Schiller Chap008

The Business CycleChapter 8

The Business Cycle

We in America are nearer to the final triumph over poverty than ever before in the history of any land…We shall soon with the help of God be in sight of the day when poverty will be banished from this nation.

President-elect Herbert Hoover, 1928

The Business Cycle

• The Great Depression shook not only the foundations of the world economy but the self-confidence of the economics profession

• The search for explanations focused 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?

The Business Cycle

• Out of the Great Depression grew a clamor for answers to why it was happening

• People were seeking answers…and solutions!

• Thus, for the first time, emerged the concept of macroeconomics…– Basic purpose of macroeconomics is to explain

how and why economies grow and what causes recurrent ups and downs of the business cycle

Macroeconomics

• First…some definitions: • Macroeconomics is the study of aggregate economic

behavior of the economy as a whole

• The business cycle is the occurrence of alternating periods of economic growth and contraction

• Macro theories try to explain the business cycle; economic policies try to control it

Stable or Unstable?

• Prior to the 1930s, macroeconomists thought there could never be a Great Depression– They believed a market-driven economy was

inherently stable

• Laissez faire: The doctrine of “leave it alone”; of non-intervention by government in the market mechanism seemed reasonable at the time

The Self-Regulating Economy

• According to the classical economists, the economy “self-adjusts” to deviations from its long-term growth trend

• Economic downturns were viewed as temporary setbacks, not permanent problems

• The cornerstones of classical optimism were flexible prices and flexible wages

Classical Theory

• The optimistic views of the classical economists were summarized in Say’s Law: Supply creates its own demand– Whatever was produced would be sold– All workers seeking employment would be hired

• Unsold goods and unemployed labor could emerge, but both would disappear once people had time to adjust prices and wages

Classical Theory

• There could be no Great Depression in the classical view of the world

• Yet, there was!

• Fifty, sixty, seventy years after the Great Depression, and the analyses that have taken place during that time, have presented a different picture than was first imagined at the time

Macro Failure

• The Great Depression was (seemingly) a stunning blow to classical economists– Unemployment grew and persisted despite falling prices

and wages

– The classical self-adjustment mechanism simply didn’t (seem to) work

• People seeking answers and solutions to the Depression were desperate…and desperate people often are misled (intentionally or unintentionall

Inflation and Unemployment: 1900-1940

1900 1910 1920 1930 1940

Inflation

Unemployment

Source: U.S. Bureau of the Census, The Statistics of the United States, 1957

The Keynesian Revolution

• John Maynard Keynes developed an alternate view of the macro economy, asserting that a market-driven economy is inherently unstable– Small disturbances in output, prices, or

unemployment were likely to be magnified by the invisible hand of the marketplace

– The Great Depression was not a unique event, Keynes argued, but a calamity that would recur if we relied on the market mechanism to self-adjust

Government Intervention

• In Keynes’ view, the inherent instability of the marketplace required government intervention– When the economy falters we can’t afford to wait

for some assumed self-adjustment mechanism but must intervene to protect jobs and income

– The government could do this by “priming the pump”: buying more output, employing more people, providing more income transfers, and making more money available

Historical Cycles

• Upswings and downturns of the business cycle are gauged in terms of changes in total output

• Real GDP: The value of final output produced in a given period, adjusted for changing prices

• Changes in employment typically mirror changes in production

• The following slide depicts the stylized features of a business cycle

The Business Cycle

Trough

Growth trendPeak

Trough

Contraction

The Business Cycle

• An economic upswing (expansion) is an increase in the volume of goods and services produced

• An economic downturn (contraction) occurs when the volume of production declines

• Successive short-run contractions and expansions are the essence of business cycles

The Business Cycle

• The dashed horizontal line across the graph on the following slide represents the long-term growth rate of the U. S. economy

• From 1929 through 2009, the U.S. economy has expanded at an average rate of 3% per year

• The most prolonged departure from the long-term trend occurred during the Great Depression

The Business Cycle in U.S. History

Source: U.S. Department of Commerce (2009)

From 1929 to 2009, real GDP increased at an average rate of 3 percent a year.

