30 THE BUSINESS CYCLE CHAPTER 景氣循環.

30 THE BUSINESS CYCLE CHAPTER 景氣循環

Objectives After studying this chapter, you will able to
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 Explain real business cycle theory Describe the origins of, and the mechanisms at work during, the expansion of the 1990s, the recession of 2001, and 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.

Must What Goes Up Always Come Down?
In some ways, the 1990s were like the 1920s: rapid economic growth and unprecedented prosperity From 1929 through 1933, real GDP fell 30 percent and the economy entered the Great Depression, which lasted until World War II There have been ten recessions since 1945; must the cycle continue?

Cycle Patterns, Impulses, and Mechanisms
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 and that shows great diversity. Table 30.1 in the textbook dates business cycles since 1920 and the magnitude of the fall in real GDP from peak to trough. 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.

Cycle Impulses and Mechanisms Cycles can be like the ball in a tennis match, the light of night and day, or a child’s rocking horse. These cycles differ according to the role of outside force and basic system design.

In a tennis match, an outside force is applied at each turning point In the night and day cycle, no outside force is applied and the cycle results from the design of the solar system In the rocking of a horse, an outside force must be applied to start the cycle but then the cycle proceeds automatically until it needs another outside force. The business cycle is a combination of all three types of cycles; that is, both outside forces (the “impulse”) and design (the “mechanism”) are important.

The Central Role of Investment and Capital 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.

The AS-AD Model All business cycle theories can be described in terms of the AS-AD model. Business cycle theories can be divided into two types 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 aggregate demand theories have been proposed: 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.

Keynesian Theory The Keynesian theory of the business cycle regards volatile expectations as the main source of business cycle fluctuations.

Keynesian Impulse The impulse in the Keynesian theory is expected future sales and expected future profits. A change in expected future sales and expected future profits changes investment. Keynes described these expectations as “animal spirits,” which means that because such expectations are hard to form, they may change radically in response to a small bit of new information.

Keynesian Cycle Mechanism The mechanism of the business cycle is the initial change in investment, which affects aggregate demand, combined with a flat (or nearly so) SAS curve. An increase in investment has multiplier effects that shift the AD curve rightward; a decrease has similar multiplier effects that shift the AD curve leftward.

The asymmetry of money wages means that leftward shifts of AD lower real GDP but, without some other change, money wages do not fall and so the economy remains in a below full-employment equilibrium. The Keynesian theory is most like the tennis match, in which cycles are the result of outside forces applied at the turning points.

Figure 30.1 illustrates a Keynesian recession.

Figure 30.2 illustrates a Keynesian expansion.

Monetarist Theory The monetarist theory of the business cycle regards fluctuations in the quantity of money as the main source of business cycle fluctuations in economic activity. Monetarist Impulse The initial impulse is the growth rate of the money supply.

Monetarist Cycle Mechanism The mechanism is 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 of the money supply lowers interest rates and the foreign exchange rate, both of which have multiplier effects that shift the AD curve rightward. A decrease in the monetary growth rate has opposite effects.

Money wages are only temporarily sticky, so an increase in aggregate demand eventually raises money wage rates and a decrease in aggregate demand eventually lowers money wage rates. Rightward shifts in the AD curve cause an initial expansion in real GDP, but money wages rise and the expansion ends as GDP returns to potential GDP. Decreases in AD are similar: they cause an initial decrease in real GDP, but money wages fall and the recession ends as GDP returns to potential GDP.

The monetarist theory is like a rocking horse, in that an initial force is required to set it in motion, but once started the cycle automatically moves to the next phase.

Figure 30.3 illustrates a Monetarist business cycle. Part (a) shows a recession phase.

Part (b) shows an expansion phase.

Rational Expectations Theories A rational expectation is a forecast based on all the available relevant information. There are two rational expectations theories. The new classical theory of the business cycle regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations.

The new Keynesian theory of the business cycle also regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations but also leaves room for anticipated fluctuations in aggregate demand to play a role.

Rational Expectations Impulse Both rational expectations theories regard unanticipated fluctuations in aggregate demand as the impulse of the business cycle. But the new Keynesian theory says that workers are locked into long-term contracts, so even though a fluctuation in aggregate demand is today anticipated, if it was unanticipated when the contract was signed, it will create a fluctuation in economic activity.

Rational Expectations Cycle Mechanisms The mechanism in both theories stresses that changes in aggregate demand affect the price level and hence the real wage, which then leads firms to alter their levels of employment and production. In both theories, a recession occurs when a decrease in aggregate demand lowers the price level and thereby raises the real wage rate. This change causes firms to reduce employment so that unemployment rises.

In both theories, eventually money wages fall so that the recession ends. The new classical theory asserts that only unanticipated changes in aggregate demand affect real wages; anticipated changes affect the nominal wage rate and have no effect on real wage rates. Anticipated changes in aggregate demand have no effect on real GDP.

The new Keynesian theory asserts that long-term labor contracts prevent anticipated changes from affecting the nominal wage rate, so even if a change is correct anticipated today, if it was unanticipated when the labor contract was signed, it affects the real wage rate. Hence, both anticipated and unanticipated changes in aggregate demand affect real GDP.

Both theories are like rocking horses, in which an initial force starts the business cycle but then the fluctuation automatically proceeds to the end of the cycle.

Figure 30.4 illustrates a rational expectations business cycle. Part (a) shows a recession.

Part (b) shows an expansion.

AS-AD General Theory All three of these types of business cycle explanation can be thought of as special cases of a general AS-AD theory of the business cycle, in which fluctuations in aggregate demand (and sometimes aggregate supply) cause the business cycle.

Real Business Cycle Theory
The real business cycle theory (RBC theory) regards technological change that creates random fluctuations in productivity as 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. Growth accounting is used to measure the effects of 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.

Figure 30.5 illustrates the RBC Impulse over 1963–2003.

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

Figure 30.6 illustrates the capital and labor markets in a real business cycle recession.

A decrease in productivity lowers firms’ profit expectations and decreases both investment demand and the demand for labor.

The interest rate falls.

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

Employment falls by a large amount and the real wage rate falls by a small amount.

Real GDP and the Price Level The decrease in productivity shifts the LAS curve leftward (there is no SAS curve in the RBC theory). The decrease in investment demand shifts the AD curve leftward. The price level falls and real GDP decreases.

Figure 30.7 illustrates the changes in aggregate supply and aggregate demand during a real business cycle recession.

What Happened to Money? Money plays no role in the RBC theory; the 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 as generates economic growth. RBC concentrates on its short-run consequences: growth theory concentrates on its long-term consequences.

Criticisms of Real Business Cycle Theory Money wages are sticky—a fact ignored by RBC theory The intertemporal substitution effect is too weak to shift the labor supply curve by enough to decrease employment with only a small change in the real wage rate. Technology shocks an implausible source of business cycle fluctuations and measured technology shocks are correlated with factors that change aggregate demand so are not good measures of pure aggregate supply shocks

Defense of Real Business Cycle Theory RBC theory explains both cycles and growth in a unified framework RBC theory is consistent with a wide range of microeconomic evidence about labor demand and supply, investment demand, and other data The correlation between money and the business cycles can arise from economic activity causing changes in the quantity of money and not vice versa.

RBC theory raises the possibility that business cycles are efficient so that efforts to smooth the business cycle reduce economic welfare.

Expansion and Recession During the 1990s and 2000s
The U.S. Expansion of the 1990s The expansion that started in March 1991 lasted 120 months. The previous all-time record for an expansion was 106 months, which took place in the 1960s. This section of the chapter can very appropriately be coupled with the Reading Between the Lines material. There are two issues that may well generate a lot of student interest. The first is whether there is a “new economy,” or whether the economy’s behavior in the 1990s was fundamentally the same as in earlier expansions. Looking at the trends in productivity data in class may well generate some useful discussion, although the instructor should be armed with a good understanding of both the ambiguities in the measures and the tendency for productivity measures to be revised fairly drastically. The second issue is why the 2001 recession was so shallow and short, and what caused it. The proximate cause was clearly the collapse of business investment, but the interesting question is why that happened.

Productivity Growth in the Information Age Massive technological change occurred during the 1990s (computers and related technologies exploded, as did biotechnology.) The technological change created profit opportunities, which increased investment demand. In turn, the higher capital stock increased aggregate supply.

Fiscal policy and monetary policy Fiscal policy was restrained. As a fraction of GDP, government purchases remained about constant and tax revenues increased, largely as a result of a growing economy. Monetary policy also was restrained. The Fed generally kept the money supply at a relatively slow and steady rate that lead to falling inflation and interest rates.

Aggregate Demand and Aggregate Supply During the Expansion Figure 30.8 illustrates the changes in aggregate demand and aggregate supply that occurred during the 1990s expansion. In 1991, there was a small recessionary gap.

Aggregate demand and long-run aggregate supply both increased. But aggregate demand increased more than long-run aggregate supply, so both the price level and real GDP increased. In 2001, the economy was at full employment.

A Real Business Cycle Expansion Phase This expansion seems identical to those RBC predicts: technological change increases productivity, with the result that labor demand and aggregate supply increase.

The U.S. Recession of 2001 The 2001 recession was the mildest on record. There was no clearly visible external shock to set off the recession. There were no major fiscal shocks to trigger the recession. There were no major monetary shocks prior to the start of the recession, although the Fed had raised interest rates a little in 2000 and held M2 growth steady.

Real Business Cycle Effects The growth of productivity did slow in early 2001 according to preliminary data, and this would have slowed the real GDP growth rate. In itself, it seems insufficient to have caused a recession, but it was associated with a very severe reduction of business investment that was the proximate cause of the fall in aggregate demand and the start of the recession.

Labor Market and Productivity Labor productivity increased, as did the real wage, because employment and aggregate hours fell more than GDP and unemployment rose. The rise in real wages reduced short-run aggregate supply.

Figure 30.9 illustrates the changes in aggregate demand and aggregate supply in the 2001 recession.

The Great Depression In early 1929 unemployment was at 3.2 percent.
In October the stock market fell by a third in two weeks. The following four years were a terrible economic experience: the Great Depression. In 1930, the price level fell by about three percent and real GDP declined by also about nine percent. Over the next three years several adverse shocks hit aggregate demand and real GDP declined by 29 percent and the price level by 24 percent from their 1929 levels. 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 also heightened uncertainty. The uncertainty caused investment to fall, which decreased aggregate demand 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 Figure shows the changes in aggregate demand and aggregate supply during the Great Depression.

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

The Great Depression Banks failed in an unprecedented amount during the Depression. The main initial reason was loans made in the 1920s that went sour. Bank failures fed on themselves; people seeing one bank fail took their money out of other banks and caused the other banks to fail. The massive number of bank failures caused a huge contraction in the money supply that was not offset by the Federal Reserve.

The Great Depression Can It Happen Again?
Four reasons make it less likely that another Great Depression will occur Bank deposit insurance 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 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.

THE END

30 THE BUSINESS CYCLE CHAPTER 景氣循環.

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