Download Chapter 16

ECONOMICS 5e
Michael Parkin
CHAPTER
17
The Business Cycle
Copyright © 2000 Addison Wesley Longman, Inc.
Chapter 34 in Economics
Slide 17-1
Learning Objectives
• Distinguish among the different theories of
the business cycle
• Explain the Keynesian and monetarist
theories of the business cycle
• Explain the new classical and new
Keynesian theories of the business cycle
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-2
Learning Objectives (cont.)
• Explain real business cycle theory
• Describe the origins of and the mechanism
at work during two recent recessions
• Describe the origins of and the mechanisms
at work during the Great Depression
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-3
Learning Objectives
• Distinguish among the different theories of
the business cycle
• Explain the Keynesian and monetarist
theories of the business cycle
• Explain the new classical and new
Keynesian theories of the business cycle
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-4
Cycle Patterns, Impulses,
and Mechanisms
The business cycle is an irregular and
nonrepeating up-and-down movement of
business activity that takes place around a
generally rising trend and that shows great
diversity.
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Slide 17-5
Some Business Cycle Patterns
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Slide 17-6
Cycle Patterns, Impulses,
and Mechanisms
Business Cycle Patterns
• There is no simple explanation for the
causes of the business cycle.
• There is no way of forecasting when the
turning points will come.
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Slide 17-7
Cycle Patterns, Impulses,
and Mechanisms
Cycle Impulses and Mechanisms
1) The economy is like a tennis ball.
• An outside force changes its direction
2) It also resembles the day to night cycle.
• No force causes the change
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Slide 17-8
Cycle Patterns, Impulses,
and Mechanisms
Cycle Impulses and Mechanisms
3) Finally, it resembles a rocking horse:
• Some outside force has to begin the rocking.
• The cycle continues without any new force
being applied.
• The rocking (cycle) eventually dies unless a
new force is applied.
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Slide 17-9
Cycle Patterns, Impulses,
and Mechanisms
The Central Role of Investment and Capital
• Recessions begin when investment in
new capital slows down.
• Possibly due to diminishing returns
• Expansions begin when investment in
new capital speeds up.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-10
Learning Objectives
• Distinguish among the different theories of
the business cycle
• Explain the Keynesian and monetarist
theories of the business cycle
• Explain the new classical and new
Keynesian theories of the business cycle
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-11
Aggregate Demand Theories
of the Business Cycle
There are three types of aggregate demand
theories. These include:
1) Keynesian Theory
2) Monetarist Theory
3) Rational Expectations Theories
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Slide 17-12
Aggregate Demand Theories
of the Business Cycle
Keynesian Theory -- John Maynard Keynes
The Keynesian theory of the business
cycle regards volatile expectations as the
main source of economic fluctuations.
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Slide 17-13
Aggregate Demand Theories
of the Business Cycle
Keynesian Impulse
• The impulse of the business cycle is a
change in expected future sales and
profits.
• This changes the level of investment in
new capital.
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Slide 17-14
Aggregate Demand Theories
of the Business Cycle
The Keynesian Impulse
Keynes reasoned that news or rumors of future
tax changes, interest rate changes, advances in
technology, global economic and political
events (for example) affect expectations and
investment.
Referred to as “animal spirits”
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Slide 17-15
Aggregate Demand Theories
of the Business Cycle
The Keynesian Cycle Mechanism
A change in animal spirits which causes a
change in investment leads to a cycle
mechanism.
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Slide 17-16
Aggregate Demand Theories
of the Business Cycle
The Keynesian Cycle Mechanism
The cycle mechanism has two key
elements:
1) The initial change in investment has a
multiplier effect.
• It changes aggregate expenditure, real GDP, and
disposable income
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Slide 17-17
Aggregate Demand Theories
of the Business Cycle
The Keynesian Cycle Mechanism
The cycle mechanism has two key
elements (cont.):
2) The response of real GDP to a change in
aggregate demand.
• If money wages are sticky, a decline in aggregate
demand brings recession.
