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SESSION 3: MACROECONOMICS LECTURE THE MACROECONOMY Macro Basics: The Macroeconomy Topic: An Economy Let's start with a definition: An economy is an interactive system of production, distribution, and consumption of resources, goods, and services that addresses the basic economic problem of scarcity. Economic functions are divided into four basic macroeconomic sectors: 1. 2. 3. 4. Household: the consumers. Business: the producers. Government: the regulators and taxers. Foreign: the others. The household sector of the macroeconomy is everyone in an economy who consumes goods and services. Consumption is the use of natural resources, goods, or services to satisfy wants and needs. In a complex economy, consumption is expenditures by the household sector for the purchase of final goods and services. Household sector is a term that indicates the consuming, wants-and-needssatisfying population. Everyone in society is included in the household sector. The household sector is responsible for consumption. The business sector of the macroeconomy produces the goods and services that are consumed by the household sector. The business sector is responsible for production by combining the four basic resources: labor, capital, land, and entrepreneurship. A business is a method of combining resources for production. While the business sector buys raw materials, intermediate goods, and other things. The most important purchase of the business sector is capital goods, or investment in capital. The business sector is responsible for capital investment. The government sector affects resource allocation and production by imposing laws and regulations that force decisions not otherwise made. Three levels of government: Federal, State and Local. The government sector collects taxes and buys a share of the economy's production, termed government purchases. These are goods such as national defense, highway and street construction, education, and police protection. Government purchases do not include transfer payments (Social Security benefits, welfare or unemployment compensation). The government sector is responsible for government purchases. Economic activity is divided into domestic, everything within the political boundaries of a nation, and foreign, everything outside the boundaries. Any citizen of the U.S., any firm owned by a U.S. citizen, and the government of any U.S. city are part of the domestic economy. Any resident, business or government of another country is part of the foreign sector. Exports are goods purchased by the foreign sector that are produced by the domestic economy. Imports are goods purchased by the domestic economy that are produced by the foreign sector. Net exports are the difference between exports and imports, or exports minus imports. The foreign sector is responsible for net exports. Macro Basics: The Macroeconomy Topic: Macroeconomics Macroeconomics is the study of the entire economy, the aggregate economy. Microeconomics is the study of parts of the economy. Economists first studied parts of the economy (markets, demand, supply, and prices), what we now call microeconomics. The Great Depression of 1930's, motivated economists led by John Maynard Keynes, to study macroeconomics. Microeconomics and macroeconomics have their own principles, theories, and phenomena. Both are part of economics and each is intertwined with the other. The macroeconomy affects microeconomic decisions. Microeconomic decisions affect the macroeconomy. Macro Basics: Macro Problems Topic: The Goals A modern, complex economy like the U.S. economy pursues three macro goals: Full employment: Using all available resources for production. Stability: Avoiding inflation and/or fluctuations in the economy. Growth: Lessening the problem of scarcity by increasing production capabilities. We always pursue these goals but conflicts mean we cannot reach them at the same time. More conflicts result from pursuit of the micro goals of efficiency and equity. Macroeconomic problems from not reaching this goals are: production, unemployment, and inflation. Macro Basics: Macro Problems Topic: Unemployment Unemployment exists when resources, specially labor, are willing and able to produce goods but are not employed because no one is buying production. Voluntary unemployment occurs when people choose not to work. Involuntary unemployment occurs when people are willing to work, but can't find employment. Unemployment problems: The economy suffers because unemployed resources are not producing goods to lessen the scarcity problem. The unemployed suffer personal hardships and a lower living standard. Production lost from unemployed resources can never be recouped. Macro Basics : Macro Problems Topic: Inflation Inflation is a stability problem that typically results because the four macro sectors of the economy demand more goods that the economy can produce. Inflation problems: Future prices become increasingly uncertain. Financial assets like money, bank accounts, stocks and bonds decrease in value with higher prices. Income and wealth are haphazardly redistributed because prices change at different rates. Hyperinflation can reduce production because money becomes almost worthless and people revert to barter exchanges. Macro Basics | Business Cycles Topic: Instability The macroeconomy is unstable. It has periods of falling production, rising inflation, and/or high unemployment. Business cycles are recurring expansions and contractions of the aggregate economy. Expansion is a general period of increasing economic activity, or rising production, which is associated with low or falling unemployment and high or rising inflation. Contraction is a general period of decreasing economic activity, or falling production, which is associated with high or rising unemployment and low or falling inflation. Counter-cyclical policies to stabilize the business cycle: During an expansion, try to cause a contraction. During a contraction, try to cause an expansion. Macro Basics: Business Cycles Topic: Causes To understand business cycles, we need the causes: 1. Consumption: If households decide to buy more or less, the rest of the economy follows suit. 2. Capital Investment: Big swings can set in motion upward or downward spirals of total production. 