

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Keynesian Theory -- John Maynard Keynes The Keynesian theory of the business cycle regards volatile expectations as the main source of economic fluctuations.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Keynesian Impulse The impulse of the business cycle is a change in expected future sales and profits. This changes the level of investment in new capital.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Keynesian Impulse Keynes reasoned that news or rumors of future tax changes, interest rate changes, advances in technology, global economic and political events (for example) affect expectations and investment. Referred to as “animal spirits”

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Keynesian Cycle Mechanism A change in animal spirits which causes a change in investment leads to a cycle mechanism.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Keynesian Cycle Mechanism The cycle mechanism has two key elements: 1) The initial change in investment has a multiplier effect. It changes aggregate expenditure, real GDP, and disposable income

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Keynesian Cycle Mechanism The cycle mechanism has two key elements (cont.): 2) The response of real GDP to a change in aggregate demand. If money wages are sticky, a decline in aggregate demand brings recession.

Slide Copyright © 2000 Addison Wesley Longman, Inc. AD 1 A Keynesian Recession Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS SAS AD 0 ab A fall in animal spirits decreases aggregate demand... 0 …and, with sticky wages, brings recession

Slide Copyright © 2000 Addison Wesley Longman, Inc. A Keynesian Expansion Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) SAS LAS AD 1 b AD 2 c d …and, with flexible wages, brings an expansion and rise in the price level A rise in animal spirits increases aggregate demand... 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Keynesian Cycle Mechanism The Keynesian business cycle most closely resembles a tennis match. It is caused by outside forces that change direction and set off a process that ends at equilibrium.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Monetarist Theory — Milton Friedman The monetarist theory of the business cycle regards fluctuations in the money stock as the main source of economic fluctuations.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Impulse The impulse in the monetarist theory of the business cycle is the growth rate of the quantity of money. Slowdowns bring recession Speedups bring expansion

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Cycle Mechanism Once the Fed changes the money supply a cycle mechanism begins to work that first affects aggregate demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Cycle Mechanism (cont.) An increase in the money supply leads to: The quantity of real money increases. Interest rates fall. Real money balances increase. The dollar loses value on the foreign exchange market.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Cycle Mechanism (cont.) An increase in the money supply leads to: Investment demand and exports increase. Consumers spend more on durable goods. These initial changes in expenditure have a multiplier effect and an expansion begins. Decreases in the money supply have similar, but opposite, effects.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Cycle Mechanism (cont.) The second element in the monetarist cycle mechanism is the response of aggregate supply to a change in aggregate demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle The Monetarist Cycle Mechanism (cont.) Monetarists believe that real GDP deviations from full employment are temporary in both directions. This is due to their belief that money wages are only temporarily sticky.

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 1 AD 1 A Monetarist Business Cycle Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD 0 a SAS b c A slowdown in money growth decreases aggregate demand and brings recession... …but a fall in money wages eventually brings an expansion and restores full employment Recession 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 2 AD 2 A Monetarist Business Cycle Expansion c Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD 1 SAS d e 6.0 A speedup in money growth increases aggregate demand and brings expansion... …but a rise in money wages lowers real GDP and restores full employment 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Distinguish among the different theories of the business cycle Explain the Keynesian and monetarist theories of the business cycle Explain the new classical and new Keynesian theories of the business cycle

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Monetarist Cycle Mechanism The monetarist business cycle is most like a rocking horse. It needs an outside force to get it going and it rocks back and force (just once).

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Theories A rational expectation is a forecast that is based on all the available relevant information. Rational expectations theories are based on the view that money wages are determined by a rational expectation of the price level.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Theories There are two different rational expectations theories: 1) New classical theory of the business cycle. Regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuation.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Theories There are two different rational expectations theories: 2) New Keynesian Theory of the Business Cycle Is similar to the new classical theory, but also leaves room for anticipated demand fluctuations to play a role.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Impulse The impulse in the rational expectations theories is an unanticipated change in aggregate demand. A larger than anticipated increase in aggregate demand brings expansion. A smaller than anticipated increase in aggregated demand brings recession.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Impulse Unanticipated impulses include fiscal policy, monetary policy, or a change in the world economy that influences exports can change real GDP.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Cycle Mechanisms New Classical Version If firms and workers anticipated an increase in aggregate demand, they expect the price level to rise and will agree to a higher money wage rate. This can prevent the real wage rate from falling and avoid a fall in the unemployment rate below the natural rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Cycle Mechanisms New Keynesian Version Also, believe that money wages are influenced by rational expectations of the price level. Emphasizes the significance of the long-term contracts.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Aggregate Demand Theories of the Business Cycle Rational Expectations Cycle Mechanisms New Keynesian Version Firms and workers are unable to quickly adjust real money wages to changes in aggregate demand. This leads to sticky wages.