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Slide 17-18
Price level (GDP deflator, 1992 = 100)
A Keynesian Recession
A fall in animal spirits
decreases aggregate
demand...
LAS
120
110
0
b
…and, with
sticky wages,
brings
recession
6.0
a
AD1
SAS
AD0
7.0
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-19
Price level (GDP deflator, 1992 = 100)
A Keynesian Expansion
A rise in animal spirits
increases aggregate
demand...
LAS
d
120
110
…and, with flexible
wages, brings an
expansion and rise
in the price level
b
c
AD1
0
6.0
7.0
SAS
AD2
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-20
Aggregate Demand Theories
of the Business Cycle
The Keynesian Cycle Mechanism
The Keynesian business cycle most
closely resembles a tennis match.
• It is caused by outside forces that change
direction and set off a process that ends at
equilibrium.
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Slide 17-21
Aggregate Demand Theories
of the Business Cycle
Monetarist Theory — Milton Friedman
The monetarist theory of the business
cycle regards fluctuations in the money
stock as the main source of economic
fluctuations.
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Slide 17-22
Aggregate Demand Theories
of the Business Cycle
The Monetarist Impulse
The impulse in the monetarist theory of
the business cycle is the growth rate of
the quantity of money.
• Slowdowns bring recession
• Speedups bring expansion
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Slide 17-23
Aggregate Demand Theories
of the Business Cycle
The Monetarist Cycle Mechanism
Once the Fed changes the money supply
a cycle mechanism begins to work that
first affects aggregate demand.
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Slide 17-24
Aggregate Demand Theories
of the Business Cycle
The Monetarist Cycle Mechanism (cont.)
An increase in the money supply leads to:
• The quantity of real money increases.
• Interest rates fall.
• Real money balances increase.
• The dollar loses value on the foreign
exchange market.
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Slide 17-25
Aggregate Demand Theories
of the Business Cycle
The Monetarist Cycle Mechanism (cont.)
An increase in the money supply leads to:
• Investment demand and exports increase.
• Consumers spend more on durable goods.
• These initial changes in expenditure have a
multiplier effect and an expansion begins.
Decreases in the money supply have similar,
but opposite, effects.
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Slide 17-26
Aggregate Demand Theories
of the Business Cycle
The Monetarist Cycle Mechanism (cont.)
The second element in the monetarist
cycle mechanism is the response of
aggregate supply to a change in aggregate
demand.
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Slide 17-27
Aggregate Demand Theories
of the Business Cycle
The Monetarist Cycle Mechanism (cont.)
Monetarists believe that real GDP
deviations from full employment are
temporary in both directions.
• This is due to their belief that money wages
are only temporarily sticky.
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Slide 17-28
Price level (GDP deflator, 1992 = 100)
A Monetarist Business Cycle
A slowdown in money growth
decreases aggregate demand
and brings recession...
120
117
b
110
Recession
LAS
SAS0
SAS1
a
c
AD0
AD1
0
6.5
7.0
…but a fall in
money wages
eventually
brings an
expansion and
restores full
employment
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-29
Price level (GDP deflator, 1992 = 100)
A Monetarist Business Cycle
A speedup in money growth
increases aggregate demand
and brings expansion...
Expansion
LAS
SAS2
SAS1
120
e
113
110
c
d
…but a rise in
money wages
lowers real GDP
and restores
AD2 full employment
AD1
0
6.0
7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-30
Learning Objectives
• Distinguish among the different theories of
the business cycle
• Explain the Keynesian and monetarist
theories of the business cycle
• Explain the new classical and new
Keynesian theories of the business cycle
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-31
Aggregate Demand Theories
of the Business Cycle
Monetarist Cycle Mechanism
The monetarist business cycle is most like
a rocking horse.
• It needs an outside force to get it going and it
rocks back and force (just once).
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Slide 17-32
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Theories
• A rational expectation is a forecast that is
based on all the available relevant
information.
• Rational expectations theories are based
on the view that money wages are
determined by a rational expectation of
the price level.
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Slide 17-33
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Theories
There are two different rational
expectations theories:
1) New classical theory of the business cycle.