3. Government Purchases and Taxes: Government purchases can be contractionary or expansionary effect over the economy. Taxes affect the ability of the household and business sectors to buy production. 4. Net Exports: Changes in exports can trigger expansions and contractions of the domestic economy. 5. Circulating Money: Too much money can trigger and inflationary expansion, too little money can trigger contraction and unemployment. 6. Resource Supply Considerations: Resource supply changes (energy prices, technology, wages, etc.) can trigger expansions and contractions. Macro Basics: Policies Topic: Government Government tries to bring the economy closer to the macro goals of full employment, stability and growth, and to lessen the scarcity problem. Economic policies are government actions designed to affect the economy to pursue the economic goals. Stabilization policies (or counter-cyclical policies) are designed to limit economic instability and business cycles and avoid high rates of unemployment and inflation. Key macroeconomic stabilization policies: Fiscal policy is the use of government spending and taxes to stabilize the economy. Monetary policy is the use of the amount of money in circulation to stabilize the economy. Macro Basics: Policies Topic: Viewpoints People can take different views of government and economic polices that depend on political philosophies. Liberal Democrat: The view that government is the only way to keep the economy running smoothly, using paternalistic, hands-on policies. If a problem arises, then government is the answer. Conservative Republican: The view that government is the problem, not the solution. The best government is the least government because it is a tyrannical oppressor of individual rights and freedoms. One view or the other is usually the basis of an economic policy. The government can be the solution and it can be the problem. Macro Basics: Issues Topic: Politics Policy perspectives are filled with differing politics and political philosophies. Reasons for differing views of the 'best' economic policies: First: Human beings are different, with different likes, dislikes, tastes, preferences, values, beliefs, ideologies and opinions. This is the source of differences on what is considered the 'best' for the economy. Second: Human beings often have vested interests in the consequences of the policies. They personally benefit from a policy. While self-interest is okay, the question is whether self-interests of the few prevent greater welfare of the many. Macro Basics: Issues Topic: Theories Using the scientific method to test macroeconomic theories is an evolving process. Over time, more hypotheses are tested and macroeconomic theories grow, expand and improve. Hypotheses from macroeconomic theories are not easily subject to experimental testing. Economists can't control the economy but must wait for it to cooperate. The result of combining different political philosophies and vested interests with the inability to provide definitive explanations, creates alternative, competing theories that seek to explain the world. GROSS DOMESTIC PRODUCT Gross Domestic Product: Measuring Production Topic: An Indicator Economists use numerical measurements to indicate the health and well-being of the economy. Economic diagnosis relies on several indicators. Gross domestic product is the most comprehensive measure of the economy's production and one of the most basic measures of the economy's well-being. Gross domestic product, as well as other economic measures, are indicators of our economic health. A GDP Definition: Gross domestic product (GDP) is the total market value of all final goods and services produced in the economy in a given period of time, usually one year. The goal of GDP is to measure the total production of goods and services produced in the economy each year. A larger GDP means that we have more goods and services that can be used to satisfy our unlimited wants and needs. The chart presents recent numbers for GDP in the United States. Gross Domestic Product: Measuring Production Topic: Total Market Value Let's highlight the phrase 'total market value' in this definition of GDP. First, total. GDP seeks to measure ALL production of goods and services in the economy. Second, market value. Market prices indicate the value of goods. We measure the total value of production by multiplying the quantity produced and traded through markets by market prices. GDP is the aggregation of the market value of all goods. Market transactions provide an excellent source of information that can be used for calculating GDP. Dollars (market prices) provide a common denominator for aggregating different goods. Gross Domestic Product: Measuring Production Topic: Final Goods and Services A second phrase to highlight is 'final goods and services'. Production generally involves several intermediate steps which involves