Download The Business Cycle

The Business Cycle
Chapter 8
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Macroeconomics
Macroeconomics is the study of
aggregate economic behavior, of the
economy as a whole.
2
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.
3
Stable or Unstable?
Prior to 1930s, macro economists
thought there could never be a Great
Depression
They believed that a market-driven
economy was inherently stable and
that government intervention was
unnecessary.
4
Classical Theory
Laissez faire is the doctrine of
“leave it alone,” of nonintervention by
government in the market
mechanism.
5
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.
6
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.
7
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.
8
Macro Failure
The Great Depression was a
stunning blow to classical
economists.
Unemployment grew and persisted
despite falling prices and wages.
9
Inflation and Unemployment:
1900-1940
24
20
Unemployment
16
12
8
4
0
–4
Inflation
–8
1900
1910
1920
1930
1940
10
The Keynesian Revolution
British economist, John Maynard
Keynes developed an alternate view
of the macro economy.
11
Inherent Instability
Keynes asserted that a marketdriven economy is inherently
unstable.
Small disturbances in output, prices,
or unemployment were likely to be
magnified by the invisible hand of
the marketplace.
12
Government Intervention
In Keynes’ view, the inherent
instability of the marketplace
required government intervention.
13
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.
14
REAL GDP (units per time period)
The Business Cycle
Peak
Growth trend
Peak
Peak
Trough
Trough
TIME
15
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.
16
The Business Cycle in U.S. History
17
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%.
In 1939, GDP per capita was lower
than it had been in 1929.
18
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.
19
The Postwar Years
There have been 11 recessions
since 1944.
A recession is a decline in real GDP
that continues for at least two or
more consecutive quarters.
20
The 1980s
The economy experienced a growth
recession during the 1980s.
A growth recession is a period
during which real GDP grows, but at
a rate below the long-term trend of 3
percent.
21
The 1980s
A growth recession occurs when the
economy expands too slowly.
A recession occurs when real GDP
actually contracts.
22
The 1980s
In November 1982, the U.S.
economy began an expansion that
lasted over 7 years.
23
The 1990s and 2000
The 1990s started with a recession
in July 1990 that officially ended in
February 1991.
From 1992 through the fall of 2000,
total output kept increasing and
unemployment fell to a low of 3.9
percent.
24
The 1990s and 2000
The economy experienced a brief
recession in 2001 which was
extended by the 9/11 terrorist
attacks.
Growth resumed in 2002 and
accelerated through 2005.
25
A Model of the Macro Economy
Both Keynes and the Classical
economists agreed that business
cycles occur.
They disagreed on whether they’re
an appropriate target for government
intervention.
26
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.
LO1
27
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.
LO1
28
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.
LO1
29
A Model of the Macro Economy
DETERMINANTS
Internal
market
forces
External
shocks
OUTCOMES
Output
Jobs
MACRO
ECONOMY
Prices
Growth
Policy
levers
LO1
International
balances
30
A Model of the Macro Economy
The crucial macro controversy is
whether pure, market-driven
economies are inherently stable or
unstable.
LO1
31
Aggregate Demand and Supply
Any influence on macro outcomes
must be transmitted through supply
or demand.
LO2
32
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.
LO2
33
Aggregate Demand
The aggregate demand curve
illustrates how the real value of
purchases varies with the average
level of prices.
LO2
34
PRICE LEVEL (average price)
Aggregate Demand
Aggregate demand
REAL OUTPUT (quantity per year)
LO2
35
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.
LO2
36
Real-Balances Effect
The real value of money is
measured by how many goods and
services your money will buy.
Your cash balances are worth more
when the price level falls so that you
can buy more with them.
LO2
37
Foreign-Trade Effect
Consumers can buy either foreign or
domestically produced goods.
When the U.S. price level falls,
Americans buy fewer foreign
produced goods and foreigners buy
more U.S produced goods.
LO2
38
Interest-Rate Effect
With lower prices, consumers need
to borrow less, the demand for loans
diminishes, so interest rates drop.
Lower interest rates encourages
loan-financed purchases.
LO2
39
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.
LO2
40
Aggregate Supply
PRICE LEVEL (average price)
Aggregate supply
REAL OUTPUT (quantity per year)
LO2
41
Aggregate Supply
Two reasons explain the upward
slope of the aggregate supply curve:
The profit effect.
The cost effect.
LO2
42
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.
LO2
43
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.
LO2
44
Cost Effect
Cost pressures are minimal at low
rates of output but intensify as the
economy approaches capacity.
LO2
45
Macro Equilibrium
Macro equilibrium is the
combination of price and output that
is compatible with both aggregate
demand and aggregate supply, i.e.
buyers’ and sellers’ intentions.
LO3
46
PRICE LEVEL (average price)
Macro Equilibrium
Aggregate
supply
P1
E
PE
Aggregate
demand
D1
QE
S1
REAL OUTPUT (quantity per year)
LO3
47
Macro Equilibrium
Equilibrium is unique.
It is the only price level-output
combination that is mutually
compatible with both aggregate
supply and demand.
LO3
48
Macro Failures
There are two potential problems
with macro equilibrium:
Undesirability - the equilibrium price
or output level may not satisfy our
macroeconomic goals.
