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Chapter 08:
The Business Cycle
McGraw-Hill/Irwin
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 1930s, conventional wisdom was a
market-driven economy, which was inherently
stable.
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.
A Self-Regulating Economy
Says 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.
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.
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.
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.
8-12
8-13
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.
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.
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.
8-22
AD Shifts
AD will shift left if
Sending decreases.
Expectations get worse.
Taxes increase.
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.
Monetary Theory
This is also a demand-side theory.
Emphasizes the role of money in financing AD.
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.
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.