1. The Business Cycle
Chapter 8

2. Introduction
The Great Depression shook not only the foundations of the world economy but also the economics profession.
No one had predicted the Depression and few could explain it.

3. Introduction The search for explanations focused on these questions:
How stable is a market-driven economy?
What forces cause instability?
What, if anything, can the government do to promote steady economic growth?

4. Macroeconomics
The basic purpose of macroeconomics is to answer these questions.
Macroeconomics is the study of aggregate economic behavior, of the economy as a whole.

5. Macroeconomics
Macroeconomic theories try to explain the business cycle, economic policies try to control it.
Business cycles are alternating periods of economic growth and contraction.

6. Stable or Unstable?
Prior to 1930s, macroeconomists thought there could never be a Great Depression
They believe that a market-driven economy was inherently stable and that government intervention was unnecessary.

7. Classical Theory
Laissez faire is the doctrine of “leave it alone,” of nonintervention by government in the market mechanism.

8. A Self-Regulating Economy
According to the classical view, the economy “self-adjusts” to deviations from its long-term growth trend.
The corner stones of classical optimism were flexible prices and flexible wages.

9. A Self-Regulating Economy
According to law of demand, price reductions cause an increase in sales.
Thus, no one would lose a job because of weak consumer demand.

10. 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.

11. Say’s Law
Unsold goods and unemployed labor could emerge in this classical system.
Both would disappear as soon as people had time to adjust prices and wages.

12. Macro Failure
The Great Depression was a stunning blow to classical economists.
Unemployment grew and persisted despite falling prices and wages.

13. Inflation and Unemployment: 1900-194024 20 16 12 8 4
– 4
– 8
1900
1910
1920
1930
1940
Unemployment
Inflation

14. The Keynesian Revolution
Keynes developed an alternate view of the macro economy.

15. Inherent Instability
Keynes asserted that a market-driven economy is inherently unstable.

16. Government Intervention
In Keynes’ view, the inherent instability of the marketplace required government intervention.

17. Historical Cycles
Swings in the business cycle are gauged in terms of changes in total output (real GDP).
Real GDP is the value of final output produced in a given period, adjusted for changing prices.

18. The Business Cycle Peak Growth trend Peak
REAL GDP (units per time period)
TIME
Peak
Growth trend
Peak
Peak
Trough
Trough

19. The Business Cycle
The growth path of the U.S. economy is not a smooth rising trend, but instead a series of steps, stumbles and setbacks.

20. Long-term average growth (3%)
The Business Cycle 20 15 10 5 3 –5
–10
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
–15
World War II
Great
Depression
Korean War
Long-term average growth (3%)
Vietnam War
Growth recession
Recession

21. The Great Depression
The Great Depression was the most prolonged departure from long-term growth-path.
Between 1929 and 1933, real GDP contracted a total of nearly 30%.

22. The Great Depression
Economy rebounded in 1933 and continued to expand until 1937.
It got worse again in 1938 and 1939
At the end of the decade GDP per capita was lower than it had been in 1929.

23. 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.

24. World War II
Virtually everyone was employed throughout the war and America’s productive capacity was strained to the limit.

25. The Postwar Years
A recession occurred after World War II as sudden cutbacks in defense production caused GDP to decline sharply.

26. The Postwar Years
A recession is a decline in real GDP that continues for at least two or more consecutive quarters.

27. The Postwar Years
Korean War ( ) increased demands for goods, accelerating growth.

28. The 1980s
The economy experienced a growth recession from July November 1982.
A growth recession is a period during which real GDP grows, but at a rate below the long-term trend of 3 percent.

29. The 1980s
The economy’s growth rate was slower than the growth in labor force so unemployment rose.

30. The 1980s
A growth recession occurs when the economy expands too slowly.
A recession occurs when real GDP actually contracts.

31. The 1980s
In November 1982, the U.S. economy began an expansion that lasted over 7 years.
It was the second longest peacetime expansion in history.

32. The 1990s and 2000
A growth recession of 1989 became a full recession in July 1990.
The recession officially ended in February 1991.

33. The 1990s and 2000
In 1992, the economy started growing faster but unemployment rates stayed high the entire year peaking at 7.7% in June.

34. The 1990s and 2000
From 1992 through the fall of 2000, total output kept increasing and as unemployment fell to a low of 3.9 percent.

