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Chapter 08:The Business Cycle

  Copyright © 2013 by The McGraw-Hill Companies, Inc !ll rights reser"e# McGraw-Hill$Irwin

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 The Business Cycle

•  The Great Depression(1929-1933)disrupted the world’sconventional way othin!in" a#outecono$ic activity%

• &hat a#out now' Cana $ar!et-driven

econo$y #e sta#le' not can "overn$entaction sta#ili*e it'

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 The Business Cycle

• +acroecono$ics e,plains how and whyecono$ies "row and what causes therecurrent ups and downs !nown as thebusiness cycle%

• Business cycle: alternatin" periods oecono$ic "rowth and contraction%

•

&e ocus on three central uestions. – /ow sta#le is a $ar!et-driven econo$y'

 – &hat orces cause insta#ility'

 – &hat i anythin" can the "overn$ent do to pro$otesteady econo$ic "rowth'

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0earnin" #ectives

• 4-1% 5now the $aor $acro outco$esand their deter$inants%

•

4-2% 5now why the de#ate over $acrosta#ility is i$portant%

• 4-3% 5now the nature o a""re"atede$and (6D) and a""re"ate supply (67)%

• 4-8% 5now how chan"es in 6D and 67aect $acro outco$es%

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7ta#le or :nsta#le'

• ;rior to the 193s conventional wisdo$was a $ar!et-driven econo$y whichwas inherently sta#le% – Business cycles (ups and downs in theecono$y) were short-lived and the $ar!et

see$ed to correct (re"ulate) itsel% – There was no need or "overn$ent

intervention < that is the prevailin" view

dictated a policy o laisse* aire%%• Laissez faire: the doctrine o =leave italone> o nonintervention #y"overn$ent in the $ar!et $echanis$%

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6 7el-?e"ulatin" @cono$y

• Classical economics: the econo$y =sel-adusts> to any deviations ro$ its lon"-ter$ "rowth trend% – n this view wa"es and prices are Ae,i#le%

 – there are e,cess "oods the producer can• 0ower prices and sell $ore eli$inatin" e,cess "oods%

• Decrease output and lay o wor!ers% 0aid-o wor!ers

co$pete or o#s #y as!in" or lower wa"es% 6t lowerwa"es r$s will hire $ore wor!ers%

 – This is the essence o Say’s Law%

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6 7el-?e"ulatin" @cono$y

• Say’s Law: supply creates its ownde$and%

 –

&hatever was produced would #e sold% – 6ll wor!ers who sou"ht e$ploy$ent would

#e hired%

 – This would occur #ecause people have ti$e

to adust prices and wa"es downward%

•  The econo$y thereore is sel-re"ulatin"%

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+acro ailure

•  The sel-adust$ent $echanis$ did notwor! durin" the Great Depression% – John Maynar !eynes analy*ed the

situation and concluded that sel-adust$entcould not occur #ecause o =an insuciency oeective de$and%>

 – /e asserted that a $ar!et-driven econo$ywas in act inherently unsta#le%

• /e concluded that the "overn$ent $ustintervene #y increasin" a""re"atede$and%

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Govern$ent ntervention

• or an underperor$in" econo$y 5eynesproposed that the "overn$ent intervene to – By $ore output% –

@$ploy $ore people% – ;rovide $ore inco$e transers% – +a!e $ore $oney availa#le%

• or an overheated econo$y 5eynesproposed the opposite% – /i"her ta,es% – 7pendin" reductions% – ?educe availa#ility o $oney%

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Business Cycle•  The our parts o a

$odern #usiness cycleare –  The pea"  where GD;

$a,i$i*es% – #ecession where GD;

declines%

 –  The trou$h where GD;$ini$i*es%

 – #eco%ery where GD;increases%

•  These are variationsaround a "rowth trendthat slopes upward%

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 The Business Cycle in :%7%

/istory

 The "rowth rate avera"es 3E #ut the econo$y Auctuates aroundthat avera"e occasionally achievin" ne"ative GD; "rowth or

decline%

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 Ter$s 6ssociated with the

Business Cycle• &conomic $rowth: real GD; "rows

aster than 3E% @,pansion%

• 'rowth recession: real GD; "rows #utslower than 3E% The econo$y e,pandstoo slowly%

• #ecession: real GD; contracts (or twoor $ore consecutive uarters)%

• (epression: an e,tre$ely deeprecession%

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 The Great ?ecession o 24-

29• 6 recession #e"an as allin" ho$e and

stoc! prices sapped consu$er wealth andcondence% This was coupled with a credit

crisis% – 7ales plu$$eted and GD; contracted% – :ne$ploy$ent reached 1%1E%

•  The Great ?ecession reached its trou"h in

6u"ust 29 #ut econo$ic "rowth sincethat ti$e has #een so slu""ish thatune$ploy$ent re$ains hi"h (over 9E in211)%

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6 +odel o the +acro

@cono$y

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6 +odel o the +acro

@cono$y• +acro outco$es.

 – )utput: real GD;%

 – Jobs: levels o e$ploy$ent andune$ploy$ent%

 – *rices: C; and inAation%

 –

'rowth: year-to-year e,pansion o GD;% – +nternational balances: value o the

dollarF trade #alances%

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6 +odel o the +acro

@cono$y• Deter$inants o $acro peror$ance.

 – +nternal mar"et forces: population

"rowth spendin" #ehavior invention andinnovation%

 – &,ternal shoc"s: wars natural disastersterrorist attac!s trade disruptions%

 – *olicy le%ers: ta, policy "overn$entspendin" chan"es in the availa#ility o$oney re"ulation%

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 The Crucial Controversy

• +ost controversial is whether the policylevers are eective and necessary% –

5eynes said =yes%> – Classical econo$ists said =no%>

• 6lso controversial is whether pure$ar!et-driven econo$ies are inherently

sta#le or unsta#le% – 5eynes said =unsta#le%>

 – Classical econo$ists said =sta#le%>

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6""re"ate De$and and

7upply•  The orces o supply and de$and are

at wor! in the $acro econo$y%

 –

6ny inAuence on $acro outco$es $ust #etrans$itted throu"h supply or de$and%

•  The $acro $odel shows how the$acro econo$y wor!s and it consistso a$$re$ate eman anda$$re$ate supply%

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6""re"ate De$and

• -$$re$ate eman .-(/: the totaluantity o output (real GD;) de$andedat alternative price levels in a "iven

ti$e period ceteris paribus% – The collective #ehavior o all #uyers in the

$ar!etplace% – t co$prises all "oods and services%

• 6D slopes downwardF people will #uy$ore "oods and services at lower pricelevels and vice versa%

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6""re"ate De$and (6D)

• &hy does 6D slope downward' – #eal balances eect: the cash you hold is

worth $ore when the price level alls so you

can #uy $ore% – 1orei$n trae eect: lower price levels in

the :nited 7tates convince custo$ers to #uy$ore 6$erican "oods and ewer orei"n

"oods% – +nterest rate eect: lower interest rates

pro$ote $ore #orrowin" and $ore spendin"%

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6""re"ate 7upply

• -$$re$ate supply .-S/: the totaluantity o output (real GD;) producersare willin" and a#le to supply at

alternative price levels in a "iven ti$eperiod ceteris paribus% – The collective #ehavior o all suppliers (sellers)

in the $ar!etplace% – t co$prises all "oods and services%

• 67 slopes upwardF suppliers will #rin"$ore "oods and services to $ar!et athi"her price levels and vice versa%

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6""re"ate 7upply (67)

• &hy does 67 slope upward' – *ro2t eect: i there is no chan"e in the

cost o operatin" a #usiness risin" prices will

i$prove prots and suppliers will #rin" $oreproducts to the $ar!et% – Cost eect: cost increases $a!e producin"

products $ore e,pensive% ;roducers will #ewillin" to supply $ore only i prices also rise

to cover those added costs%• 6t hi"h rates o output (near productive capacity)

costs rise steeply and 67 steepens sharply%

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6""re"ate De$and and

7upply

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+acro @uili#riu$

• 67 and 6D su$$ari*ethe $ar!et activity othe $acro econo$y%

•

Macro e3uilibrium: the co$#ination o pricelevel and real outputthat is co$pati#le with#oth 6D and 67%

 – &here 6D and 67intersect%

 – at ;@ and H@%

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+acro ailures

• 0et 41 #e the "oal oull-e$ploy$entGD;%

•

 The euili#riu$output 4& isundesira#leF it doesnot reach our $acro"oal%

• 6lso 6D and 67 canshit $eanin" thatany euili#riu$ can#e unsta#le%

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67 7hits

• 67 will shit let i  – Business costs rise%

 – Business ta,es rise%

 – Iatural disaster occurs%

• 67 will shit ri"ht i  – Business costs all%

 – Business ta,es all%

 – Bounteous harvests

occur%• n the "raph 67

shits let away ro$ull-e$ploy$ent GD;%

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6D 7hits

• 6D will shit let i 

 – 7endin" decreases%

 – @,pectations "et worse%

 –

 Ta,es increase%• 6D will shit ri"ht i 

 – 7pendin" increases%

 – @,pectations i$prove%

 –  Ta,es decrease%

• n the "raph 6Dshits let away ro$ull-e$ploy$ent GD;%

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+ultiple 7hits o 6D and 67

• 7hits in 6D and 67 can cause theecono$y to "o into recession

recover ro$ a recession or causethe econo$y to sta"nate oroverheat%

•

Business cycles li!ely result ro$recurrent shits o 67 and 6D%

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7hort-?un nsta#ility.

Co$petin" Theories• Classical econo$ists #elieve the

econo$y will sel-re"ulate and "ravitatetoward ull e$ploy$ent%

• 5eynes and his ollowers do not #elievethis% They #elieve the econo$y $i"ht "etworse without "overn$ent intervention%

•n addition there are controversies a#outthe shape o 67 and 6D and the potentialto shit these curves%

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5eynesian Theory

•  This is a de$and-side theory%

• 6 recession ori"inates with a deciency ospendin"% – 6D is too ar to the let%

 – ;olicy. increase "overn$ent spendin" to shit 6D#ac! to the ri"ht%

• nAation ori"inates with an e,cess in

spendin"% – 6D is too ar to the ri"ht%

 – ;olicy. increase ta,es to shit 6D #ac! to the let%

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+onetary Theory

•  This is also a de$and-side theory% – @$phasi*es the role o $oney in nancin" 6D%

• =Ti"ht> $oney $i"ht cause 6D to shit tooar to the let% – ;olicy. increase $oney supply and lower

interest rates to shit 6D #ac! to the ri"ht%

• =@asy> $oney $i"ht cause 6D to shit too

ar to the ri"ht% – ;olicy. decrease $oney supply and raise

interest rates to shit 6D #ac! to the let%

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De$and-7ide Theories

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7upply-7ide Theory

• 6 shit in 67 to the let causes output ande$ploy$ent to decrease and inAation toincrease%

 – This pro#le$ cannot #e corrected #y shitin"6D%

• 7hit 6D ri"ht and une$ploy$ent alls #ut inAationworsens%

• 7hit 6D let and inAation is reduced #utune$ploy$ent rises%

 – ;olicy. devise ways to shit 67 #ac! to the ri"ht%

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7upply-7ide Theories

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0on"-?un 7el-6dust$ent

• 6dvocates ar"ue that short-run insta#ilityis not as i$portant as the lon"-run trend inecono$ic "rowth%

 – ?elies on the view that the econo$y can sel-adust%

 – nce it adusts to a short-run deviation theecono$y will return to its lon"-run "rowth path%