The Business Cycle

• Recessions are periods when total output (real GDP) declines for two or more consecutive quarters

• A Growth recession is a period during which real GDP grows, but at a rate below the long-term trend of 3 percent

• In November 1982, the U.S. economy began an economic expansion that lasted over 7 years– During that period, real GDP increased over $1 Trillion and

nearly 20 million new jobs were created

– As an aside, the Congress passed the Reagan tax cuts in July of 1981

Business SlumpsDates

Duration (months)

Percentage Decline in Real GDP

Peak Unemployment

Aug. ‘29–Mar. ‘33 43 53.4% 24.9%

May ‘37 –June ‘38 13 32.4 20.0

Feb. ‘45 –Oct. ‘45 8 38.3 4.3

Nov. ‘48–Oct. ‘49 11 9.9 7.9

July ‘53–May ‘54 10 10.0 6.1

Aug. ‘57–Apr. ‘58 8 14.3 7.5

Apr. ‘60–Feb. ‘61 10 7.2 7.1

Dec. ‘69–Nov. ‘70 11 8.1 6.1

Nov. ‘73–Mar. ‘75 16 14.7 9.0

Jan. ‘80–July ’80 6 8.7 7.6

July ‘81–Nov. ‘82 16 12.3 10.8

July ‘90–Feb. ‘91 8 2.2 6.5

Mar. ‘01–Nov. ‘01 8 0.6 5.6

Dec 07– ? ? ?

A Model of the Macro Economy

• Both Keynes and the Classical economists agreed that business cycles occur, but disagreed on whether they’re an appropriate target for government intervention

• In order to understand whether and how the government should try to control the business cycle, it is necessary to understand the origins of the business cycle– What causes the economy to expand and contract?

– What market forces dampen (self-adjust) or magnify economic swings?

The Macro Economy

Internal market forces

External shocks

Policy levers

DETERMINANTS

Output

Prices

Growth

International balances

OUTCOMES

MACROECONOMY

The primary outcomes of the macro economy are output of goods and services (GDP), jobs, prices, economic growth, and international balances…Outcomes result from the interplay of internal market forces, external shocks, and policy levers

Macroeconomic Performance

• Determinants of macro performance include:– Internal market forces - Population growth,

spending behavior, intervention & innovation, etc.– External shocks - Wars, natural disasters, terrorist

attacks, trade disruptions, and so on– Policy levers - Tax policies, government spending,

changes in the availability of money, and regulation, for example

Macroeconomic Performance

• Macroeconomic outcomes include:– Output - Value of goods and services produced (real

– Jobs - Levels of employment and unemployment

– Prices - Average price of goods and services

– Growth - Year-to-year expansion in production capacity

– International balances - International value of the dollar; trade and payment balances with other countries

Aggregate Demand and Supply• To determine which view of economic performance are valid,

we need to examine the inner workings of the macro economy

• The previous slide tells us that macro outcomes depend on certain identifiable forces but doesn’t explain how t eh forces and outcomes are connected

• The macro outcomes are the result of market transactions (supply & demand)– Any influence on macro outcomes must be transmitted through the

interactions of supply or demand

Aggregate Demand and Supply• Economists have developed a simple model of how the economy

• They use aggregate demand to refer to the collective behavior of all buyers in the market• Economists define aggregate demand as the total quantity of output

(real GDP) demanded at alternative price levels in a given time period, ceteris paribus

• To understand the concept, imagine that everyone is paid on the same day and with their incomes in hand, they enter the product market. The question then becomes: How much output will people purchase?

• To answer the question we must know something about prices– If goods are cheap, people will be able to buy more with their given

income

– High prices will limit both willingness and ability to buy

Aggregate Demand

• The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices– The downward slope suggests that with a given

(constant) income, at lower price levels people will buy more goods and services

Aggregate Demand

REAL OUTPUT

Aggregate demand

Aggregate Demand

• Three reasons for the downward slope:– Real-balances effect - a change in the price level

affects the purchasing power of money– Foreign-trade effect - balance of trade depends on

domestic price level relative to foreign– Interest-rate effect - change in price level affects

demand for loan-financed purchases

Aggregate Supply

• Aggregate supply: 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

• Two reasons for upward sloping curve:– The profit effect – the primary reason for producing goods

and services

– The cost effect – cost pressures are minimal at low levels of output but intense as the economy approaches capacity

