Download Business Cycles

Business Cycles
May 2006/May 2007
Business Cycle/Fluctuations
 The ups and downs in an economy as
measured by changes in the level of
total output (Real GDP).
What is the business cycle?
 “The business cycle or economic cycle
refers to the ups and downs seen
somewhat simultaneously in most parts of
an economy. The cycle involves shifts over
time between periods of relatively rapid
growth of output (recovery and prosperity),
alternating with periods of relative
stagnation or decline (contraction or
recession). These fluctuations are often
measured using the real gross domestic
product.” (wikipedia)
AKA “Fluctuations”
 Because no two business cycles are
alike and they can occur without
regularity, many economists now
prefer the term “Business
Fluctuations”.
What determines the phase of the
business cycle?
 Level of total output as measured by
Real GDP
Four Phases
 Peak or Boom – A period of
prosperity with higher levels of output
and low unemployment. New
businesses may open and many
factories are producing at full or near
full capacity.
Contraction or Slowdown
 Real GDP begins to level off and
eventually slows down.
 Characterized by reductions in the
outputs of factories, layoffs of
workers, and reduction in consumer
spending.
Four Phases of the Business Cycle
If a contraction is long and deep
enough, it can develop into a
recession, two consecutive
quarters of no growth, or
negative growth in Real GDP.
A Recession can develop into a
depression, characterized by
extremely high unemployment and
many business failures.
Growth Recession v. Recession
 Growth recession – A period during
which real GDP grows, but at a rate
below the long-term trend of 3
percent.
 A growth recession occurs when the
economy expands too slowly.
 A recession occurs when real GDP
actually contracts.
Four Phases of the Business Cycle
 Trough – Lowest point of the cycle,
In a trough, Real GDP stops its slide,
levels off and slowly begins to grow.
 Expansion or Recovery –
Unemployment decreases, consumers
begin spending more, Real GDP
increases, and more businesses open.
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.
Laissez-faire/Classical View
 According to law of demand, price
reductions cause an increase in sales,
thus no one would lose a job because
of weak consumer demand.
 Optimistic views of the macro
economy were summarized in Say’s
Law
 Definition:Say’s Law - Supply
creates its own demand.
Macro Failure
 The Great Depression was a stunning
blow to Classical economists.
 Unemployment grew and persisted
despite falling prices and wages
The Keynesian Revolution
 Inherent Instability - John
Maynard Keynes asserted that a
market-driven economy is inherently
unstable.
 Government Intervention – In
Keynes’s view, the inherent
instability of the marketplace
required government intervention.
A Model of the Macro Economy
 Keynes and the Classical economists were
not debating whether business cycles
occur, but whether they are an appropriate
target for government intervention.
 The primary measures of the
macroeconomic outcomes include:
 Output - total value of goods and services
produced.
 Jobs - levels of employment and
unemployment.
Model of the Macro Economy
 Prices - average price of goods and
services.
 Growth - year-to-year expansion in
production capacity.
 International balances international value of the dollar; trade
and payments balances with other
countries.
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.
Aggregate Demand and Supply.
 Aggregate Demand – The total
quantity of output demanded at
alternative price levels in a given
time period, ceteris paribus.
Reasons why the aggregate
demand curve is downward
sloping:
 Real-balances effect –
 The real value of money is measured
by how many goods and services
your money will buy.
 The cash balances you hold in your
pocket, in your bank account, or
under your pillow are worth more
when the price level falls.
Reasons why the aggregate
demand curve is downward
sloping:
 Foreign-trade effect – This effect
reinforces downward sloping curve
by changes in imports and exports.
If the average price level of U.S.
goods is increasing, consumers may
opt for imports and if the average
price level of U.S. goods is falling,
consumers may opt for domestically
produced goods.
Reasons why the aggregate
demand curve is downward
sloping:
 Interest-rate effect – with lower
prices, consumers need to borrow
less, the demand for loans
diminishes, so interest rates drop.
Aggregate Supply
 Aggregate Supply - The total
quantity of output producers are
willing and able to supply at
alternative price levels in a given time
period, ceteris paribus.
The Aggregate Supply curve is
upward sloping for two
reasons:
 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.
 Cost effect - cost pressures make it more
expensive to produce output, therefore
producers are only willing to supply
additional output if prices rise at least as
far as costs. Cost pressures are minimal at
low rates of output but intense as the
economy approaches capacity.
Macro Equilibrium
 Equilibrium (macro) – The
combination of price and output that
is compatible with both aggregate
demand and aggregate supply.
 Equilibrium is unique; it is the only
price-output combination that is
mutually compatible with aggregate
supply and demand.
Macro failures.
 Undesirability - the price-output
relationship at equilibrium may not
satisfy our macroeconomic goals.
 Instability – even if the designated
macro equilibrium is optimal, it may
be displaced by macro disturbances
Competing Theories of ShortRun Instability: Demand Side
Keynesian Theory
 Keynesian theory is the most
prominent of the demand-side
theories.
 Argued that deficiency of spending
would tend to depress an economy.
 Keynes concluded that inadequate
aggregate demand would cause
persistently high unemployment.
Demand Side Theories
 Monetary Theories
 Emphasize the role of money in financing
aggregate demand.
 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.
 If money supply is too tight, businesses
might curtail investment.
Supply-Side Theories
 Decreases in aggregate supply can cause
multiple macro problems while increases
can move us closer to both our price
stability and full employment goals.
 Eclectic explanations. Shifts in either or
both aggregate supply or demand curves
could be used to explain unemployment,
inflation, or recurring business cycles or to
achieve any specific output or price level.