market exchanges of intermediate goods. GDP measures only the market value of final goods. The cost of intermediate goods is already included in the price and thus the market value of finished product when sold to final users. To avoid double counting, GDP does not separately include the market value of any intermediate goods. Final goods are those reaching their final user and include: household consumption, business investment in capital, government purchases, and exports. Gross Domestic Product: Measuring Production Topic: Given Year The third GDP highlight phrase is 'a given period of time'. GDP is production that takes place during a specific period, usually one year. GDP is a flow. Current production takes place during the specific period of time under study. Flows are measured over a period of time. GDP is measured from January 1st to December 31st. Stocks are measured at a point in time. The quantity of money is measured at an instant in time, like July 26th at 8:15. In addition to GDP, other production and income measures in this lesson are flows. In addition to money, employment, business inventories, and labor force are stocks. Lesson 10: Gross Domestic Product: Looking Behind GDP Topic: Ins and Outs Measuring GDP in the U.S. economy uses data involving $8 trillion of production, 270 million consumers, hundreds of thousands of businesses, and a huge number of market transactions. The circle on the left represents all current economic production in the economy. This is what GDP seeks to measure. But GDP can not measure this directly. Information for measuring GDP comes from market transactions. The circle on the right represents all market transactions. Much of the economic production circle overlaps the market transaction circle. But each circle has a slice not contained in the other. Gross Domestic Product: Looking Behind GDP Topic: Past and Future Slice A includes market transactions that are NOT economic production, and are excluded from GDP. Two activities in slice A: Future production. Intermediate goods will become part of GDP in the future when production is finished. To avoid double counting, we exclude these market transactions. Past production. Used items (cars, houses) produced before the start of our current time period. Because they are not current production and were included in GDP in a previous year, they are excluded from GDP Slice A is excluded from GDP. Gross Domestic Product: Looking Behind GDP Topic: Estimated Value Slice B includes economic production that does NOT involve market transactions. The market value of nonmarket economic production for some goods can be estimated and included in GDP. In-kind payments: This is nonmarketed production obtained by business owners or employees in lieu of money payment. Although no market transaction, GDP includes the estimated value of these transactions. Owner-occupied housing: The value of owner-occupied housing services are not measured by market transaction. GDP includes the estimate the value of these services. At least part of slice B is included in GDP. Gross Domestic Product: Looking Behind GDP Topic: Home Production Chunk C also is economic production that does NOT involve market transactions. It includes household productive activities, such as cooking, cleaning, home repairs, and entertainment. Hiring others for these tasks would be market transactions included in GDP. If tasks are done personally, without pay, there is no market transaction and no record of production. While information needed to estimate the value of household production could be collected, it might be more trouble than it's worth. Chunk C is excluded from GDP. Gross Domestic Product: Looking Behind GDP Topic: Illegal Goods Chunk D also is economic production that DOES involve market transactions. Lack of information about market transactions prevent these activities from being included in GDP Chunk D includes illegal activities, such as gambling, drug sales, and prostitution. Because they satisfy wants and needs they are economic production. Because they are illegal activities 'official market transaction records are not available. Chunk D is excluded from GDP. Gross Domestic Product: Looking Behind GDP Topic: GDP Economic production that involves market transactions is the foundation of GDP. This is area E. It is combined with area B to measure GDP. A summary of measuring GDP: Start with all market transactions of record. Toss out past and future production in Slice A. Add the estimated value of nonmarket 'in-kind' production in Slice B. Don't include the value of nonmarket production in chunk C and the value of illegal production in chunk D. Combine areas B and E for the final tabulation of GDP. Gross Domestic Product: Looking Behind GDP Topic: Real GDP GDP is the total MARKET VALUE of current economic production, that is, GDP measures current production at current market prices. If we measure current economic production, current prices work fine. If we compare GDP from one year to the next year, current prices can be misleading. For example... a 10% increase in GDP could result from changes in production, prices, or both. Production could be 10% higher will prices do not change. Or prices could 10% higher while production does not change. Or this could be a mix of changes in production and prices. All we know is that GDP has risen by 10%, but it is difficult to know what has happened to physical production. We need something more, we need real GDP. Gross Domestic Product: Two Views of GDP Topic: Demand and Supply GDP can be measured in two different ways. Demand-side: In a market transaction, the buyer pays a price for a good or a service based on the value of the good. This indicates that the value of GDP can be measured from expenditures. Supply-side: For seller's, the revenue received from selling a good is used to pay resources--the cost of production. This indicates that the value of GDP can be measured by the resource cost of production. These two sides--expenditures and resources--give us two ways of measuring GDP. Each can be used to check the other. Gross Domestic Product: Two Views of GDP Topic: Expenditures The four sectors of the economy buy ALL current economic production and when aggregated give us GDP. The four sectors and their expenditures: 1. 