Chapter 8: Business Cycles

Business Cycles: Fluctuations in aggregate economic activity of industrialized nations. A full cycle of expansions in most economics activities is followed by a contraction or recession – fluctuations are not periodic and may vary in length.

1) Aggregate Economic Activity – Not just GDP, includes employment, output, price level, and other economic variables.

2) Expansions and Contractions

    T= Trough low point or contraction – after the trough economic activity increases
    P= Peak High point or expansion – after the peak activity decreases
    P and T have been determined from historical data by the NBER.

In reality some shocks might be permanent which changes trend line

3) Co-movement Changes in economic variables occur at same time. The co-movement is regular and predictable (when an economy expands, the price level increases, output increases…)

4) Not periodic – Cycles do not occur at regular periodic intervals. Pattern of contraction-trough-expansion-peak occurs again and again.

5) Persistence – Duration of a complete business cycle (expansion and contraction) lasts from one year to over a decade.

 

Since WWII the major goal of economic policy has been to reduce the size and frequency of recessions. Economists generally believe that the policy has been effective since WWII, reducing the amount of volatility in the economy. Recently new studies have shown that the economy may have not been decreased in volatility since WWII. Some simple relationships are agreed upon by economists, these are discussed below.

Business Cycles Facts

A) The cyclical behavior of economic variables – direction and timing

    1. What direction does a variable move relative to aggregate economic activity?

        a. Procyclical: in the same direction as aggregate economic activity

        b. Countercyclical: in the opposite direction as aggregate economic activity

        c. Acyclical: No clear relationship with aggregate economic activity

    2. What is the timing of a variable’s relative to aggregate economic activity

        a. Leading: moves in advance of aggregate economy

        b. Coincident: moves with aggregate economy

        c. Lagging: moves after the aggregate economy

   

Review of AD/AD

KEY POINTS:
  1. All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.
  2. Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
  3. The aggregate-demand curve slopes downward for three reasons. First, a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. Third, as a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports.
  4. Any event or policy that raises consumption, investment, government purchases, or net exports at a given price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate demand.
  5. The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, and technology, but not on the overall level of prices.
  6. Three theories have been proposed to explain the upward slope of the short-run aggregate-supply curve. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky-price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. All three theories imply that output deviates from its natural rate when the price level deviates from the price level that people expected.
  7. Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology shift the short-run aggregate supply curve (and may shift the long-run aggregate supply curve as well). In addition, the position of the short-run aggregate supply curve depends on the expected price level.
  8. One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-demand curve shifts to the left, output and prices fall in the short run. Over time, as changes in the expected price level cause perceptions, wages, and prices to adjust, the short-run aggregate-supply curve moves to the right, and the economy returns to its natural rate of output at a new, lower price level.
  9. A second possible cause of economic fluctuations is a shift in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level falls back to its original level, and output recovers.

I. Economic activity fluctuates from year to year.

A. Definition of Recession: 2 quarters of declining real incomes.

B. Definition of Depression: a severe recession.

II. Three Key Facts about Economic Fluctuations

A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable

1. Economic fluctuations correspond to changes in business conditions.

2. These fluctuations are not at all regular and are almost impossible to predict.

B. Fact 2: Most Macroeconomic Quantities Fluctuate Together

1. Real GDP is the variable that is most often used to examine short-run changes in the economy.

2. However, most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together.

C. Fact 3: As Output Falls, Unemployment Rises

1. Changes in the economy’s output level will have an effect on the economy’s utilization of its labor force.

III. Explaining Short-Run Economic Fluctuations

A. How the Short Run Differs from the Long Run

1. Most economists believe that the classical theory describes the world in the long run but Keynesians believe that is is not a good predictor in the short run.

2. Beyond a period of several years, changes in the money supply affect prices and other nominal variables, but do not affect real GDP, unemployment, or other real variables.

