MacroeconomicsBusiness Cycles and

Macroeconomic Policy

lector univ. dr. ec. av. Alexis DAJ

Phases of the Business Cycle

Business Cycle - Definition: alternating increases and decreases in the level of business activity of varying amplitude and length

How do we measure “increases and decreases in business activity?” Percent change in real GDP!

Why do we say “varying amplitude and length?”Some downturns are mild and some are

severeSome are short (a few months) and some are

long (over a year) Do not confuse with seasonal fluctuations!

Phases of the Business Cycle

Expansion ExpansionRecession

The Phases of the Business Cycle

Boom

Secular growth

trend

DownturnUptu

rn

Trough

Peak

0Jan.-Mar

Tot

al O

utpu

t

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Note: Shaded areas indicate recessions.

Real GDP 1958-2007, in 2000 dollars Note: “Years” is on horizontal axis and “real GDP”

is on vertical axis. General trend of economic growth Recession years are shaded blue: note downward

slope on graph indicating that GDP is decreasing.

The GDP Gap, 1945-2000

The GDP gap is the amount of production by which potential GDP exceeds actual GDP 10-9

ActualGDP

ActualGDP

Potential GDPGDP gap

PotentialGDP

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Since potential GDP has exceeded actual GDP for most years since World War II, we have had a GDP gap. However in some periods, most recently from 1996

through 2000, actual GDP has been greater than potential GDP

U.S. real gross domestic product per person

from 1900 to 2004

Long-Run Economic Growth

Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades.

A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.

The Conventional Three-Phase Business Cycle

10-4

Year

ProsperityPeak

Trough Trough

Peak

Peak

2005 2010 2015

Recession

What is a recession?

Generally, 2 or more quarters of declining real GDP

Implication: it’s not officially a called a recession until the economy has already been declining for 6 months!

Who decides when we’re in a recession?

E.g.: National Bureau of Economic Research traditionally declares recessions

Private research organization, not a federal agency

Recession dates from peak of business

Post-World War II Recessions*

*The February 1945–October 1945 recession began before the war ended in August 1945.

Note: These recessions were of varying duration and severity.

Another Look at Expansions and Recessions

Can you find a pattern? Neither can economists! That’s why recessions are hard to predict.

Business Cycle Theories

Endogenous theories:

Innovation theory: innovation leads to saturation. Psychological theory: alternating optimism and

pessimism Inventory cycle theory: inventory and demand not

in sync Monetary theory: changes in money supply by

Federal Reserve Underconsumption theory: or overproduction

Business Cycle Theories

Exogenous theories:

The external demand shock theory: effect of foreign economies

War theory: war stimulates economy; peace leads to recession

The price shock theory: fluctuations in oil prices

Endogenous Starts from within the model Endo- inside, source Genous- born

From outside of the model Exo- outside Genous- born, source

Exogenous

The Main Instruments of Macroeconomic Policy

18

Objectives and Instruments of Macroeconomic Policy

Objectives of Macroeconomic Policy Instruments of Macroeconomic Policy Birth and Development of

Macroeconomic Policy

19

Objectives and Instruments of Macroeconomic Policy

Objectives of Macroeconomic Policy

Full EmploymentStable PriceEconomic GrowthBalance of Payments

20

Objectives and Instruments of Macroeconomic Policy

Instruments of Macroeconomic Policy

Demand Management Supply Management International Economic Policy

21

Objectives and Instruments of Macroeconomic Policy

Birth and Development of Macroeconomic Policy

Since 1930s, three phases: Phase 1: 1930s-World war , ”New Policy”Ⅱ Phase 2: After World war , fiscal policy and Ⅱ

monetary policy. Phase 3: 1970s, ”Stagflation” appeared. Western

countries strengthen the adjustment of market mechanism.

The Main Instruments of Macroeconomic Policy

Fiscal Policy Government expenditure Taxation Influence on AD / AS

Monetary Policy Interest rates Money supply Exchange rates

Supply side policies

What is fiscal policy Fiscal policy looks at how government spend their money and how

they control their taxes. There are 2 types of fiscal policy:

Contractionary fiscal policy: Where the government reduce spending and / or when they make taxes higher.

Expansionary fiscal policy: Where the government cut taxes or increase government spending. They will increase the amount the government borrows to fund the expenditure.

Observation: Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

Government Expenditure

Government expenditure covers all spending by the public sector

The government spends money on many things including: Education Defence Welfare benefits Healthcare Infrastructure Police

Government Borrowing

As well as gaining revenue through taxation the government can also finance their spending through borrowing

The public sector net cash requirement (PSNCR) measures the annual borrowing requirement of the government in an economy

The budget deficit has been renamed to the public sector net cash requirement (PSNCR) to avoid confusion with net borrowing.

Government Borrowing

Public sector borrowing requirement (PSBR) is the old name for the budget deficit in the United Kingdom.

PSBR occurs when expenditures for the government activities in the public sector of the economy exceed the income. The resulting deficit is then financed by borrowing funds from the public, usually by the means of government bonds.

Direct & indirect taxes

Direct taxes are taxes of income and expenditure e.g. income tax, corporation tax (levied on company profits).

Indirect taxes are taxes such as VAT (value added tax), changes in this type of tax has a rapid effect on the level of economic activity. E.g. an increase in VAT will cut consumption

Fiscal Policy and AD

Taxation influences the AD curve because: An increase in taxation will decrease the level of consumption in the

economy An increase in taxation will increase the level of government spending

in the economy A decrease in taxation will increase the level of consumption in the

economy A decrease in taxation can decrease the level of government

expenditure in the economy The impact of a change in government expenditure depends on

the size of the multiplier

Fiscal Policy and AD

Governments can utilise fiscal policy to control the level of AD in the economy

There can be problems with this due to:Time lagsThe size of the multiplierFiscal crowding outPeoples reaction to cuts / rises in taxation

Fiscal Policy and AS

Fiscal policy can be used to increase the productive capacity of the economy

This is because government expenditure can be used to: Increase the skill levels of workersProvide economic incentives to firms Increase factor mobility

Monetary Policy

Monetary policy is the use of interest rates, money supply and exchange rates to influence economic growth and inflation

Interest rates – are the cost of borrowing money Exchange rates – the value of one currency in terms of

another Money supply – the amount of money in circulation in an

economy

Interest Rates

The Central Banks are responsible for setting interest rates in a national economy

The Bank sets the rate after analysing macroeconomic trends and risks associated with inflation

E.g.: Since 1997 the UK government has used interest rates to control the level of inflation in the economy (at a level of 1.5-3.5% - target = 2.5%)

If the Bank believes the level of AD is rising too quickly (potentially causing demand pull inflation), they will decide to raise interest rates

Interest Rates and The Economy

Changes to interest rates influence many things in the economy:Housing prices and housing market – if interest rates

rise the cost of mortgages increases therefore reducing demand for housing in theory

Disposable income of house owners – if interest rates rise the real disposable income of home owners falls as they have larger mortgage payments (variable rate only)

Interest Rates and The Economy

Credit demand – if interest rates rise the amount of credit sales should decrease as it becomes more expensive

Investment – if interest rates rise they lead to a decrease in the level of investment

Exchange rates – E.g.: An increase in interest rates may lead to an appreciation of UK currency making exports less attractive

Interest rates and Inflation

Interest rates are used to control inflation as when interest rates are increased consumption decreases as peoples real incomes are eroded by mortgage payments and credit payments and the opportunity cost of spending has increased

By controlling interest rates the government aims to keep inflation at a low level

Interest and Exchange Rates

E.g., changes in the UK’s interest rates will lead to changes in the exchange value of the pound.

If interest rates rise the value of the pound will rise so the pound will now buy more US dollars, Japanese Yen, Euros etc.

If interest rates fall the value of the pound will fall so the pound will now buy less US dollars, Japanese Yen, Euros etc

Exchange rates

A fall in the exchange rate reduces the price of exports and increases the price of imports

Domestic demand will be stimulated and more people will buy exports as they are cheaper

This will create a deficit on the current account of the balance of payments

As consumption will increase it will increase AD which will increase the level of output in the economy and more it towards full employment

Supply Side Policies

Supply side policies are policies that improve the supply-side of the economy increasing its efficiency and thereby resulting in economic growth

Supply side policies can act in the product and labour markets

Supply side policies

Trade union reforms Increased expenditure on training and education Changes in taxation Changes to welfare system Privatisation Deregulation Free trade Incentives for small businesses

Supply side policies

Supply side policies cause economic growth as they cause the LRAS to shift outwards increasing the potential output of the economy

If the economy is operating near full potential increases in aggregate demand can cause cost push inflation, by the LRAS curve shifting outwards this inflationary pressure is reduced

Supply side policies

As supply side policies can cause the LRAS to shift outwards they can lead to a fall in unemployment levels

Many supply side policies concentrate on the labour market and increase skills for workers which help reduce structural unemployment in the economy

Supply Side Policies

As the LRAS shifts outwards businesses will have lower average costs as productivity has increased

Lower costs mean that businesses are able to compete more internationally therefore making the balance of payments more healthy

Summary Fiscal Policy is the use of government expenditure and taxation to

influence the level of inflation / economic growth Government expenditure covers all things the public sector spends

money on Taxation earns revenue for the government either directly through

income taxes or indirectly through VAT Monetary Policy is the control of the economy through interest rates,

money supply and exchange rates The central bank sets the rate of interest in a national economy The government uses interest rates to control the rate of inflation

around its target of 2.5% Supply side policies aim to increase productivity in the economy

therefore stimulating economic growth