2. 3. 4. Household: Consumption (C). Business: Investment (I). Government: Government Expenditures (G). Foreign: Net Exports (X-M), the difference between Exports (X) and Imports (I). Expenditures on GDP: GDP = C + I + G + (X-M) C, I and G buy not just domestic goods and services, but also imports. When we aggregate C, I, G and X we have domestic production plus imports. To measure only domestic production, we subtract imports (M). Gross Domestic Product : Two Views of GDP Topic: Resources Calculating GDP from the resource side is based on the fact that ALL revenue received by the business sector is paid to or claimed by a factor of production. Factor payments and the productive factors are: o Wages are paid to labor. o Interest is paid to capital. o Rent is paid to land. o Profit is paid to entrepreneurship. Official government names are compensation to employees (wages) and corporate profit (profit). Proprietors' income is a combination of wages, interest, rent and profit, collected by the owner of a proprietorship. Gross Domestic Product : Measuring Income Topic: National Income The first three related, but slightly different income measures is national income (NI), income earned by the factors of production. National income is the sum of wages (W), interest (I), rent (R), profit (P) and proprietors' income (PI): NI = W + I + R + P + PI National income is also found by subtracting capital consumption allowance (CCA) and indirect business taxes (IBT) from, and adding net foreign factor income (NFFI) to, GDP: NI = GDP - CCA - IBT + NFFI And because NDP = GDP - CCA: NI = NDP - IBT + NFFI Gross Domestic Product: Measuring Income Topic: Personal Income Personal income (PI) is the second income measure. Personal Income is income RECEIVED by households. Compare this with national income which is income earned by the factors of production. These two income measures are similar, but not exactly the same. Some income earned by the factors of production is not received by the household sector. Let's call it IEBNR. Some income received by the household sector is not earned by a factor of production. Let's call it IRBNE. Gross Domestic Product: Measuring Income Topic: IEBNR Income earned by the factors of production that is not received by the households (IEBNR) is subtracted from national income to derive personal income. Social Security taxes: This is income earned by workers for their production, but paid to the government and not received by households. Corporate profit taxes: Part if profit redirected to government. Undistributed corporate profits: Retained earnings kept by business for future capital investment. Workers, entrepreneurship and/or capital owners earn this income, but do not receive it. Gross Domestic Product: Measuring Income Topic: IRBNE Income received by households but not earned by the factors of production (IRBNE) is added to national income to derive personal income. IRBNE are transfer payments. Households without factors of production receive income through transfer payments such as: 1. Social Security benefits. 2. Welfare payments. 3. Unemployment compensation. To calculate personal income, income earned but not received (IEBNR) is subtracted from and income received but not earned (IRBNE) is added to national income. PI = NI - IEBNR + IRBNE Gross Domestic Product: Issues Topic: What It Does The study of gross domestic product is important for at least for two reasons. First, Scarcity. Real GDP indicates how well the economy is addressing the economic problem of scarcity. Second, Stability. Real GDP is a key measurement for analyzing economic instability and business cycles. Gross Domestic Product: Issues Topic: What It Doesn't Do GDP and related measures are not perfect. GDP is only an indicator of economic activity. Because it requires interpretation and analysis it is subject to misinterpretation and misanalysis. GDP is an aggregate measure for the economy. It measures total production, but it does not indicate who receives the production, the distribution of production. GDP does not measure the satisfaction of wants and needs. GDP can increase even though welfare does not increase, or even decreases. GDP might even decrease even though welfare is greater. CIRCULAR FLOW Circular Flow: Basic Flow Topic: Overview Economic activity can be separated according to the four basic macroeconomic sectors--household, business, government, and foreign. The circular flow model helps us analyze the interaction among these sectors. The circular flow is a model of the continuous production and consumption interaction among the four major sectors (household, business, government, and foreign), that takes place through the three aggregated macroeconomic markets (product, factor and financial). The circular flow is a simple model that helps us understand the complex real world economy. Circular Flow: Basic Flow Topic: Four Sectors The four basic macroeconomics sectors: Household sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption. Business sector: This includes those undertaking the task of combining resources to produce goods and services. This sector is responsible for the production. Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function, especially to pass laws, collect taxes, and force other economic sectors to do things that they wouldn't do voluntary. Foreign sector: Includes everyone and everything beyond the boundaries of the domestic economy. Circular Flow: Basic Flow Topic: Three Markets The three aggregated markets in the circular flow are: Product markets: The combination of all markets in the economy that exchange final goods and services. These markets are the mechanism that exchanges gross domestic product. These are also termed the aggregate market. Factor markets: These markets exchange the services of the economy's resources, or factor of production--labor, capital, land, and entrepreneurship. These are also called resource markets. Financial markets: These are markets that trade financial instruments, like stocks and bonds. They play an important role in capital investment. Circular Flow: Basic Flow Topic: The Physical Flow Two sectors: household and business. Two markets: product and factor. The physical flow is the counterclockwise flow of resources from the household to business sector and production from the business to household sector. Production flows from the business sector (supply) to the household sector (demand) through the product markets. Resources flow from the household sector (demand) to the business (supply) sector through the factor markets. The household sector sells the resources through the factor markets and buy goods through the product markets. The business sector buys resources through the factor markets and sells goods through the product markets. Circular Flow: Basic Flow Topic: The Payment Flow The payment flow goes in the opposite direction of the physical flow. A physical commodity goes one direction through markets and payment goes the other. The household sector buys production from the business sector (counter-clockwise flow) in exchange for payment (clockwise flow) through product markets. The business sector buys resources from the household sector (counterclockwise flow) in exchange for payment (clockwise flow) through factor markets. Revenue received by the business sector for selling goods is used to pay the factors of production. Factor payments become income used by household sector to buy production from the business sector. The circular flow makes about six cycles around the economy each year. Circular Flow: Financial Markets Topic: The Paper Economy Financial markets divert national income from household consumption to business investment. Real side: Goods and resources, physical production used to satisfy wants and needs. Paper side: Legal claims on these physical goods and resources. Examples: Corporate stocks, government bonds, money, bank statements, mortgage contracts. Trading legal claims through financial markets diverts income from consumption to investment. A legal claim buyer gets the legal claim, but gives up income. The legal claim seller gives up the claim and takes possession of the income. Income is diverted from a legal claim buyer (lender, saver) to a legal claim seller (borrower) through the financial markets.Two additional flows: Saving and Investment. Circular Flow: Financial Markets Topic: Saving Saving is a nonconsumption use of income, making a loan or supplying income to the financial markets in exchange for a legal claim. The red financial markets box is a third set of aggregate markets. The green flow is saving supplied to the financial markets. It is income diverted from the household sector. Why save? To get paid. Interest is the payment for using income. Income is needed later more than now. Income is set aside this year to buy more production next year. Saving does not disappear, it is income diverted away from the consumption flow and supplied, or loaned, to the financial markets. Circular Flow: Financial Markets Topic: Investment Investment is business expenditures on gross domestic product for capital goods. The green flow from the business sector to the product markets is investment. The physical flow of capital goods moves in the opposite direction. The process: Financial markets have buyers (savers) and sellers (borrowers). Savers buy legal claims that divert income TO financial markets. Borrowers sell legal claims that divert income OUT of the financial markets. The business sector borrows income through financial markets, which is used to finance capital investment. Circular Flow: Government Topic: What It Does The government sector plays a key role in the economy and the circular flow with government spending, especially for the purchase of GDP, and taxes. Government purchases include: national defense, roads, educational system, post offices, fire and police protection, parks, sewage treatment plants, and more. Taxes are used to divert household sector income to the government sector to pay for these purchases. The diversion of income into taxes used to purchase government production shows up in the circular flow model. Circular Flow: Government Topic: Taxes The government sector tends to be in the middle of most economic activity. Taxes are collected by all levels of government, federal, state, and local. The green flow from the household sector to the government sector is taxes. This flow is household income diverted to the government sector. Three basic uses of national income: Consumption: Income used by the household sector to buy GDP. Saving: Income diverted to the financial markets for business sector borrowing for capital purchases. Taxes: Income diverted to the government sector for government purchases. All three come from national income. Circular Flow:Government Topic: Government Purchases Government spending is divided into government purchases of GDP and transfer payments. Transfer payments include welfare to the poor, unemployment compensation, and Social Security benefits. Transfer payments are like negative taxes, but flow from the government sector to the household sector. The circular tax flow is the net tax flow from households to government, taxes minus transfer payments. Government purchases are the green flow from the government sector to the product markets. As an expenditure on GDP, government purchases are comparable to consumption by the household sector and investment by the business sector. Circular Flow: Government Topic: Government Borrowing When government does not collect enough taxes to pay for purchases, it borrows through the financial markets. The federal deficit is borrowing by the federal government to make up the difference between taxes and spending. State and local governments also borrow through financial markets. The green flow leaving the financial markets and entering the government sector is government borrowing. Government sector purchases can be less than taxes, which means government saves to the financial markets. Many state and local governments actually save. State and local saving reduces total government sector borrowing in times of high federal deficits. Circular Flow: Foreign Topic: Foreign Trade The foreign sector is the fourth and last circular flow sector. The foreign sector is households, businesses, and governments outside the domestic economy (including other planets). Market exchanges are a natural means of addressing the scarcity problem. Mutually beneficial exchanges aren't limited by geographic location or political boundaries. Foreign trade, the exchange among buyers and sellers in different nations, is an extension of mutually beneficial exchanges among people of the same country. Foreign trade gives us the terms exports and imports. Circular Flow: Foreign Topic: Exports and Imports Exports are goods and services produced by the domestic economy and purchased by the foreign sector. Imports are goods and services produced by the foreign sector and purchased by the domestic economy. Exports are the green flow coming from the foreign sector and joining GDP before reaching the business sector. Imports are the green flow leaving the consumption, investment, government purchases stream and going to the foreign sector. Note that the physical flow of production (exports and imports) moves in opposite direction as the green payment flows. Circular Flow: Real World Topic: Expenditures Gross domestic product (GDP) is the sum of consumption, investment, government purchases, and net exports. Circular Flow: Real World Topic: Production And Income Measures of production and income. Net domestic product (NDP) is GDP minus capital consumption allowances CCA). National income (NI) is NDP minus indirect business taxes (IBT). Personal income (PI) is NI minus undistributed corporate profits (UCP), corporate profits taxes (CPT) and Social Security Taxes (SST), plus transfer payments. Disposable income (DI) is PI minus personal taxes. Circular Flow: Real World Topic: Investment Investment expenditures are financed from the capital consumption allowance (CCA), undistributed corporate profits (UCP), and investment borrowing. Circular Flow: Real World Topic: Government Spending Government spending, purchases and transfer payments, is financed by indirect business taxes (IBT), Social Security taxes (SST), corporate profits taxes (CPT), personal taxes, and borrowing. BUSINESS CYCLES Business Cycles: Instability Topic: Overview It's a fact of life that the economy is unstable. Like a roller coaster rises and falls, the economy expands and contracts. The economy goes up and down, twisting and turning along the way. In general, we prefer the good that comes with a rising, expanding economy and don't like the bad that comes with a falling, contracting one. The fluctuations in the economy never stop. It is difficult for the economy to run full speed at all times. Economic fluctuations go by the term business cycles. Business Cycles: Instability Topic: Business Cycles Business cycles are irregular, nonperiodic fluctuations in aggregate economic activity. Life is good, then it's bad. It's a roller coaster ride. For example, the Great Depression was the worst economic period in this century. Unemployment reached 25%. Total production declined by about 40%. Investment declined by 90%. During the 1920s, production was up, unemployment was down, life was good, then it got bad. Although we use the term 'cycle', we don't know how long an expansion or a contraction will last. The economy might expand for a year or it might expand for a decade before it declines. Business Cycles: Instability Topic: Expansionary Good Times Expansionary good times are almost always good. But here is a bad side. The good side: The economy is growing, more goods are produced, living standards rise, businesses are profitable, and scarcity problems are lessened. The bad side: Inflation and inefficiency. Inflation tends to worsen when the economy expands too rapidly. Inflation is usually a bigger problem for some than for others, including those on fixed incomes and with financial wealth. Inefficiency is likely during an expansion. With the entire economy expanding, and everyone becoming better off, the incentive to be efficient is reduced. Business Cycles: Instability Topic: Contractionary Bad Times Contractionary bad times give us the most problems. First: Real GDP declines during a contraction. This means less production for the four sectors to buy. Second: Unemployment increases. Resources, especially labor, produce less and receive less income. 