3. However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined.

B. The Basic Model of Economic Fluctuations

1. Definition of Model of Aggregate Demand and Aggregate Supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend.

2. We can show this model using a graph.

a. On the vertical axis is the overall price level in the economy.

b. On the horizontal axis is the overall quantity of goods and services.

c. Definition of Aggregate-Demand Curve: a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

d. Definition of Aggregate-Supply Curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

3. In this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

IV. The Aggregate-Demand Curve

A. Why the Aggregate-Demand Curve Is Downward Sloping

1. Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

2. Each of the four components is a part of aggregate demand.

a. Government purchases are assumed to be fixed by policy.

b. This means that to understand why the aggregate-demand curve slopes downward, we must understand how changes in the price level affect consumption, investment, and net exports.

3. The Price Level and Consumption: The Wealth Effect

a. A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more.

b. The increase in consumer spending means a larger quantity of goods and services demanded.

4. The Price Level and Investment: The Interest-Rate Effect

a. The lower the price level, the less money households need to buy goods and services.

b. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries).

c. As households try to convert some of their money into interest-bearing assets, the interest rate will drop.

d. Lower interest rates encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing.

e. Thus, a lower price level reduces the interest rate, encourages spending on investment goods, and therefore increases the quantity of goods and services demanded.

5. The Price Level and Net Exports: The Exchange-Rate Effect

a. A lower price level in the United States lowers the U.S. interest rate.

b. American investors will seek higher returns by investing abroad, increasing U.S. net foreign investment.

c. The increase in net foreign investment raises the supply of dollars, lowering the real exchange rate.

d. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase.

e. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded.

6. All three of these effects imply that, all else equal, there is an inverse relationship between the price level and the quantity of goods and services demanded.

B. Why the Aggregate-Demand Curve Might Shift

1. Shifts Arising from Consumption

a. Americans become more concerned with saving for retirement and reduce current consumption. This will decrease aggregate demand.

b. When the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate demand.

2. Shifts Arising from Investment

a. The computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand.

b. If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left.

c. An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand.

d. An increase in the supply of money lowers the interest rate in the short run. This lead to more investment spending, which causes an increase in aggregate demand.

3. Shifts Arising from Government Purchases

a. Congress decides to reduce purchases of new weapon systems. This will decrease aggregate demand.

b. If state governments decide to build more state highways, aggregate demand will shift to the right.

4. Shifts Arising from Net Exports

a. When Europe experiences a recession, it buys fewer American goods which lowers net exports. Aggregate demand will shift to the left.

b. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

V. The Aggregate-Supply Curve

A. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon.

B. Why the Aggregate-Supply Curve Is Vertical in the Long Run

1. In the long run, an economy’s supply of goods and services depends on its supplies of resources along with the available production technology.

2. Because the price level does not affect the determinants of output in the long run, the long-run aggregate-supply curve is vertical at the natural rate of output.

C. Why the Long-Run Aggregate-Supply Curve Might Shift

1. The position of the aggregate supply curve occurs at an output level sometimes referred to as potential output or full-employment output.

2. This is the level of output that the economy produces when unemployment is at its natural rate.

3. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

4. Shifts Arising From Labor

a. Increases in immigration increase the number of workers available. The long-run aggregate-supply curve would shift to the right.

b. Any change in the natural rate of unemployment will alter long-run aggregate supply as well.

5. Shifts Arising from Capital

a. An increase in the economy’s capital stock raises productivity and thus shifts long-run aggregate supply to the right.

b. This would also be true if the increase occurred in human capital rather than physical capital.

6. Shifts Arising from Natural Resources

a. A discovery of a new mineral deposit increases long-run aggregate supply.

b. A change in weather patterns that makes farming more difficult shifts long-run aggregate supply to the left.

c. A change in the availability of imported resources can also affect long-run aggregate supply.

7. Shifts Arising from Technological Knowledge

a. The invention of the computer has allowed us to produce more goods and services from any given level of resources. As a result, it has shifted the long-run aggregate-supply curve to the right.

b. Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts the long-run aggregate-supply curve to the right.