35. The 1990s and 2000
In 2001, economic growth slowed as the economy experienced another growth recession.

36. A Model of the Macro Economy
Both Keynes and the Classical economists agreed that business cycles occur.
They disagreed on whether government should deal with them.

37. 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.

38. Macroeconomic Performance
Macro outcomes include:
Growth - year-to-year expansion in production capacity.
International balances - international value of the dollar; trade and payments balances with other countries.

39. 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 - tax policy, government policy, changes in the availability of money, credit regulation, etc.

40. A Model of the Macro Economy
Internal market forces
External
shocks
Policy
levers
DETERMINANTS
Output
Jobs
Prices
Growth
International balances
OUTCOMES
MACRO
ECONOMY

41. A Model of the Macro Economy
The crucial macro controversy is whether pure, market-driven economies are inherently stable or unstable

42. Aggregate Demand and Supply.
Any influence on macro outcomes must be transmitted through supply or demand.

43. Aggregate Demand
Aggregate demand is 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.

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

45. Aggregate Demand Aggregate demand PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)

46. 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.

47. Real-Balances Effect
The real value of money is measured by how many goods and services your money will buy.
The cash balances you hold in your pocket, in your bank account, or under your pillow are worth more when the price level falls.

48. Foreign-Trade Effect
This effect reinforces downward sloping curve by changes in imports and exports.
When the U.S. price level falls, Americans buy fewer foreign produced goods and foreigners buy more U.S produced goods.

49. Interest-Rate Effect
With lower prices, consumers need to borrow less, the demand for loans diminishes, so interest rates drop.

50. Aggregate Supply
Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

51. Aggregate Supply Aggregate supply PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)

52. Aggregate Supply
Two reasons explain the upward slope of the aggregate supply curve:
The profit effect.
The cost effect.

53. 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.

54. 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.

55. Cost Effect
Cost pressures are minimal at low rates of output but intense as the economy approaches capacity.

56. Macro Equilibrium
Aggregate supply and demand curves summarize the market activity of the whole (macro) economy.

57. Macro Equilibrium
Macro equilibrium is the combination of price and output that is compatible with both buyers’ and sellers’ intentions.

58. Macro Equilibrium Equilibrium is unique.
It is the only price-output combination that is mutually compatible with aggregate supply and demand.

59. Macro Equilibrium Aggregate supply Aggregate demand P1 D1 S1 E PE
PRICE LEVEL (average price) QE
REAL OUTPUT (quantity per year)

60. Macro Failures
There are two potential problems with macro equilibrium:
Undesirability - the price-output relationship at equilibrium may not satisfy our macroeconomic goals.
Instability – even if the designated macro equilibrium is optimal, it may be displaced by macro disturbances.

61. Undesirability
The macroeconomic equilibrium may be more or less than our full employment capacity.

62. Undesirability
Full-employment GDP is the total market value of final goods and services that could be produced in a given time period at full employment; potential GDP

63. Undesirability
If equilibrium is below full-employment GDP, we have failed to achieve our goal of full employment.

64. An Undesired Equilibrium
Aggregate
supply
Aggregate
demand E
PRICE LEVEL (average price) PE QE F P* QF
Equilibrium
output
Full employment

65. Undesirability
Similar problems may arise from the equilibrium price level.
Inflation is an increase in the average level of prices of goods and services.

66. An Undesired Equilibrium
Aggregate
supply
Aggregate
demand E
PRICE LEVEL (average price) PE
Desired
price level QE F P* QF
Equilibrium
output

67. Instability
The macroeconomic equilibrium will change when there are macroeconomic disturbances.
Business cycles result from recurrent shifts of aggregate supply and demand curves.

68. Instability
The aggregate supply curve shifts to the left when there is an increase in production costs.
The aggregate demand curve shifts when volatility in currencies cause significant changes in import and export prices.

69. Macro Disturbances (a) Supply shifts (b) Demand shifts AS1 AS0 AS0 AD0G P1 Q1 F P* QF
PRICE LEVEL (average price) F P* QF
PRICE LEVEL (average price) P2 Q2 H
AD0
REAL OUTPUT (quantity per year)
REAL OUTPUT (quantity per year)

70. Competing Theories of Short-Run Instability
Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

71. Demand-Side Theories
Keynesian and Monetary theories are the two basic demand-side theories.
Both theories emphasize the potential of aggregate-demand shifts to alter macro outcomes.