3-5 million workers newly employed. Third: The incomes of employed resources also tend to fall, or at least not rise as much as an expansion. Fourth: Business profits decline and bankruptcies increase. Fifth: Social problems, including crime, poverty, and alcoholism, worsen. But contractions have some good: Inflation remains low or declines. Some resources are more efficiently allocated. Business Cycles: A Simple Cycle Topic: Long-Run Trend A closer look to the business cycle. The red line represents the pattern of actual real GDP over time. The blue line is the long-run trend, the historical average of real GDP growth, about 3% each year. In general, real GDP increases. But real GDP occasionally declines, frequently rises faster the long-run trend, and seldom rises exactly equal to the long-run trend. A business cycle is combination of the two periods, (1) expanding economic activity moves the economy up to and above the long-run trend and (2) declining activity that drops it below this trend. Business Cycles: A Simple Cycle Topic: Contraction Contractions generally last about a year, but some have persisted for 1 1/2 years and some end after six months. A contraction, also termed recession, is the decline of real GDP, from A to B. A contraction is officially designated as at least six months of declining economic activity. The 1930s Great Depression had two contractions, one lasting 43 months. A contraction takes the economy from above the long-run trend to below the long-run trend. The long-run trend is full-employment production. Below the long-run trend resources are not fully employed, unemployment increases. Business Cycles: A Simple Cycle Topic: Trough Contractions don't last forever. The end of a contraction is the trough, the turning point to an expansion. Point B is the end of the contraction and the beginning of the expansion, the trough. A trough is the turning point between a contraction and an expansion. A trough is the lowest level reached by the economy before an expansion begins, the dark before the dawn. Turning points are important because they are the transition from bad to good of good to bad. A turning point might not be identified until well after it has happened. Business Cycles: A Simple Cycle Topic: Expansion An expansion is a period of increasing aggregate economic activity, indicated by the growth of real GDP from B to C. Expansions typically last about 2-4 years, but can continue up to a decade. The economy generally grows faster than, often surpassing, the long-run trend. A recovery is the early part of an expansion. As the economy approaches point C, above the long-run trend, inflation is most likely to become a problem, as we try to buy more output than our resources can produce. At or above the full-employment, long-run trend line, unemployment is less of a problem. Business Cycles: A Simple Cycle Topic: Peak Expansions don't last forever. The end of an expansion is the peak, the turning point to a contraction. Point C is the end of the expansion and the beginning of the contraction, the peak. A peak is the turning point between an expansion and a contraction. A peak is the highest level reached by the economy before a contraction begins, the high before the drop. Anticipating a peak turning point helps avoid the problems of unemployment, a bankrupt business, or lower income. Business Cycles: Measurement Topic: Indicators Since the 1930s Great Depression, when the modern study of economics was prompted, economists have sought indicators of business cycles. Some indicators are: Real GDP, the unemployment rate, and the inflation rate are useful measures, but they measure only specific aspects of the economy. These may not be the best indicators of overall business cycle activity.Economists have identified three sets of indicators to track business cycles: o Leading indicators. o Coincident indicators. o Lagging indicators. Business Cycles: Measurement Topic: Leading Leading economic indicators indicate business-cycle activity 3 or 12 months ahead. If leading indicators decline now, then the economy is likely to decline in 3 to 12 months. Leading indicators are eleven statistics that precede changes in the economy. Three notable leading indicators are stock market prices, the money supply, and consumer confidence. The Composite Index of Leading Indicators, displayed in this chart, combines all eleven into a single number. The Composite Index works better than individual indicators, but they are not perfect. Some declines not followed by a contraction. Business Cycles: Measurement Topic: Coincident Coincident economic indicators move along with the aggregate economy. They mark the business cycle. We don't know how the economy is doing until after the fact. Real GDP is released every three months. Coincident indicators are available monthly. The four coincident indicators are measures of production, employment, income, and sales. The Composite Index of Coincident Indicators, displayed in the graph, combines all four. Turns in this index mark business cycle peaks and troughs. Leading and coincident indicators work together. Leading indicators forecast turning points. Coincident indicators turn 