Instability – even if the designated
macro equilibrium is optimal, it may not
last long.
LO3
49
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.
It represents potential GDP.
LO3
50
Undesirability
If macro equilibrium is below fullemployment GDP, then we have
failed to achieve the full employment
goal.
LO3
51
PRICE LEVEL (average price)
An Undesired Equilibrium
Aggregate
demand
Aggregate
supply
E
PE
F
P*
Equilibrium
output
Full-employment output
QE
LO3
QF
52
Undesirability
Similar problems may arise when the
equilibrium price level is inflationary.
Inflation is an increase in the average
level of prices of goods and services.
LO3
53
PRICE LEVEL (average price)
An Undesired Equilibrium
Aggregate
demand
PE
Aggregate
supply
E
Desired
price level
F
P*
Equilibrium
output
QE
LO3
QF
54
Instability
Macroeconomic equilibrium changes
whenever the aggregate supply
and/or demand curves shift.
LO3
55
AS Shifts
A decrease in aggregate supply
reduces real output and raises the
price level.
Can be caused by higher import
prices, natural disasters, changes in
tax policies, or other events.
LO3
56
AD Shifts
A decrease in aggregate demand
reduces real output and the price
level.
Can be caused by decreased export
demand, changes in expectations,
higher taxes, or other events.
LO3
57
(a) Supply shifts
AS1
AS0
AD0
P1
P*
G
F
Q 1 QF
REAL OUTPUT (quantity per year)
LO3
(b) Demand shifts
PRICE LEVEL (average price)
PRICE LEVEL (average price)
Macro Disturbances
AS0
P*
P2
F
H
AD0
AD1
Q2 Q F
REAL OUTPUT (quantity per year)
58
Multiple Shifts
Business cycles are likely to result
from recurrent shifts of aggregate
supply and demand curves.
LO3
59
Competing Theories of Short-Run
Instability
Macro controversies focus on the
shape of aggregate supply and
demand curves and the potential to
shift them.
LO3
60
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.
LO3
61
Demand-Side Theories
AS
P*
E0
E1
AD0
AD1
Q
QF
1
REAL OUTPUT
(quantity per year)
LO3
(b) Excessive demand
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(a) Inadequate demand
AS0
P2
P*
E2
E0
AD2
AD0
QF Q2
REAL OUTPUT (quantity per year)
62
Keynesian Theory
Keynes argued that deficiency of
spending would tend to depress an
economy.
Keynes concluded that inadequate
aggregate demand would cause
persistently high unemployment.
LO3
63
Monetary Theories
Money and credit affect the ability
and willingness of people to buy
goods and services.
If credit isn’t available or is too
expensive, consumers curtail the
credit purchases and businesses
might curtail investment.
LO3
64
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.
LO3
65
PRICE LEVEL (average price)
Supply-Side Theories
AS1
AS0
E3
P3
E0
P0
AD0
Q3
QF
REAL OUTPUT (quantity per year)
LO3
66
Eclectic Explanations
Eclectic explanations of macro
failure draw from both the demandside and the supply-side of the
economy.
LO3
67
Long-Run Self Adjustment
Some economists argue that shortrun fluctuations in real output or
prices are just statistical noise.
They assert that there is a long-run
aggregate supply curve that is
vertical that is anchored at the
natural rate of output (QN).
LO3
68
Long-Run Self Adjustment
A vertical long-run AS curve means
that aggregate-demand shifts affect
prices but not output in the long-run.
LO3
69
PRICE LEVEL (average price)
The “Natural” Rate of Output
AS
P2
P1
AD2
AD1
QN
REAL OUTPUT(quantity per year)
LO3
70
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.
LO3
71
Taming the Cycle
The real challenge for macro theory
is to determine which curves or shifts
best represents reality.
72
Three Basic Policy Strategies
Shift aggregate demand curve –
find and use policy tools that
stimulate or restrain total spending.
LO3
73
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.
LO3
74
Three Basic Policy Strategies
Laissez-faire – Don’t interfere with
the market; let markets self adjust.
LO3
75
Specific Policy Options
There are a host of policy tools for
any given AS/AD strategy:
Classical laissez faire.
Fiscal policy.
Monetary policy.
Supply-side policy.
Trade policy.
LO3
76
Classical Laissez Faire
The laissez-faire approach requires
no tools.
The economy naturally self-adjusts
to full employment.
LO3
77
Fiscal Policy
Fiscal policy is the use of
government taxes and spending to
alter macroeconomic outcomes.
The government can shift the AD
curve to the right by spending more
money or by cutting taxes.
LO3
78
Monetary Policy
Monetary policy is the use of
money and credit controls to
influence macroeconomic outcomes.
Lower interest rates encourage
consumers and businesses to
borrow and spend more.
LO3
79
Supply-Side Policy
Supply-side policy seeks to shift
aggregate supply curve.
Supply-side policy is the use of tax
incentives, deregulation, and other
mechanisms to increase the ability
and willingness to produce goods
and services.
LO3
80
Trade Policy
International trade and money flows
can be changed to shift the
aggregate demand and/or the
aggregate supply curve.
LO3
81
The Business Cycle
End of Chapter 8
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved