2. The Business Cycle
Macroeconomics explains how and why economies grow and what causes the recurrent ups and downs known as the business cycle.
Business cycle: alternating periods of economic growth and contraction.
We focus on three central questions:
How stable is a market-driven economy?
What forces cause instability?
What, if anything, can the government do to promote steady economic growth?
You could enter into a preliminary look at the business cycle.

3. Learning Objectives
Know the major macro outcomes and their determinants.
Know why the debate over macro stability is important.
Know the nature of aggregate demand (AD) and aggregate supply (AS).
Know how changes in AD and AS affect macro outcomes.
We will use these objectives to review the chapter.

4. Stable or Unstable?
Prior to the 1930s, conventional wisdom was a market-driven economy, which was inherently stable.
Business cycles (ups and downs in the economy) were short-lived, and the market seemed to correct (regulate) itself.
There was no need for government intervention – that is, the prevailing view dictated a policy of laissez faire..
Laissez faire: the doctrine of “leave it alone,” of nonintervention by government in the market mechanism.
This is the modern view of classical economics (which they did not call “classical” back in the day).
There actually was no particular view of what we call macroeconomics before Keynes and the Keynesians who gathered at Harvard after WWII.
“Laissez faire” essentially described the economics of Adam Smith (who battled mercantilism) and the early French and English economists.

5. A Self-Regulating Economy
Classical economics: the economy “self-adjusts” to any deviations from its long-term growth trend.
In this view, wages and prices are flexible.
If there are excess goods, the producer can
Lower prices and sell more, eliminating excess goods.
Decrease output and lay off workers. Laid-off workers compete for jobs by asking for lower wages. At lower wages, firms will hire more workers.
This is the essence of Say’s Law.
Classical economics was a good description of how the economy worked through the middle to late 1800s and early 1900s.
It no longer worked well when institutions became of such significant size that they had power and influence: corporations, unions, government tax authorities, the Fed (and other central banks), restrictions on international trade. Then classical economics no longer could “self-adjust.”

6. A Self-Regulating Economy
Say’s Law: supply creates its own demand.
Whatever was produced would be sold.
All workers who sought employment would be hired.
This would occur because people have time to adjust prices and wages downward.
The economy therefore is self-regulating.
Say observed the self-contained villages of France to come up with his law.
At that time (1700s), there was little intervillage economic activity.
So his law seemed to explain the everyday activity of the village, and by extension, the country.

7. Macro Failure
The self-adjustment mechanism did not work during the Great Depression.
John Maynard Keynes analyzed the situation and concluded that self-adjustment could not occur because of “an insufficiency of effective demand.”
He asserted that a market-driven economy was, in fact, inherently unstable.
He concluded that the government must intervene by increasing aggregate demand.
From 1929 to 1933, tariffs rose to unprecedented heights; values of exporting companies dropped; the stock market crashed and wiped out considerable wealth; businesses began to fail; many were thrown out of work, losing their homes; banks took losses on unpaid loans and some closed; the Fed tightened the money supply(!); and Congress raised taxes to “balance the budget.” All of these actions worked against any possibility of the laissez faire economy self-adjusting. Just two of them support Keynes’s insufficiency of demand: people losing their jobs and Fed tightening the money supply.
The economy was not market-driven - institutions were driving the economy over the cliff.

8. Government Intervention
For an underperforming economy, Keynes proposed that the government intervene to
By more output.
Employ more people.
Provide more income transfers.
Make more money available.
For an overheated economy, Keynes proposed the opposite.
Higher taxes.
Spending reductions.
Reduce availability of money.
During the Depression the economy was underperforming. Keynes did not worry much about an overheated (inflating) economy.
Keynesians, however, have applied Keynes’s prescription of government intervention to both problems, as outlined on the slide.

9. Business Cycle The four parts of a modern business cycle are
The peak, where GDP maximizes.
Recession, where GDP declines.
The trough, where GDP minimizes.
Recovery, where GDP increases.
These are variations around a growth trend that slopes upward.
This slide is stylized. The time from peak to trough typically is much shorter than the time from trough to peak.