3 to 12 months later. Business Cycles: Measurement Topic: Lagging Lagging economic indicators lag the turning points of business cycles by 3 to 12 months. Lagging indicators 'seal the deal' by certifying that a contraction or an expansion is over. The next turning point usually doesn't begin until lagging indicators confirm that the last one has happened. Seven statistics are used as lagging indicators, including in the inflation rate, consumer debt, and the prime interest rate. The Composite Index of Lagging Indicators, displayed in this graph, combines all seven into a single number. This index turns after the official business cycle. Business Cycles: Causes Topic: Complexity Business cycle instability happens, 3 to 4 years of expansion and a year or so of contraction. During each new expansion, we think the business cycle contraction problem has been solved. Every expansion, except the current one, has ended with a contraction. Perhaps we have found THE cause of business cycles and can avoid future contractions. Economy is complex, with many different business cycle causes. Hard to juggle a cell phone, remote control, and lit candle. Eventually you stop and begin again. Aggregate economic activity is delicate balancing act, with numerous reasons for a contraction. Note that explanations are often influenced by politics and vested interests. Business Cycles: Causes Topic: Investment Instability of business investment is one explanation of business cycles. During the Great Depression, production declined by 40% and investment declined by over 90%. Did this big drop in investment cause the overall drop in production? Investment can trigger changes in production through the circular flow. A decrease in investment, causes a decrease in production, which reduces household income, which reduces consumption, which causes further reductions in production, income, and consumption. Small changes in investment can cause magnified changes in aggregate production. A $10 billion decrease in investment might cause a $50 billion decrease in GDP. Business Cycles: Causes Topic: The Process Three points about investment and business cycles: First: Investment is sensitive to interest rates. Higher interest rates increase the cost of investment borrowing and discourages investment. Second: Interest rates rise and fall with the business cycle. During an expansion, interest rates rise enough to discourage investment, and trigger a contraction. During a contraction, interest rates fall enough to encourage investment and cause a new expansion. Third: Investment doesn't react immediately to interest rates. The production of capital goods takes time and does not respond instantly to interest rate changes. Interest-rate-induced changes in investment seem to be a natural cause-and-effect part of business cycles. Business Cycles: Causes Topic: Politics Re-election seeking politicians is a second explanation for business cycles. Four propositions lay the foundation: An elected leader remains an elected leader only if re-elected. Government can influence economic activity through stabilization policies. Fiscal policy, lower taxes and more spending, can trigger an expansion. The opposite can cause a contraction. Voters re-elect current leader during good times and elect new leaders during bad times. They vote their pocketbooks. Elected leaders know how this process works and give us the recipe for a politically induced business cycles. Business Cycles: Causes Topic: The Process Here's how the political business cycle would work: First: Elected leaders start promoting an expansion 2 to 3 years before an election. Second: One means of inducing an expansion is fiscal policy, with lower taxes and more spending. Third: The economy expands, voters are happy, leaders are re-elected. But the expansion causes problems, such as inflation or budget deficits. Fourth: These problems are solved with a contraction after the election, which ends in time for the next pre-election expansion. Fifth: With major elections every 4 years, many leaders have a vested interest making this happen. Business Cycles: Policies Topic: Options Stabilization policies try to avoid or correct the problems caused by business cycle instability. The two most popular are fiscal policy and monetary policy. Do nothing 'nonpolicies' might be best in some cases, but are seldom used because people often demand immediate solutions to problems. Business cycle instability is indicated by the red line rising above and falling below the longrun trend line. The flatter, smoother line is the goal of stabilization policy, to limit business cycle instability. Stabilization policies can be either expansionary or contractionary. Business Cycles: Policies Topic: Expansionary Expansionary policies avoid or limit the problems of business cycle contractions. Expansionary fiscal policy is increasing government spending or reducing taxes. More spending can offset the decline in investment, directly. Lower taxes leaves households with more income from consumption. Expansionary monetary policy is increasing in the amount of money in circulation. More money means more spending. Business Cycles: Policies Topic: Contractionary Contractionary policies avoid or limit the problems of business cycle expansions. Contractionary fiscal policy is decreasing government spending or increasing taxes. Less spending can directly offset an inflation-inducing expansion. Higher taxes reduces spending indirectly by reducing household income. Contractionary monetary policy is decreasing in the amount of money in circulation. Less money means less spending.