•  There is a =natural> rate o outputdeter$ined #y institutional actors%

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0on"-?un 7el-6dust$ent

•  The lon"-run 67 curve isvertical at the =natural>rate o output%

•  The i$plication is that

shits in 6D will aectprices #ut not output in thelon" run% – 6D1 shits to 6D2 prices

rise #ut output stays at 45%

 – &hy no increase in output'

6s prices rise short-runprots "row #ut so do costswipin" out the new prots%

 This !ills the incentive toincrease output%

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7hort- and 0on"-?un

;erspectives• &e live in the short run%

 – 7hort-run variations aect our currentecono$ic situation%

 –&e call on "overn$ent to =,> short-runpro#le$s < nowJ

 – $ple$ented policies ta!e eect in the short-run%

 – n the short run 67 slopes upward%

•  The $acro $odel we will use to descri#epolicy i$ple$entation will have anupward-slopin" 67 curve%

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 The @cono$y To$orrow

• ;olicy options durin" the Great ?ecession24-211%

• ;residents Bush and #a$a had severalstrate"ies availa#le. – 1% 7hit 6D ri"ht. sti$ulate total spendin"%

• 1iscal policy: the use o "overn$ent ta, andspendin" powers to alter $acroecono$ic outco$es%

• Monetary policy: the use o $oney and creditcontrols to inAuence $acroecono$ic outco$es%

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 The @cono$y To$orrow

 – 2% 7hit 67 ri"ht. reduce the costs oproduction or otherwise sti$ulate $oreoutput%

• Supply6sie policy: the use o ta, incentives(de)re"ulation and other $echanis$s toincrease the a#ility and willin"ness to produce%

• Trae policy: reduce trade #arriers and lower

the value o the dollar to lower input costs% – 3% 0aisse* aire. let the $ar!et sel-adust%

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 The @cono$y To$orrow

• 0aisse* aire was never considered%

• ;resident Bush i$ple$ented a sti$ulus

pac!a"e that had a #rie and s$allcounteractin" eect%

• ;resident #a$a i$ple$ented a$assive scal sti$ulus pac!a"e drivin"

up the decit% t did not see$ to #eenou"h to turn the let-shitin" 6D curvearound%

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 The @cono$y To$orrow

•  The ederal ?eserve i$ple$ented ane,tre$ely =easy> $oney policy with lowinterest rates%

•

 The Treasury and the ed =#ailed out>alterin" co$panies and #an!s%• 7o$e o this activist policy wor!ed < shited

6D ri"ht < and so$e didn’t% n any eventrecovery is very slu""ish%

•  These policy levers will #e used a"ain toco$#at uture econo$ic pro#le$s in theecono$y to$orrow%

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?evisitin" the 0earnin"

#ectives• 4-1% 5now the $aor $acro

outco$es and their deter$inants%

 –utco$es. output prices o#s andinternational #alances%

 – Deter$inants. internal $ar!et orcese,ternal shoc!s and policy levers%

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?evisitin" the 0earnin"

#ectives• 4-2% 5now why the de#ate over

$acro sta#ility is i$portant%

 – ;olicy will #e chosen dependin" onwhich co$petin" theory is considered to#e correct #y policy $a!ers%

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?evisitin" the 0earnin"

#ectives• 4-3% 5now the nature o a""re"ate

de$and (6D) and a""re"ate supply (67)% – 6D is a downward-slopin" line on the $acro

$odel (#uyers #uy $ore at lower pricelevels)%

 – 7hort-run 67 is an upward-slopin" line on the$acro $odel (producers supply $ore at

hi"her price levels)% – 0on"-run 67 is vertical at the =natural> rate

o output%

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?evisitin" the 0earnin"

#ectives• 4-8% 5now how chan"es in 6D and 67

aect outco$es%

 – 6n increase in 6D (shit ri"ht) will increaseoutput decrease une$ploy$ent and increaseinAation% Kice versa or a decrease in 6D (shitlet)%

 – 6n increase in 67 (shit ri"ht) will increase

output decrease une$ploy$ent and decreaseinAation% Kice versa or a decrease in 67 (shitlet)%