10. Terms Associated with the Business Cycle
Economic growth: real GDP grows faster than 3%. Expansion.
Growth recession: real GDP grows, but slower than 3%. The economy expands too slowly.
Recession: real GDP contracts (for two or more consecutive quarters).
Depression: an extremely deep recession.
The term “depression” was coined by writers to describe the 1930s era and to separate that particular recession from other, less severe, recessions.
It is unlikely the term will be used by responsible people again unless the economic situation becomes dire as it was in the 1930s.

11. The Great Recession of 2008-2009
A recession began as falling home and stock prices sapped consumer wealth and confidence. This was coupled with a credit crisis.
Sales plummeted and GDP contracted.
Unemployment reached 10.1%.
The Great Recession reached its trough in August 2009, but economic growth since that time has been so sluggish that unemployment remains high (over 9% in 2011).
So the recession of was not a depression, but it was not a typical economic downturn. It seems to have acquired its own name: the Great Recession.

12. A Model of the Macro Economy
Macro outcomes:
Output: real GDP.
Jobs: levels of employment and unemployment.
Prices: CPI and inflation.
Growth: year-to-year expansion of GDP.
International balances: value of the dollar; trade balances.
These each can vary from year to year. They must be measured. When they are “unacceptable,” some policy lever must be used to make them “acceptable.” Acceptability must be defined.

13. A Model of the Macro Economy
Determinants of macro performance:
Internal market forces: population growth, spending behavior, invention and innovation.
External shocks: wars, natural disasters, terrorist attacks, trade disruptions.
Policy levers: tax policy, government spending, changes in the availability of money, regulation.
Included are several events that can affect the macroeconomy and the five categories of outcomes.

14. The Crucial Controversy
Most controversial is whether the policy levers are effective and necessary.
Keynes said “yes.”
Classical economists said “no.”
Also controversial is whether pure, market-driven economies are inherently stable or unstable.
Keynes said “unstable.”
Classical economists said “stable.”
This sets the stage for the unresolved controversy that has raged in macroeconomics since the 1930s.
Note that it does not include a nonpure, market-driven economy that existed when the Great Depression began.

15. Aggregate Demand and Supply
The forces of supply and demand are at work in the macro economy.
Any influence on macro outcomes must be transmitted through supply or demand.
The macro model shows how the macro economy works, and it consists of aggregate demand and aggregate supply.
This is the start of the creation of the AD - AS model typically used in any macroeconomics course.

16. Aggregate Demand
Aggregate demand (AD): the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus.
The collective behavior of all buyers in the marketplace.
It comprises all goods and services.
AD slopes downward; people will buy more goods and services at lower price levels, and vice versa.
The formal definition of AD.

17. Aggregate Demand (AD) Why does AD slope downward?
Real balances effect: the cash you hold is worth more when the price level falls, so you can buy more.
Foreign trade effect: lower price levels in the United States convince customers to buy more American goods and fewer foreign goods.
Interest rate effect: lower interest rates promote more borrowing and more spending.
You might want to elaborate on these three reasons why AD slopes downward.

18. Aggregate Supply
Aggregate supply (AS): 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.
The collective behavior of all suppliers (sellers) in the marketplace.
It comprises all goods and services.
AS slopes upward; suppliers will bring more goods and services to market at higher price levels, and vice versa.
The formal definition of AS.

19. Aggregate Supply (AS) Why does AS slope upward?
Profit effect: if there is no change in the cost of operating a business, rising prices will improve profits, and suppliers will bring more products to the market.
Cost effect: cost increases make producing products more expensive. Producers will be willing to supply more only if prices also rise to cover those added costs.
At high rates of output (near productive capacity), costs rise steeply and AS steepens sharply.
You might want to elaborate on these reasons why AS slopes upward.