Aggregate SupplyP

REAL OUTPUT

Aggregate supply

Macro Equilibrium

• Aggregate supply and demand curves summarize the market activity of the whole (macro) economy

• Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply

• Equilibrium is unique; it is the only price-level-output combination that is mutually compatible with aggregate supply and demand

Macro EquilibriumP

REAL OUTPUT

Aggregatedemand

Aggregatesupply

Macro equilibrium

Macro Failures

• Nevertheless, there are potential problems with macro equilibrium that may lead to disequilibrium:– Undesirability - the equilibrium price or output

level may not satisfy policy goals– Instability - even if the designated macro

equilibrium is optimal, it may not last long

An Undesired EquilibriumP

Aggregatedemand

Aggregatesupply

Equilibriumoutput Full-employment output (Goal)

Where we’d like to be!

Where we are!

An Undesired EquilibriumP

Aggregatedemand

Aggregatesupply

Equilibriumoutput

Goal: Desiredprice level

Actual price level

Instability

• Macroeconomic equilibrium changes whenever the aggregate supply and/or demand curves shift

• Business cycles are likely to result from recurrent shifts of aggregate supply and demand curves

AS and AD Shifts

• Shifts in aggregate supply can be caused by changes in costs of production due to import prices, natural disasters, changed tax policies, or other events

• Shifts in aggregate demand can be caused by changes in export demand, expectations, taxes, or other events

Macro Disturbances

REAL OUTPUT

(b) Demand shifts

REAL OUTPUT

(a) Supply shifts

Example: OPEC raises price of oil,Causing production costs to rise

9/11 affects physical and economic security; AD shifts left

Competing Theories of Short-Run Instability

• Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them

• The AS/AD Model does not really settle the question of who is right!

• It does, however, provide a framework for comparing the different theories, of which there are several:– Demand-side theories, such as Keynesian and Monetary,

emphasize aggregate-demand shifts

– Supply-side theories center on shifts in supply

Demand-Side Theories

(b) Excessive demand

REAL OUTPUT

(a) Inadequate demand

AD0 AD0

Keynesian Theory

• Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment

• Advocated increasing government spending – a rightward AD shift – to move the economy toward full employment

Monetary Theories• Monetary Theories emphasize the role of money in

financing aggregate demand• Money and credit affect ability and willingness to buy

goods and services• If credit isn’t available or is too expensive consumers

reduce spending and businesses curtail investment• Excessive aggregate demand may cause inflation• Both Keynesians and monetarists theories emphasize

the potential of aggregate-demand shifts to alter macro outcomes

Supply-Side Theories

• Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well

• Might producers be unwilling to supply more goods at current prices?– Could this be a result of greed? Rising costs? Resource

shortages? Government taxes and regulation?

• Supply-side economists believe that the real problem is that high rates of taxation and heavy regulation reduce the incentive to work, to save, and to invest. What is needed is not a demand stimulus but better incentives to stimulate supply.

• Increases in aggregate supply move us closer to goals of price stability and full employment

REAL OUTPUT

Long-Run Self Adjustment

• Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations

• They assert a long-run aggregate supply curve anchored at the natural rate of output (QN)

– Flexible prices (and wages) enable the economy to maintain the natural rate of output QN

REAL OUTPUT

The “Natural” Rate of Output

Fluctuations in aggregate demand affect the price level but not real output.

Short vs. Long-run Perspectives

• The long-run aggregate supply curve is likely to be vertical at QN

• The short-run aggregate supply curve is likely to be upward-sloping

• Both aggregate supply and aggregate demand influence short-run macro outcomes

Policy Strategies

• Only three strategy options for macro policy:– Shift the aggregate demand curve: Use policy

tools that affect total spending– Shift the aggregate supply curve: Implement

policy levers that influence the costs of production or otherwise affect output

– Laissez-faire: Don’t interfere with the market; let markets self adjust

Selecting Policy Tools

• There are a host of tools available that we will be covering in more detail in later chapters:– Classical laissez faire

– Fiscal policy

– Monetary policy

– Supply-side policy

– Trade policy

• We will start with a brief introduction to each here…

Policy Tools

• The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment

• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

Policy Tools

• Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

• Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

Policy Tools

• Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve

The Business CycleEnd of Chapter 8

Schiller Chap008

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