72. Demand-Side Theories AD0 AD1 E1 E0 AS0 Q1 QF Inadequate demand
REAL OUTPUT
AD2 P0 P2 E2 Q2
Excessive demand

73. Keynesian Theory
Keynesian theory is the most prominent of the demand-side theories.
Keynes argued that deficiency of spending would tend to depress an economy.

74. Keynesian Theory
Keynes concluded that inadequate aggregate demand would cause persistently high unemployment.

75. Monetary Theories
Money and credit affect the ability and willingness of people to buy goods and services.

76. Monetary Theories
If credit isn’t available or is too expensive, consumers curtail the credit purchases and businesses might curtail investment.

77. Monetary Theories
Both Keynesian and monetarist theories emphasize the potential of aggregate-demand shifts to alter macro outcomes.

78. Supply-Side Theories
Decreases in aggregate supply cause inflation and higher unemployment.
Increases in aggregate supply move us closer to both our price stability and full employment goals.

79. Supply-Side Theories AS1 AS0 Q3 P3 E3 E0 PRICE LEVEL (average price)QF
AD0
REAL OUTPUT (quantity per year)

80. Eclectic Explanations
Eclectic explanations of macro failure draw from both the demand-side and the supply-side of the economy.

81. Long-Run Self Adjustment
Some economists argue that short-run theories are pointless.
In their view, short-run fluctuations in real output or prices are just statistical noise.
This argument is based on Classical and monetarist views of long-run stability.

82. Long-Run Self Adjustment
They assert that there is a long-run aggregate supply curve that is vertical that is anchored at the natural rate of output (QN).

83. Long-Run Self Adjustment
A vertical long-run AS curve means that aggregate-demand shifts affect prices but not output in the long-run.

84. The “Natural” Rate of OutputAS
AD2
PRICE LEVEL (average price) P2 P1
AD1 QN
REAL OUTPUT(quantity per year)

85. Short vs. Long-run Perspectives
Even if the long-run AS curve is vertical, as Keynes pointed out: “in the long-run we are all dead.”
Whatever is true in the long-run, it is in the short-run that we must consume, invest, and find a job.

86. Short vs. Long-run Perspectives
The long-run aggregate supply curve is likely to be vertical.
The short-run aggregate supply curve is likely to be upward-sloping.

87. Macro Policy Options
The real challenge for macro theory is to determine which curves or shifts best represents reality.

88. Three Basic Policy Strategies
Shift aggregate demand curve - find and use policy tools that stimulate or restrain total spending.

89. Three Basic Policy Strategies
Shift the aggregate supply curve - find and implement policy levers that reduce the costs of production or otherwise stimulate more output at every price level.

90. Three Basic Policy Strategies
Laissez-faire - if we can’t identify or control the determinants of aggregate supply and demand, then we shouldn’t interfere with the market.

91. Specific Policy Options
All the following policy strategies have been tried at one time or another:
Classical approaches.
Fiscal policy.
Monetary policy.
Supply-side policy.
Trade policy.
Eclecticism.

92. Classical Approach
Embraced the laissez-faire approach prior to the Great Depression.
The economy was believed to self-adjust to full employment.

93. Classical Approach
New classical economists stress the market’s “natural” ability to self-adjust to long-run equilibrium and government’s inability to improve short-run market outcomes.

94. Fiscal Policy
Fiscal policy is an integral part of modern economic policy.
Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes.

95. Monetary Policy
Monetary policy is the use of money and credit controls to influence macroeconomic outcomes.

96. Monetary Policy
The Federal Reserve increases or decreases the money supply in accordance with its view of macro equilibrium.

97. Supply-Side Policy
Supply-side policy seeks to shift aggregate supply curve.
Supply-side policy is the use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.

98. Trade Policy
International trade and money flows can be changed to shift the aggregate demand and/or the aggregate supply curve.

99. Eclecticism Presidents are often willing to embrace a mix of policies.
Eclecticism, in part, reflects a “do-whatever-it-takes-to-win” attitude on the part of politicians.

100. Eclecticism
The different economic theories each fall short in explaining one or more of our economic problems.
In these circumstances, policymakers prefer a more flexible mix of all policies.

101. The Business Cycle
End of Chapter 8