Download Notes on Business Cycles

Business Cycle Theory:
The economy goes through temporary ups and downs over time. This behavior is called
the “business cycle”.
The temporary decrease in business activity and fall in income is called a “recession”.
Temporary boom times are called “expansions”.
There are numerous theories about why business cycles occur. The book lumps them
into two main categories: supply led and demand led. I break down the demand led into
two different theories. The book does characterize two different types supply led
recessions: one based on a long run AS shift and the other based only on the short run AS
shift. I do only one type of supply shift, long run AS.
The AS/AD model: The Aggregate Supply and Aggregate Demand model is used to help
explain business cycles. The basic model combines elements from the market for
loanable funds (chapter 8), market for money (chapter 11 and 12), and theory of
production (chapter 7). To understand the model, you need to understand the basic
shapes of the curves and what would cause the curves to shift.
Aggregate Demand Curve
The AD curves slopes downward. The reason the AD curve slopes down is more
complicated than why a typical microeconomic demand curve slopes down. In
microeconomics, a demand curve slopes down showing that as price rises, people
will want to buy less (or, as price falls, people will want to buy more). The
microeconomic argument is that as a good gets expensive, consumers will switch,
or substitute, to other goods. This theory won’t work in the macroeconomic
world of AD. The problem is there is no “other goods” in the macro world. The
AD curve is the demand for ALL goods. Also, in the micro world, as the price of
a single rises, other prices are not changing. But in the macro world, we look at
the price of all goods. So as prices rise in the macro economy, there is no other
cheaper good to switch to.
So what is the more complicated theory about why the AD curve slopes down?
The book offers three possible reasons, I use only one: interest rates. The interest
rate is the hidden connector between the price level and demand for all goods:
When the real interest rate increases:
Aggregate demand falls because demand for C & I falls
Prices rise
When the real interest rate decreases:
Aggregate demand rises because demand for C & I rises
Prices fall
What would shift the AD curve?
The AD curve would increase or shift to the right if:
C increases: Consumers become more confident, consumers become less
patient, disposable income increases (maybe), or the government
changes its policy on savings
I increases: Investors sentiments improve, increase in technology,
government changes its policy on investment
G increases: government spends more
NX increases: exports increase or imports decrease
The AD curve would decrease or shift to the left if the opposite of the above
happened
Aggregate Supply Curve (Long Run):
The long run AS curve is vertical. This shows that as prices change, it has no
effect on supply goods (production). In the microeconomic world, typically the
supply curve slopes up. This means as the price of a good increases, businesses
have an increased incentive to produce more of the good and they respond by
producing more. This theory will not work in the macroeconomic world. In
macroeconomic theory, it’s not just a single good price rising, it’s the price of all
goods rising. This includes the price of all productive resources (for example,
land, labor, capital).
As prices of all goods and resources increase, businesses have no reason to
produce more (or less). So, as the price level increases, quantity of production
stays the same. This makes the AS curve vertical. Higher prices don’t encourage
additional production because there are also higher costs.
What determines where the AS curve is located, and what would cause the AS
curve to shift? AS is determined by the quantity of resources (land, labor, capital,
technology, quality of institutions). If the quantity of resources increase, the AS
curve shifts right. As to the quantity of labor, the AS curve is drawn for the
natural rate of unemployment (or “full employment”). If the natural rate of
unemployment were to increase (fewer people working), the AS curve would
decrease or shift left. This would be an example of a decrease in the quantity of a
resource (labor).
Aggregate Supply Short Run:
The book also generates a short run AS curve. This is how the economy behaves
in the short run. I describe how recessions occur without using this curve.
Demand Led Recessions
One type of theorized recessions begins with a decrease in AD. However, using
the AS/AD model above, a shift in demand should result in a change of prices and
interest rates, but no change in income or unemployment. That is, long run
equilibrium doesn’t generate a recession. To get a recession, an additional
assumption must be made. Two different additional assumptions are presented.
One is the Keynesian model. The other is the misperception model.
Keynesian Recession:
Keynes suggested that the economy in the short run is different than the
long run because in the short run, the economy may not be able to reach
equilibrium. The original version of Keynes suggested that wages may
not adjust to reach equilibrium. Now, some economists suggest that prices
might not be able to adjust possibly due to menu costs. The ideas that
wages or prices can’t adjust to equilibrium is called “sticky wages” and
“sticky prices” theory.
Generating a recession: start with a drop in AD (a drop in C, or I, or G, or
NX). Prices and interest rates should drop. But the Keynesian assumption
says prices are sticky and won’t fully adjust downward. Since prices don’t
fully adjust, this leaves the market out of balance: supply is greater than
demand and there’s a surplus of goods in the economy. Company
inventories will start to build up. What will companies do? They won’t
lower price (prices are sticky). Since they aren’t selling everything they
produce, they cut production back. They do that by laying off workers.
So in the short run, production (or income) falls as companies cut
production. And unemployment rises as workers are laid off. In the short
run, income is down and unemployment is up: that’s a recession. In the
long run, prices (and interest rates) will eventually drift downward and
bring demand back up to match long run supply. Companies’ sales will go
back to normal, so they’ll increase their production and employment back
to normal, long run equilibrium, full employment, natural rate.
Misperception Theory:
The misperception theory doesn’t use disequilibrium like the Keynesian
theory does. Instead, it uses the idea that businesses get fooled into
reducing production and employment.
Generating a recession: start, again, with a drop in AD (a drop in C, or I,
or G, or NX). Prices begin to fall. As prices fall, businesses don’t realize
that prices across the entire economy are falling. Instead, businesses fear
that the price of their product is falling because there’s a lack of demand
for their specific product. That is, businesses confuse the macroeconomic
event (the fall of AD and all prices) with a microeconomic event (fall of
demand for their product and the price of their product). When companies
fear that demand for their product is falling, what do they do? They cut
production and lay workers off. In the short run, income is down and
unemployment is up: that’s a recession. In the long run, companies will
realize that demand for their product did not fall. It was just prices across
the entire economy and their resource costs are falling to match.
Companies will return production and employment back to normal, long
run equilibrium, full employment, natural rate.
Real Business Cycles: Supply Led Theory
The last business cycle theory covered is caused by shift in AS, not AD.
Temporary changes in the availability of resources and the cost of production is
called a “supply shock”. Examples of supply shocks could be sudden drop in oil
production, bad weather destroying crops, or natural disasters. Supply shocks can
also be good which would cause an expansion, not a recession.
Generating a recession: a bad supply shock hits the economy. The AS curve
shifts the left. The new equilibrium has higher prices, lower income, and higher
unemployment. That’s a recession. In the long run, the supply shock goes away
or is dealt with so production returns to the previous level.
This recession is different than the Demand Led recessions because as income
falls, prices rise. With demand led recessions, prices fall during the recession.
Prices rising during a recession became known as “stagflation” meaning a
stagnation of production + inflation.
The book also talks about a supply led recession being cause by businesses just
expecting higher production costs. This would cause the short run AS curve to
decrease. The resulting recession would appear identical to the above described
supply led recession. The only difference is instead of an actual decrease in
resources, companies only anticipate higher resource costs.