• Regards unanticipated fluctuations in
aggregate demand as the main source of
economic fluctuation.
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Slide 17-34
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Theories
There are two different rational expectations
theories:
2) New Keynesian Theory of the Business
Cycle
• Is similar to the new classical theory, but also
leaves room for anticipated demand fluctuations
to play a role.
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Slide 17-35
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Impulse
The impulse in the rational expectations
theories is an unanticipated change in
aggregate demand.
• A larger than anticipated increase in aggregate
demand brings expansion.
• A smaller than anticipated increase in
aggregated demand brings recession.
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Slide 17-36
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Impulse
Unanticipated impulses include fiscal policy,
monetary policy, or a change in the world
economy that influences exports can change
real GDP.
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Slide 17-37
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Cycle Mechanisms
New Classical Version
• If firms and workers anticipated an increase in
aggregate demand, they expect the price level to
rise and will agree to a higher money wage rate.
• This can prevent the real wage rate from falling
and avoid a fall in the unemployment rate below
the natural rate.
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Slide 17-38
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Cycle Mechanisms
New Keynesian Version
• Also, believe that money wages are influenced
by rational expectations of the price level.
• Emphasizes the significance of the long-term
contracts.
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Slide 17-39
Aggregate Demand Theories
of the Business Cycle
Rational Expectations Cycle Mechanisms
New Keynesian Version
• Firms and workers are unable to quickly adjust
real money wages to changes in aggregate
demand.
• This leads to sticky wages.
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Slide 17-40
A Rational Expectations
Business Cycle
Price level (GDP deflator, 1992 =
100)
LAS
SAS
Recession
110
107
Aggregate demand
less than expected
brings recession
a
b
EAD
AD0
0
6.5
7.0
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-41
A Rational Expectations
Business Cycle
Price level (GDP deflator, 1992 = 100)
LAS
SAS
c
113
110
107
Expansion
Aggregate demand
greater than expected
brings expansion
a
b
AD1
EAD
AD0
0
6.5
7.0
7.5
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-42
Learning Objectives (cont.)
• Explain real business cycle theory
• Describe the origins of and the mechanism
at work during two recent recessions
• Describe the origins of and the mechanisms
at work during the Great Depression
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-43
Real Business Cycle Theory
Real business cycle theory (RBC) regards
random fluctuations in productivity as the
main source of economic fluctuations.
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Slide 17-44
Real Business Cycle Theory
The RBC Impulse
• The impulse in RBC theory is the growth rate
in productivity.
• Rapid technological progress and productivity
growth increases quickly.
• Slow progress and productivity grows more
moderately.
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Slide 17-45
The Real Business Cycle Impulse
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Slide 17-46
Real Business Cycle Theory
The RBC Mechanism
Two immediate effects that follow a change in
productivity that effect the business cycle are:
1) Investment demand changes
2) The demand for labor changes
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-47
Price interest rate (percent per year)
Capital and Labor Markets
in a Real Business Cycle
Technology shock
decreases investment
demand...
10
SS
Investment, saving,
and interest rate
8
…and investment,,
saving, and real
interest rate fall
6
4
2
ID1
0
0.5
0.7 1.0
ID0
1.5
Investment (trillions of 1992 dollars)
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Slide 17-48
Real wage rate (1992 dollars per hour)
Capital and Labor Markets
inTechnology
a Real
Business
Cycle
shock
18.00
decreases demand
for labor...
0
LS0
…and a fall in
real interest rate
decreases supply
of labor...
15.00
14.50
10.00
LS1
…and employment
and real wage
rate fall
190 195 200
LD1
Labor and
wage rate
LD0
210
Labor (billions of hours per year)
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Slide 17-49
AS-AD in a Real Business Cycle
Price level (GDP deflator, 1992 = 100)
LAS1
LAS0
Technology shock
decreases both
LAS and AD. Real
GDP and price
level fall
110
107
AD0
AD1
0
6.8
7.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-50
Real Business Cycle Theory
Criticisms of Real Business Cycle Theory
• Money wages are sticky.
