13 e Chapter 08 The Business Cycle Mc

The Business Cycle • Macroeconomics explains how and why economies grow and what causes the recurrent ups and downs known as the business cycle. • Business cycle: alternating periods of economic growth and contraction. • We focus on three central questions: – How stable is a market-driven economy? – What forces cause instability? – What, if anything, can the government do to promote steady economic growth? 8 -2

Learning Objectives • 08 -01. Know the major macro outcomes and their determinants. • 08 -02. Know why the debate over macro stability is important. • 08 -03. Know the nature of aggregate demand (AD) and aggregate supply (AS). • 08 -04. Know how changes in AD and AS affect macro outcomes. 8 -3

Stable or Unstable? • Prior to the 1930 s, conventional wisdom was a market-driven economy, which was inherently stable. – Business cycles (ups and downs in the economy) were short-lived, and the market seemed to correct (regulate) itself. – There was no need for government intervention – that is, the prevailing view dictated a policy of laissez faire. . • Laissez faire: the doctrine of “leave it alone, ” of nonintervention by government in the market mechanism. 8 -4

A Self-Regulating Economy • Classical economics: the economy “selfadjusts” to any deviations from its long-term growth trend. – In this view, wages and prices are flexible. – If there are excess goods, the producer can • Lower prices and sell more, eliminating excess goods. • Decrease output and lay off workers. Laid-off workers compete for jobs by asking for lower wages. At lower wages, firms will hire more workers. – This is the essence of Say’s Law. 8 -5

A Self-Regulating Economy • Say’s Law: supply creates its own demand. – Whatever was produced would be sold. – All workers who sought employment would be hired. – This would occur because people have time to adjust prices and wages downward. • The economy therefore is self-regulating. 8 -6

Macro Failure • The self-adjustment mechanism did not work during the Great Depression. – John Maynard Keynes analyzed the situation and concluded that self-adjustment could not occur because of “an insufficiency of effective demand. ” – He asserted that a market-driven economy was, in fact, inherently unstable. • He concluded that the government must intervene by increasing aggregate demand. 8 -7

Government Intervention • For an underperforming economy, Keynes proposed that the government intervene to – By more output. – Employ more people. – Provide more income transfers. – Make more money available. • For an overheated economy, Keynes proposed the opposite. – Higher taxes. – Spending reductions. – Reduce availability of money. 8 -8

Business Cycle • The four parts of a modern business cycle are – The peak, where GDP maximizes. – Recession, where GDP declines. – The trough, where GDP minimizes. – Recovery, where GDP increases. • These are variations around a growth trend that slopes upward. 8 -9

Terms Associated with the Business Cycle • Economic growth: real GDP grows faster than 3%. Expansion. • Growth recession: real GDP grows, but slower than 3%. The economy expands too slowly. • Recession: real GDP contracts (for two or more consecutive quarters). • Depression: an extremely deep recession. 8 -10

The Great Recession of 2008 -2009 • A recession began as falling home and stock prices sapped consumer wealth and confidence. This was coupled with a credit crisis. – Sales plummeted and GDP contracted. – Unemployment reached 10. 1%. • The Great Recession reached its trough in August 2009, but economic growth since that time has been so sluggish that unemployment remains high (over 9% in 2011). 8 -11

A Model of the Macro Economy • Macro outcomes: – Output: real GDP. – Jobs: levels of employment and unemployment. – Prices: CPI and inflation. – Growth: year-to-year expansion of GDP. – International balances: value of the dollar; trade balances. 8 -12

A Model of the Macro Economy • Determinants of macro performance: – Internal market forces: population growth, spending behavior, invention and innovation. – External shocks: wars, natural disasters, terrorist attacks, trade disruptions. – Policy levers: tax policy, government spending, changes in the availability of money, regulation. 8 -13

The Crucial Controversy • Most controversial is whether the policy levers are effective and necessary. – Keynes said “yes. ” – Classical economists said “no. ” • Also controversial is whether pure, marketdriven economies are inherently stable or unstable. – Keynes said “unstable. ” – Classical economists said “stable. ” 8 -14

