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Ch. 14. The Business Cycle. –Different theories of the business cycle •Keynesian •Monetarist •Real Business Cycle –Origins of and the mechanisms at work during the Great Depression • 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. – http://www.nber.org/cycles.html – Recessions are getting shorter. – Expansions are getting longer. The Role of Investment • 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. Cycle Patterns, Impulses, and Mechanisms • The AS-AD Model – All business cycle theories can be described in terms of the AS-AD model. – Two business cycle theories • Aggregate demand theories • Real business cycle theory Aggregate Demand Theories of the Business Cycle – Three types of AD theories • Keynesian • Monetarist • Rational expectations AD Theories of Business Cycle • Keynesian Theory – Volatile expectations are the main source of business cycle fluctuations. – Nominal wages are rigid downward, but not upward. • Keynesian Impulse – “Animal spirits” change radically in response to a small bit of new information. – Expected future sales and expected future profits, which changes investment. AD Theories of Business Cycle • Keynesian Cycle Mechanism – Changes in “animal spirits” lead to change in investment – AD shifts – a flat (or nearly so) SAS curve. – Changes in I have multiplier effects • e.g. as income rises, consumption rises, causing AD to shift further to the right, etc. AD Theories of Business Cycle – A Keynesian recession. – Real wages and productivity should rise during a recession. AD Theories of Business Cycle – A Keynesian expansion. – Real wages and productivity should fall during an expansion. AD Theories of Business Cycle • Monetarist Theory – fluctuations in the quantity of money are the main source of business cycle fluctuations in economic activity. • Monetarist Impulse – The initial impulse is the growth rate of the money supply. AD Theories of Business Cycle • Monetarist Cycle Mechanism – 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 • lowers interest rates and the value of the dollar, shifting AD rightward • multiplier effects amplify the effect. – A decrease in the monetary growth rate has opposite effects. AD Theories of Business Cycle • Recession phase of Monetarist business cycle. • Real wages and productivity should rise during a recession. Aggregate Demand Theories of the Business Cycle • Expansion phase of monetarist business cycle. • Real wages and productivity should fall during an AD Theories of Business Cycle • Rational Expectations Theories – New classical theory • Unanticipated fluctuations in AD are the main source of economic fluctuations. – New Keynesian theory • Unanticipated fluctuations in AD are the main source of economic fluctuations but also leaves room for anticipated fluctuations in AD to play a role. AD Theories of Business Cycle – A rational expectations business cycle recession. AD Theories of Business Cycle – Rational expectations expansion. Real Business Cycle Theory – technological change creating random fluctuations in productivity is 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. Real Business Cycle Theory • The RBC Mechanism – Two immediate effects follow from a change in productivity • Investment demand changes • The demand for labor changes Real Business Cycle Theory – The capital and labor markets in a real business cycle recession. Real Business Cycle Theory – A decrease in productivity lowers firms’ profit expectations and decreases both investment and labor demand Real Business Cycle Theory – The interest rate falls. Real Business Cycle Theory – The lower real interest rate lowers the return from current work so the supply of labor decreases. Real Business Cycle Theory • Employment falls by a large amount and the real wage rate falls by a small amount. Labor productivity decreases. Real Business Cycle Theory • Money in RBC – plays no role in the RBC theory; – RBC 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 that generates economic growth. – RBC concentrates on its SR consequences: growth theory concentrates on its long-term consequences. The Great Depression • In early 1929 unemployment was at 3.2 percent. • In October the stock market fell by a third in two weeks. • In 1930, the price level fell by about three percent and real GDP declined by about nine percent. • Over the next three years – real GDP declined 29% – price level fell 24% 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 heightened uncertainty. • The uncertainty caused investment to fall, which decreased AD and real GDP in 1930. • Until 1930, the Great Depression was The Great Depression • Why the Great Depression Happened – Some economists think that the decrease in investment was the primary cause that decreased aggregate demand and created the depression. – Other economists (notably Milton Friedman & monetarists) assert that inept monetary policy was the primary cause of the decrease in aggregate demand. The Great Depression – Unprecedented number of bank failures – Bank failures led to bank panics and more failures. – Huge contraction in the money supply that was not offset by the Federal Reserve. – Difficult to borrow money. The Great Depression • Can It Happen Again? – Four reasons make it less likely that another Great Depression will occur • • • • Bank deposit insurance Fed as lender of last resort. Taxes and government spending Multi-income families