• Intertemporal substitution is too weak to
account for large fluctuations in labor supply
and employment with small real wage changes.
• Technology shocks are not capable of creating
the swings in productivity indicated by growth
accounting.
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Slide 17-51
Real Business Cycle Theory
Criticisms of Real Business Cycle Theory
Fluctuations in productivity do not cause
the business cycle but are caused by it.
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Slide 17-52
Real Business Cycle Theory
Defense of Real Business Cycle Theory
• It explains and is consistent with the
macroeconomic facts about the business cycle
and economic growth.
• It is consistent with a wide range of
microeconomic evidence.
• They view the relation between money and
GDP as reverse causation.
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Slide 17-53
Real Business Cycle Theory
Defense of Real Business Cycle Theory
It raises the possibility that the business cycle is
efficient.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-54
Learning Objectives (cont.)
• Explain real business cycle theory
• Describe the origins of and the mechanism
at work during the 1990s
• Describe the origins of and the mechanisms
at work during the Great Depression
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-55
Recessions and Expansions
During the 1990s
• The U.S. recession of 1990-1991
• The U.S. expansion of the 1990s
• The Japanese Recession
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Slide 17-56
Recessions and Expansions
During the 1990s
The recession 1990-1991
The economy was at full employment at
the beginning of 1990.
• The unemployment rate was just above 5
percent.
• Inflation was a steady 4 percent.
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Slide 17-57
Recessions and Expansions
During the 1990s
The U.S. recession of 1990-1991 (cont.)
External Shock: The Gulf Crises
• The Gulf War resulted in aggregated demand
and aggregate supply shocks.
• Uncertainty led to a decline in investment.
Fiscal Policy and Monetary Policy
• Fiscal policy was not enough to offset this
decrease.
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Slide 17-58
Recessions and Expansions
During the 1990s
The U.S. recession of 1990-1991 (cont.)
Aggregate Demand and Aggregate Supply
Aggregate demand shifted left.
Aggregate supply shifted left.
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Slide 17-59
Recessions and Expansions
During the 1990s
The U.S. recession of 1990-1991 (cont.)
Labor Market and Productivity
Labor productivity growth slowed to about
half a percent and overall productivity
decreased by more than half a percent during
1991.
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Slide 17-60
Price level (GDP deflator, 1992 = 100)
The 1990-1991 Recession
SAS91
94
94
SAS93
1990
1991
…fall in investment
decreases AD
AD90
AD91
0
6.14
6.14
Real GDP (trillions of 1992 dollars)
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Slide 17-61
Recessions and Expansions
During the 1990s
The U.S. expansion of the 1990s
By the end of 1998, the U.S. economy had
completed 94 months of uninterrupted
expansion.
Real GDP had grown by 23 percent during this
period.
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Slide 17-62
Recessions and Expansions
During the 1990s
The U.S. expansion of the 1990s (cont.)
Productivity Growth in the Information Age
• Internet
• Personal computer
• Biotechnology
Fiscal Policy and Monetary Policy
• Fiscal policy was restrained.
• Monetary policy was passive.
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Slide 17-63
Price level (GDP deflator, 1992 = 100)
The 1990s Expansion
LAS91 LAS98
SAS98
SAS91
114
Full employment
in 1998
97
AD98
Recessionary
gap in 1991
AD91
0
6.08
7.5
Real GDP (trillions of 1992 dollars)
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Slide 17-64
Recessions and Expansions
During the 1990s
The U.S. expansion of the 1990s (cont.)
A Real Business Cycle Expansion Phase
• A strong and sustained burst of technological
change brought rising productivity.
• The lower unemployment rate is a lower
natural rate, and not a sign that the economy
is overheating.
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Slide 17-65
Recessions and Expansions
During the 1990s
The U.S. expansion of the 1990s
A Real Business Cycle Expansion Phase
(cont.)
The Stock Market During the Expansion
• Between 1995 and 1998, real stock prices
increased by 130 percent.