Slide Copyright © 2000 Addison Wesley Longman, Inc. AD 0 a Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) 110 EAD SAS b Recession Aggregate demand less than expected brings recession LAS 0 A Rational Expectations Business Cycle

Slide Copyright © 2000 Addison Wesley Longman, Inc. EAD Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) 110 a LAS SAS AD 0 b Expansion Aggregate demand greater than expected brings expansion AD 1 c 0 A Rational Expectations Business Cycle

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain real business cycle theory Describe the origins of and the mechanism at work during two recent recessions Describe the origins of and the mechanisms at work during the Great Depression

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory Real business cycle theory (RBC) regards random fluctuations in productivity as the main source of economic fluctuations.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory The RBC Impulse The impulse in RBC theory is the growth rate in productivity. Rapid technological progress and productivity growth increases quickly. Slow progress and productivity grows more moderately.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Real Business Cycle Impulse

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory The RBC Mechanism Two immediate effects that follow a change in productivity that effect the business cycle are: 1) Investment demand changes 2) The demand for labor changes

Slide Copyright © 2000 Addison Wesley Longman, Inc. ID 1 Capital and Labor Markets in a Real Business Cycle Investment (trillions of 1992 dollars) Price interest rate (percent per year) ID SS …and investment,, saving, and real interest rate fall Investment, saving, and interest rate Technology shock decreases investment demand... 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Capital and Labor Markets in a Real Business Cycle LS 1 LD 1 Labor (billions of hours per year) Real wage rate (1992 dollars per hour) LS 0 LD Labor and wage rate Technology shock decreases demand for labor... …and a fall in real interest rate decreases supply of labor... …and employment and real wage rate fall 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. AD 1 LAS 1 AS-AD in a Real Business Cycle 7.0 Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) 110 AD 0 LAS Technology shock decreases both LAS and AD. Real GDP and price level fall 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory Criticisms of Real Business Cycle Theory Money wages are sticky. Intertemporal substitution is too weak to account for large fluctuations in labor supply and employment with small real wage changes. Technology shocks are not capable of creating the swings in productivity indicated by growth accounting.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory Criticisms of Real Business Cycle Theory Fluctuations in productivity do not cause the business cycle but are caused by it.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory Defense of Real Business Cycle Theory It explains and is consistent with the macroeconomic facts about the business cycle and economic growth. It is consistent with a wide range of microeconomic evidence. They view the relation between money and GDP as reverse causation.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Real Business Cycle Theory Defense of Real Business Cycle Theory It raises the possibility that the business cycle is efficient.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain real business cycle theory Describe the origins of and the mechanism at work during the 1990s Describe the origins of and the mechanisms at work during the Great Depression

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. recession of The U.S. expansion of the 1990s The Japanese Recession

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The recession The economy was at full employment at the beginning of The unemployment rate was just above 5 percent. Inflation was a steady 4 percent.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. recession of (cont.) External Shock: The Gulf Crises The Gulf War resulted in aggregated demand and aggregate supply shocks. Uncertainty led to a decline in investment. Fiscal Policy and Monetary Policy Fiscal policy was not enough to offset this decrease.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. recession of (cont.) Aggregate Demand and Aggregate Supply Aggregate demand shifted left. Aggregate supply shifted left.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. recession of (cont.) Labor Market and Productivity Labor productivity growth slowed to about half a percent and overall productivity decreased by more than half a percent during 1991.