Aggregate Demand Supply • The forces of supply and demand are at work in the macro economy. – Any influence on macro outcomes must be transmitted through supply or demand. • The macro model shows how the macro economy works, and it consists of aggregate demand aggregate supply. 8 -15

Aggregate Demand • Aggregate demand (AD): the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus. – The collective behavior of all buyers in the marketplace. – It comprises all goods and services. • AD slopes downward; people will buy more goods and services at lower price levels, and vice versa. 8 -16

Aggregate Demand (AD) • Why does AD slope downward? – Real balances effect: the cash you hold is worth more when the price level falls, so you can buy more. – Foreign trade effect: lower price levels in the United States convince customers to buy more American goods and fewer foreign goods. – Interest rate effect: lower interest rates promote more borrowing and more spending. 8 -17

Aggregate Supply • Aggregate supply (AS): the total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. – The collective behavior of all suppliers (sellers) in the marketplace. – It comprises all goods and services. • AS slopes upward; suppliers will bring more goods and services to market at higher price levels, and vice versa. 8 -18

Aggregate Supply (AS) • Why does AS slope upward? – Profit effect: if there is no change in the cost of operating a business, rising prices will improve profits, and suppliers will bring more products to the market. – Cost effect: cost increases make producing products more expensive. Producers will be willing to supply more only if prices also rise to cover those added costs. • At high rates of output (near productive capacity), costs rise steeply and AS steepens sharply. 8 -19

Macro Equilibrium • AS and AD summarize the market activity of the macro economy. • Macro equilibrium: the combination of price level and real output that is compatible with both AD and AS. – Where AD and AS intersect. – … at PE and QE. 8 -20

Macro Failures • Let QF be the goal of full-employment GDP. • The equilibrium output QE is undesirable; it does not reach our macro goal. • Also, AD and AS can shift, meaning that any equilibrium can be unstable. 8 -21

AS Shifts • AS will shift left if – Business costs rise. – Business taxes rise. – Natural disaster occurs. • AS will shift right if – Business costs fall. – Business taxes fall. – Bounteous harvests occur. • On the graph, AS shifts left away from fullemployment GDP. 8 -22

AD Shifts • AD will shift left if – Sending decreases. – Expectations get worse. – Taxes increase. • AD will shift right if – Spending increases. – Expectations improve. – Taxes decrease. • On the graph, AD shifts left away from fullemployment GDP. 8 -23

Short-Run Instability: Competing Theories • Classical economists believe the economy will self-regulate and gravitate toward full employment. • Keynes and his followers do not believe this. They believe the economy might get worse without government intervention. • In addition, there are controversies about the shape of AS and AD and the potential to shift these curves. 8 -24

Keynesian Theory • This is a demand-side theory. • A recession originates with a deficiency of spending. – AD is too far to the left. – Policy: increase government spending to shift AD back to the right. • Inflation originates with an excess in spending. – AD is too far to the right. – Policy: increase taxes to shift AD back to the left. 8 -25

Monetary Theory • This is also a demand-side theory. – Emphasizes the role of money in financing AD. • “Tight” money might cause AD to shift too far to the left. – Policy: increase money supply and lower interest rates to shift AD back to the right. • “Easy” money might cause AD to shift too far to the right. – Policy: decrease money supply and raise interest rates to shift AD back to the left. 8 -26

Demand-Side Theories 8 -27

Supply-Side Theory • A shift in AS to the left causes output and employment to decrease and inflation to increase. – This problem cannot be corrected by shifting AD. • Shift AD right and unemployment falls but inflation worsens. • Shift AD left and inflation is reduced but unemployment rises. – Policy: devise ways to shift AS back to the right. 8 -28

Long-Run Self-Adjustment • Advocates argue that short-run instability is not as important as the long-run trend in economic growth. – Relies on the view that the economy can self-adjust. – Once it adjusts to a short-run deviation, the economy will return to its long-run growth path. • There is a “natural” rate of output determined by institutional factors. 8 -29

Short- and Long-Run Perspectives • We live in the short run. – Short-run variations affect our current economic situation. – We call on government to “fix” short-run problems – now! – Implemented policies take effect in the short-run. – In the short run, AS slopes upward. • The macro model we will use to describe policy implementation will have an upward-sloping AS curve. 8 -30