Business Cycles

May 2006/May 2007

Business Cycle/Fluctuations

The ups and downs in an economy as measured by changes in the level of total output (Real GDP).

What is the business cycle? “The business cycle or economic cycle

refers to the ups and downs seen somewhat simultaneously in most parts of an economy. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product.” (wikipedia)

AKA “Fluctuations”

Because no two business cycles are alike and they can occur without regularity, many economists now prefer the term “Business Fluctuations”.

What determines the phase of the business cycle?

Level of total output as measured by Real GDP

Four Phases

Peak or Boom – A period of prosperity with higher levels of output and low unemployment. New businesses may open and many factories are producing at full or near full capacity.

Contraction or Slowdown

Real GDP begins to level off and eventually slows down.

Characterized by reductions in the outputs of factories, layoffs of workers, and reduction in consumer spending.

Four Phases of the Business Cycle

If a contraction is long and deep enough, it can develop into a recession, two consecutive quarters of no growth, or negative growth in Real GDP.

A Recession can develop into a depression, characterized by extremely high unemployment and many business failures.

Growth Recession v. Recession

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

A growth recession occurs when the economy expands too slowly.

A recession occurs when real GDP actually contracts.

Four Phases of the Business Cycle

Trough – Lowest point of the cycle, In a trough, Real GDP stops its slide, levels off and slowly begins to grow.

Expansion or Recovery – Unemployment decreases, consumers begin spending more, Real GDP increases, and more businesses open.

A Self-Regulating Economy

According to the Classical view, the economy “self-adjusts” to deviations from its long-term growth trend.

The corner stones of Classical optimism were flexible prices and flexible wages.

Laissez-faire/Classical View According to law of demand, price

reductions cause an increase in sales, thus no one would lose a job because of weak consumer demand.

Optimistic views of the macro economy were summarized in Say’s Law

Definition: Say’s Law - Supply creates its own demand.

Macro Failure

The Great Depression was a stunning blow to Classical economists.

Unemployment grew and persisted despite falling prices and wages

The Keynesian Revolution

Inherent Instability - John Maynard Keynes asserted that a market-driven economy is inherently unstable.

Government Intervention – In Keynes’s view, the inherent instability of the marketplace required government intervention.

A Model of the Macro Economy Keynes and the Classical economists were

not debating whether business cycles occur, but whether they are an appropriate target for government intervention.

The primary measures of the macroeconomic outcomes include:

Output - total value of goods and services produced.

Jobs - levels of employment and unemployment.

Model of the Macro Economy

Prices - average price of goods and services.

Growth - year-to-year expansion in production capacity.

International balances - international value of the dollar; trade and payments balances with other countries.

Determinants of macro performance include:

Internal market forces - population growth, spending behavior, intervention & innovation.

External shocks - wars, natural disasters, trade disruptions, etc.

Policy levers - tax policy, government policy, changes in the availability of money, credit regulation, etc.

Aggregate Demand and Supply.

Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Reasons why the aggregate demand curve is downward sloping:

Real-balances effect – The real value of money is measured

by how many goods and services your money will buy.

The cash balances you hold in your pocket, in your bank account, or under your pillow are worth more when the price level falls.

Reasons why the aggregate demand curve is downward sloping:

Foreign-trade effect – This effect reinforces downward sloping curve by changes in imports and exports. If the average price level of U.S. goods is increasing, consumers may opt for imports and if the average price level of U.S. goods is falling, consumers may opt for domestically produced goods.

Reasons why the aggregate demand curve is downward sloping:

Interest-rate effect – with lower prices, consumers need to borrow less, the demand for loans diminishes, so interest rates drop.

Aggregate Supply

Aggregate Supply - The total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

The Aggregate Supply curve is upward sloping for two reasons:

Profit effect - changing price levels will affect the profitability of supplying goods. We expect the rate of output to increase when the price level rises.

Cost effect - cost pressures make it more expensive to produce output, therefore producers are only willing to supply additional output if prices rise at least as far as costs. Cost pressures are minimal at low rates of output but intense as the economy approaches capacity.

Macro Equilibrium

Equilibrium (macro) – The combination of price and output that is compatible with both aggregate demand and aggregate supply.

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

Macro failures.

Undesirability - the price-output relationship at equilibrium may not satisfy our macroeconomic goals.

Instability – even if the designated macro equilibrium is optimal, it may be displaced by macro disturbances

Competing Theories of Short-Run Instability: Demand Side

Keynesian Theory Keynesian theory is the most

prominent of the demand-side theories.

Argued that deficiency of spending would tend to depress an economy.

Keynes concluded that inadequate aggregate demand would cause persistently high unemployment.

Demand Side Theories Monetary Theories Emphasize the role of money in financing

aggregate demand. Money and credit affect the ability and

willingness of people to buy goods and services.

If credit isn’t available or is too expensive, consumers curtail the credit purchases.

If money supply is too tight, businesses might curtail investment.

Supply-Side Theories Decreases in aggregate supply can cause

multiple macro problems while increases can move us closer to both our price stability and full employment goals.

Eclectic explanations. Shifts in either or both aggregate supply or demand curves could be used to explain unemployment, inflation, or recurring business cycles or to achieve any specific output or price level.