20. Macro Equilibrium
AS and AD summarize the market activity of the macro economy.
Macro equilibrium: the combination of price level and real output that is compatible with both AD and AS.
Where AD and AS intersect.
… at PE and QE.
On this diagram, we really only know where the intersection is: at the price level just calculated and the real GDP just measured.

21. Macro Failures Let QF be the goal of full-employment GDP.
The equilibrium output QE is undesirable; it does not reach our macro goal.
Also, AD and AS can shift, meaning that any equilibrium can be unstable.
The economy can be at equilibrium, but not at a point where society wants it to be.
Here it occurs in an underperforming economy.

22. AS Shifts AS will shift left if AS will shift right if
Business costs rise.
Business taxes rise.
Natural disaster occurs.
AS will shift right if
Business costs fall.
Business taxes fall.
Bounteous harvests occur.
On the graph, AS shifts left away from full-employment GDP.
Also, equilibrium can be eliminated if either AD or AS shifts.
Here are some reasons why AS might shift.
The picture depicts AS shifting left. Go through the opposite in your class: AS shifting right.

23. AD Shifts AD will shift left if AD will shift right if
Sending decreases.
Expectations get worse.
Taxes increase.
AD will shift right if
Spending increases.
Expectations improve.
Taxes decrease.
On the graph, AD shifts left away from full-employment GDP.
Similar presentation for shifting AD.
Add a right shift discussion in your class.

24. Short-Run Instability: Competing Theories
Classical economists believe the economy will self-regulate and gravitate toward full employment.
Keynes and his followers do not believe this. They believe the economy might get worse without government intervention.
In addition, there are controversies about the shape of AS and AD and the potential to shift these curves.
There seems to be no resolution of this competition.
You might wish to elaborate on the differences or maybe just identify that there are differences and stick to events.

25. Keynesian Theory This is a demand-side theory.
A recession originates with a deficiency of spending.
AD is too far to the left.
Policy: increase government spending to shift AD back to the right.
Inflation originates with an excess in spending.
AD is too far to the right.
Policy: increase taxes to shift AD back to the left.
This is a succinct description of Keynesian theory.

26. Monetary Theory This is also a demand-side theory.
Emphasizes the role of money in financing AD.
“Tight” money might cause AD to shift too far to the left.
Policy: increase money supply and lower interest rates to shift AD back to the right.
“Easy” money might cause AD to shift too far to the right.
Policy: decrease money supply and raise interest rates to shift AD back to the left.
A succinct description of monetary theory. A more elaborate presentation comes later in the course.

27. Demand-Side Theories
Compare the resulting real output with QF on each graph.

28. Supply-Side Theory
A shift in AS to the left causes output and employment to decrease and inflation to increase.
This problem cannot be corrected by shifting AD.
Shift AD right and unemployment falls but inflation worsens.
Shift AD left and inflation is reduced but unemployment rises.
Policy: devise ways to shift AS back to the right.
This is a succinct description of supply-side theory.
It might be a good time to caution your students that consciously using a policy lever to shift AS left leads to nothing but bad outcomes: high unemployment, high inflation, and stagnant or declining economic growth.

29. Long-Run Self-Adjustment
Advocates argue that short-run instability is not as important as the long-run trend in economic growth.
Relies on the view that the economy can self-adjust.
Once it adjusts to a short-run deviation, the economy will return to its long-run growth path.
There is a “natural” rate of output determined by institutional factors.
Here we extend the controversy among macroeconomic schools on how the economy works and which policy levels should be pushed.

30. Short- and Long-Run Perspectives
We live in the short run.
Short-run variations affect our current economic situation.
We call on government to “fix” short-run problems – now!
Implemented policies take effect in the short-run.
In the short run, AS slopes upward.
The macro model we will use to describe policy implementation will have an upward-sloping AS curve.
Keynes said to his long run-advocating critics, “In the long run, we will all be dead.”
We will keep our discussion in the short run.