Slide Copyright © 2000 Addison Wesley Longman, Inc. AD 91 SAS 91 The Recession Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) SAS 93 AD …fall in investment decreases AD

Slide Copyright © 2000 Addison Wesley Longman, Inc. The U.S. expansion of the 1990s By the end of 1998, the U.S. economy had completed 94 months of uninterrupted expansion. Real GDP had grown by 23 percent during this period. Recessions and Expansions During the 1990s

Slide Copyright © 2000 Addison Wesley Longman, Inc. The U.S. expansion of the 1990s (cont.) Productivity Growth in the Information Age Internet Personal computer Biotechnology Fiscal Policy and Monetary Policy Fiscal policy was restrained. Monetary policy was passive. Recessions and Expansions During the 1990s

Slide Copyright © 2000 Addison Wesley Longman, Inc. LAS 98 The 1990s Expansion AD 98 SAS 98 Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) SAS 91 AD Full employment in 1998 LAS 91 0 Recessionary gap in 1991

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. expansion of the 1990s (cont.) A Real Business Cycle Expansion Phase A strong and sustained burst of technological change brought rising productivity. The lower unemployment rate is a lower natural rate, and not a sign that the economy is overheating.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The U.S. expansion of the 1990s A Real Business Cycle Expansion Phase (cont.) The Stock Market During the Expansion Between 1995 and 1998, real stock prices increased by 130 percent.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession Between 1992 and 1998, Japan’s real GDP expanded by more than 6 percent - a growth rate of only 0.7 percent per year. By 1999, real GDP in Japan was shrinking at a near 5 percent annual rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) The main factors that have contributed to Japan’s recession are: Collapse of asset prices Fiscal Policy Monetary Policy Structural rigidities

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Collapse of asset prices Investors believed Japan’s medium term and long term prospects were bright. Financial deregulation brought an increase of foreign investment into Japan. The Bank of Japan lowered interest rates between 1985 and 1987 and permitted a rapid growth rate of money.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Collapse of asset prices Asset prices collapsed in Investment decreased sharply and so did aggregate demand. The capital stock and potential GDP grew more slowly.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Fiscal Policy From 1991 through 1996, Japan pursued ambitious fiscal policies to stimulate the economy. The stimulus was not persistent during the 1990s.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Fiscal Policy The removal of temporary tax cuts and cuts in government investment expenditures lowered aggregate expenditure by 3 percent of real GDP in This fiscal policy tightening decreased aggregate demand and contributed to the recession of 1998.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Monetary Policy Since 1996, a weaker yen and lower real short term interest rates have had a smaller but positive effect on aggregate demand in Japan.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Structural Problems Market distortions in agriculture, transportation, retail and wholesale trades, and construction protect inefficient farms and firms create a lack of competition and low productivity growth.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Recessions and Expansions During the 1990s The Japanese Recession (cont.) Structural Problems This aspect of Japan’s economy goes to the core of the real business cycle explanation for fluctuations - fluctuations in the productivity growth rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Fiscal Stimulation in Japan Date proposedTotal Stimulation (percent of GDP) August April September February September Mid 1996-mid April Total 12.9

Slide Copyright © 2000 Addison Wesley Longman, Inc. Japan’s Sliding Growth Rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain real business cycle theory Describe the origins of and the mechanism at work during two recent recessions Describe the origins of and the mechanisms at work during the Great Depression

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression The 1920s were a time of prosperity. During the Great Depression, twenty-five percent of the work force was unemployed. No social security or unemployment compensation. The employed workers actually were better off because of the rise in real wages.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression Why the Great Depression Happened The patterns of world trade were changing. Changing international currency fluctuations and trade restrictions added to firms’ uncertainties. People began to fear a slowdown. These factors led to a slowdown in consumer spending.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression Why the Great Depression Happened The stock market crash heightened those fears. Investment collapsed. Banks failed as people withdrew their funds. Bank failures fed on themselves.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression Can It Happen Again? Severe depression is less likely today because of: 1) Bank Deposit Insurance 2) The Fed’s role as lender of last resort

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression Can It Happen Again? Severe depression is less likely today because of: 3) Taxes and governments spending 4) Multi-income families

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Great Depression AD 33 SAS 30 Real GDP (billions of 1992 dollars) Price level (GDP deflator, 1992 = 100) SAS AD 30 AD 29 SAS ,028 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. The End