13e

Chapter 08:
The Business Cycle

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

The Business Cycle

The Great Depression
(1929-1933)
disrupted the worlds
conventional way of
thinking about
economic activity.
What about now? Can
a market-driven
economy be stable? If
not, can government
action stabilize it?

8-2

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?
8-3

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.

8-4

Stable or Unstable?
Prior to the 1930s, 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.

8-5

A Self-Regulating Economy
Classical economics: the economy selfadjusts to any deviations from its longterm 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 Says Law.

8-6

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.

The economy therefore is self-regulating.

8-7

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.
8-8

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.

8-9

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.
8-10

The Business Cycle in U.S.

History

The growth rate averages 3%, but the economy fluctuates around
that average, occasionally achieving negative GDP growth, or
decline.

8-11

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.
8-12

The Great Recession of 20082009

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).
8-13

A Model of the Macro

Economy

8-14

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.
8-15

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.
8-16

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,

market-driven economies are inherently
stable or unstable.
Keynes said unstable.
Classical economists said stable.
8-17

Aggregate Demand and

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 and
aggregate supply.
8-18

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.
8-19

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.

8-20

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.
8-21

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.

8-22

Aggregate Demand and

Supply

8-23

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.

8-24

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.
8-25

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
full-employment GDP.
8-26

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
full-employment GDP.
8-27

Multiple Shifts of AD and AS

Shifts in AD and AS can cause the
economy to go into recession,
recover from a recession, or cause
the economy to stagnate or
overheat.
Business cycles likely result from
recurrent shifts of AS and AD.

8-28

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.
8-29

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.
8-30

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.

8-31

Demand-Side Theories

8-32

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.

8-33

Supply-Side Theories

8-34

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 selfadjust.
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.
8-35

Long-Run Self-Adjustment
The long-run AS curve is
vertical at the natural
rate of output.
The implication is that
shifts in AD will affect
prices but not output in the
long run.
If AD1 shifts to AD2, prices
rise but output stays at QN.
Why no increase in output?
As prices rise, short-run
profits grow, but so do costs,
wiping out the new profits.
This kills the incentive to
increase output.

8-36

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 shortrun.
In the short run, AS slopes upward.

The macro model we will use to describe

policy implementation will have an
upward-sloping AS curve.
8-37

The Economy Tomorrow

Policy options during the Great Recession,
2008-2011.
Presidents Bush and Obama had several
strategies available:
1. Shift AD right: stimulate total spending.
Fiscal policy: the use of government tax and
spending powers to alter macroeconomic outcomes.
Monetary policy: the use of money and credit
controls to influence macroeconomic outcomes.

8-38

The Economy Tomorrow

2. Shift AS right: reduce the costs of
production or otherwise stimulate more
output.
Supply-side policy: the use of tax incentives,
(de)regulation, and other mechanisms to
increase the ability and willingness to produce.
Trade policy: reduce trade barriers and lower
the value of the dollar to lower input costs.

3. Laissez faire: let the market self-adjust.

8-39

The Economy Tomorrow

Laissez faire was never considered.
President Bush implemented a stimulus
package that had a brief and small
counteracting effect.
President Obama implemented a
massive fiscal stimulus package, driving
up the deficit. It did not seem to be
enough to turn the left-shifting AD curve
around.
8-40

The Economy Tomorrow

The Federal Reserve implemented an
extremely easy money policy with low
interest rates.
The Treasury and the Fed bailed out
faltering companies and banks.
Some of this activist policy worked shifted
AD right and some didnt. In any event,
recovery is very sluggish.
These policy levers will be used again to
combat future economic problems in the
economy tomorrow.
8-41

Revisiting the Learning

Objectives
08-01. Know the major macro
outcomes and their determinants.
Outcomes: output, prices, jobs, and
international balances.
Determinants: internal market forces,
external shocks, and policy levers.

8-42

Revisiting the Learning

Objectives
08-02. Know why the debate over
macro stability is important.
Policy will be chosen depending on
which competing theory is considered to
be correct by policy makers.

8-43

Revisiting the Learning

Objectives
08-03. Know the nature of aggregate
demand (AD) and aggregate supply (AS).
AD is a downward-sloping line on the macro
model (buyers buy more at lower price
levels).
Short-run AS is an upward-sloping line on the
macro model (producers supply more at
higher price levels).
Long-run AS is vertical at the natural rate
of output.
8-44

Revisiting the Learning

Objectives
08-04. Know how changes in AD and AS
affect outcomes.
An increase in AD (shift right) will increase
output, decrease unemployment, and increase
inflation. Vice versa for a decrease in AD (shift
left).
An increase in AS (shift right) will increase
output, decrease unemployment, and decrease
inflation. Vice versa for a decrease in AS (shift
left).
8-45