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Slide 17-66
Recessions and Expansions
During the 1990s
The Japanese Recession
Between 1992 and 1998, Japan’s real
GDP expanded by more than 6 percent - a
growth rate of only 0.7 percent per year.
By 1999, real GDP in Japan was
shrinking at a near 5 percent annual rate.
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Slide 17-67
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
The main factors that have contributed to
Japan’s recession are:
• Collapse of asset prices
• Fiscal Policy
• Monetary Policy
• Structural rigidities
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Slide 17-68
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Collapse of asset prices
• Investors believed Japan’s medium term and
long term prospects were bright.
• Financial deregulation brought an increase of
foreign investment into Japan.
• The Bank of Japan lowered interest rates
between 1985 and 1987 and permitted a rapid
growth rate of money.
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Slide 17-69
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Collapse of asset prices
• Asset prices collapsed in 1990.
• Investment decreased sharply and so did
aggregate demand.
• The capital stock and potential GDP grew
more slowly.
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Slide 17-70
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Fiscal Policy
• From 1991 through 1996, Japan pursued
ambitious fiscal policies to stimulate the
economy.
• The stimulus was not persistent during the
1990s.
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Slide 17-71
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Fiscal Policy
• The removal of temporary tax cuts and cuts
in government investment expenditures
lowered aggregate expenditure by 3 percent
of real GDP in 1996-1997.
• This fiscal policy tightening decreased
aggregate demand and contributed to the
recession of 1998.
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Slide 17-72
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Monetary Policy
• Since 1996, a weaker yen and lower real
short term interest rates have had a smaller
but positive effect on aggregate demand in
Japan.
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Slide 17-73
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Structural Problems
• Market distortions in agriculture,
transportation, retail and wholesale trades,
and construction protect inefficient farms and
firms create a lack of competition and low
productivity growth.
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Slide 17-74
Recessions and Expansions
During the 1990s
The Japanese Recession (cont.)
Structural Problems
• This aspect of Japan’s economy goes to the
core of the real business cycle explanation
for fluctuations - fluctuations in the
productivity growth rate.
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Slide 17-75
Fiscal Stimulation in Japan
Date proposed
August 1992
Total Stimulation
(percent of GDP)
2.3
April 1993
2.8
September 1993
1.3
February 1993
3.2
September 1995
3.0
Mid 1996-mid 1997
April 1998
Total
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-3.0
3.3
12.9
Slide 17-76
Japan’s Sliding Growth Rate
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Slide 17-77
Learning Objectives (cont.)
• Explain real business cycle theory
• Describe the origins of and the mechanism
at work during two recent recessions
• Describe the origins of and the mechanisms
at work during the Great Depression
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 17-78
The Great Depression
• The 1920s were a time of prosperity.
• During the Great Depression, twenty-five
percent of the work force was unemployed.
• No social security or unemployment
compensation.
• The employed workers actually were better
off because of the rise in real wages.
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Slide 17-79
The Great Depression
Why the Great Depression Happened
• The patterns of world trade were changing.
• Changing international currency fluctuations
and trade restrictions added to firms’
uncertainties.
• People began to fear a slowdown.
• These factors led to a slowdown in consumer
spending.
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Slide 17-80
The Great Depression
Why the Great Depression Happened
• The stock market crash heightened those fears.
• Investment collapsed.
• Banks failed as people withdrew their funds.
• Bank failures fed on themselves.
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Slide 17-81
The Great Depression
Can It Happen Again?
Severe depression is less likely today because of:
1) Bank Deposit Insurance
2) The Fed’s role as lender of last resort
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Slide 17-82
The Great Depression
Can It Happen Again?
Severe depression is less likely today because of:
3) Taxes and governments spending
4) Multi-income families
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Slide 17-83
Price level (GDP deflator, 1992 = 100)
The Great Depression
1929
15.0
14.6
SAS29
SAS30
1930
AD29
SAS33
11.4
0
1933
734
AD33
AD30
936 1,028
Real GDP (billions of 1992 dollars)
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Slide 17-84
The End
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Slide 17-85