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Business Cycle Theory
Changes in Business Activity
©2012, TESCCC
Economics, Unit: 06 Lesson: 01
Objectives
1. Describe phases of business cycle
2. Identify and explain the factors that
cause business cycles
3. Analyze how economists use
business cycle theory to predict what
is going to happen
4. Analyze how the government uses
predictions to make public policy
©2012, TESCCC
Business Cycle Theory
A free market economy does not grow at a constant rate. It
goes through a series of expansions and contractions.
These fluctuations are called business cycles. Business
cycles reflect patterns to the general level of economic
activity or the level of production of goods and services
(GDP). Since this is a pattern it keeps repeating itself.You
can see the business cycle activity from 1914 to 1992 below
in the graph.
©2012, TESCCC
Business Cycle Theory
Four Phases of business
cycle are:
–Expansion
–Peak
–Contraction–recession
–Trough
©2012, TESCCC
Contraction or Recession
For a contraction to be a true
recession, you must see 2
consecutive quarters or six
months of declining real
GDP.
©2012, TESCCC
Business Cycle Theory
Peak
Stages
Expansion
Trough
©2012, TESCCC
Recession
Expansion Phase
1.
2.
3.
4.
5.
6.
7.
©2012, TESCCC
GDP
Durable goods
Factory orders
Raw materials orders
Unemployment
Consumer confidence
problem: inflation
Contraction or Recession
1. Demand
2. GDP
3. Durable goods
4. Factory orders
5. Unemployment
6.Consumer confidence
7. problem: unemployment.
©2012, TESCCC
Causes
• There are several things that may
lead to fluctuations in the
economy. Some are within the
economy and we call them
internal factors. Some are
outside the economy and we call
them external factors.
©2012, TESCCC
Internal factors (within the
economic system)
1. Business Investment
In an expanding economy firms
invest in new capital goods. This
investment spending creates new
jobs and growth. If firms decide to
halt investment, this slows the
economy down and can cause
unemployment.
©2012, TESCCC
2. Interest Rates and Credit
When interest rates go up, consumers
will not make big ticket purchases.
Lower demand slows down economy.
When interest rates go down we see
more purchases being made – causing
growth.
©2012, TESCCC
3. Consumer Expectations
Fears of the economy slowing down can
cause consumers to stop spending. This
will then actually slow down the
economy.
If consumers feel confident about the
economy, they spend more. Spending
more can cause growth.
©2012, TESCCC
External factors (outside the
economic system)
External Shocks
These are factors outside the economic
system, but they can cause fluctuations in
business activities. Examples include:
wars
natural disasters
foreign economies
9/11
©2012, TESCCC
Business Cycle Forecasting
Must anticipate changes in real GDP
Economic Indicators-
©2012, TESCCC
Leading Indicators
• Stock prices
• Manufacturing
orders
• Housing starts
• Consumer
confidence
©2012, TESCCC
Lagging Indicators
• Interest rates
• Unemployment
• Credit/Income ratio
©2012, TESCCC
Inflation
Prices
©2012, TESCCC
Prices
Objectives
• Define inflation
• Explain and graph the 2 types of
inflation
• Identify the causes and effects of
inflation
• Define stagflation
• Explain wage-price spiral
©2012, TESCCC
Price Instability
2 types of Price Instability
©2012, TESCCC
1. Inflation - a rise in the general level
of prices
2. Deflation - a decline in the general
level of prices”
©2012, TESCCC
Core Inflation Rate
• Core inflation rate – rate of inflation
excluding the effects of food and energy
prices
©2012, TESCCC
Major Types of
Inflation
and Their Causes
©2012, TESCCC
1.Demand-pull inflation: “too many dollars
chasing too few
goods”
demand > supply
AS1
PL1
AD1
GDP
©2012, TESCCC
Q1
1.Demand-pull inflation: “too many dollars
chasing too few goods”
aggregate demand > aggregate supply
AS1
PL2
PL1
AD2
AD1
GDP
©2012, TESCCC
Q1
Q2
1. Demand-pull inflation: all sectors of the
economy contribute to demand-pull inflation.
Aggregate demand is C+I+G so the household
sector, the business sector and the government
sector contribute to too much aggregate demand.
AS1
PL2
PL1
AD2
AD1
GDP
©2012, TESCCC
Q1
Q2
2. Cost-push inflation:
cost of producing
goods rises
(ex. cost of inputs
increases)
AS1
PL1
AD1
GDP
©2012, TESCCC
Q1
2. Cost-push inflation:
cost of producing
goods rises
AS2
AS1
PL2
PL1
AD1
GDP
Q
2
©2012, TESCCC
Q1
(ex. cost of inputs
increases). This is
more harmful because
not only does the PL
go up, output or GDP
declines.
Causes of Inflation
There are several factors that can cause
or lead to one of the major types of
inflation.
©2012, TESCCC
1. Wage-price spiral . . .
– prices rise
– workers want raises to pay higher prices
– prices go up b/c workers paid more money
– workers want raises to pay higher prices
– prices rise
– higher wages
– ETC. . .
Related to cost-push inflation
©2012, TESCCC
2. Government deficit or deficit
spending
“crowding-out effect”
– related to demand-pull inflation
©2012, TESCCC
3. Quantity Theory
• Quantity theory of inflation- Milton
Friedman and University of
Chicago economists
(Monetarists) stated that too
much money in the economy
causes inflation. The money
supply is growing; leave it alone -Fed should not increase or
decrease.
©2012, TESCCC
Effects of
Inflation
©2012, TESCCC
1. The dollar buys less
purchasing power decreases
©2012, TESCCC
2. Spending habits change,
interest rates rise (won’t get loans
for big ticket purchases)
©2012, TESCCC
3. Distribution of income is altered
• lenders hurt (money paid back
worth less)
• borrowers helped (used $ when
worth more)
©2012, TESCCC
4. Reduces real wages of workers.
©2012, TESCCC
5. Decreases value of savings dollar is worth less
©2012, TESCCC
Ways to Measure Inflation
1. CPI
2. PPI
©2012, TESCCC
Cost Of Living Adjustments
COLA’s
automatic
adjustments to
wages each year
that takes into
account the rate
of inflation
©2012, TESCCC
Stagflation
• This refers to a time of high
unemployment (stagnant growth)
plus
high rates of inflation
©2012, TESCCC