D. A New Way to Depict Long-Run Growth and Inflation

1. Two important forces that govern the economy in the long run are technological progress and monetary policy.

a. Technological progress shifts long-run aggregate supply to the right.

b. The Fed increases the money supply over time, which raises aggregate demand.

2. The result is growth in output and continuing inflation (increases in the price level).

3. Although the purpose of developing the aggregate demand/aggregate supply model is to describe short-run fluctuations, these short-run fluctuations should be considered to be deviations from the long-run trends developed here.

E. Why the Aggregate-Supply Curve Is Upward Sloping in the Short Run

1. The Misperceptions Theory--A Classical Point of View

a. Changes in the overall price level can temporarily fool suppliers about what is happening in the markets in which they sell their output.

b. As a result of these misperceptions, suppliers respond to changes in the level of prices and thus, the short-run aggregate-supply curve is upward-sloping.

c. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the prices of their products fall, it is a drop in the relative price of their product. Suppliers may then believe that the reward of supplying their product has fallen, and thus they decrease the quantity that they supply. The same misperception may happen if workers see a decline in their nominal wage (caused by a fall in the price level).

d. Thus, a lower price level causes misperceptions about relative prices, and these misperceptions lead suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

2. The Sticky-Wage Theory--A Keynesian Point of View

a. Nominal wages are often slow to adjust in the economy due to long-run contracts between workers and firms.

b. Example: Suppose a firm has agreed in advance to pay workers a certain amount and then the price level falls unexpectedly. This implies that the firm is now paying a real wage that is larger than it intended, raising the costs of production. Thus, the firm hires less labor and produces a smaller quantity of goods and services.

c. Therefore, because wages do not adjust to the price level, a lower price level makes employment and production less profitable, leading firms to lower the quantity of goods and services supplied.

3. The Sticky-Price Theory--Another Keynesian Point of View

a. The prices of some goods and services are also sometimes slow to respond to changes in the economy. This is often blamed on menu costs.

b. If the price level falls unexpectedly, and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales.

c. Thus, when sales decline, firms will produce a lower quantity of goods and services.

d. Because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, which depress sales and cause firms to lower the quantity of goods and services supplied.

4. Note that each of these theories suggest that output deviates from its natural rate when the price level deviates from the price level that people expected.

5. Note also that the effects of the change in the price level will be temporary. Eventually people will adjust their price level expectations and output will return to its natural level; thus, the aggregate-supply curve will be vertical in the long run.

F. Why the Short-Run Aggregate-Supply Curve Might Shift

1. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well.

2. However, people’s expectations of the price level will affect the position of the short-run aggregate-supply curve even though it has no effect on the long-run aggregate-supply curve.

3. A higher expected price level will decrease the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A lower expected price level increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

VI. Two Causes of Recession

A. Long-Run Equilibrium

1. Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve.

2. Output is at its natural rate.

3. Also at this point, perceptions, wages, and prices have all adjusted so that the short-run aggregate-supply curve intersects at this point as well.

B. The Effects of a Shift in Aggregate Demand

1. Example: Pessimism causes household spending and investment to decline.

2. This will cause the aggregate demand curve to shift to the left.

3. In the short run, both output and the price level fall. This drop in output means that the economy is in a recession.

4. It is possible that policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right.

5. However, even if policymakers do nothing, the economy will eventually move back to the natural rate of output.

a. People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward-sloping in the short run.

b. The expected price level will fall, shifting the short-run aggregate-supply curve to the right.

6. In the long run, the decrease in aggregate demand can be seen solely by the drop in the equilibrium price level. Thus, the long-run effect of a change in aggregate demand is a nominal change (in the price level) but not a real change (output is the same).

C. The Effects of a Shift in Aggregate Supply

1. Example: Firms experience a sudden increase in their costs of production. THIS IS NOT THE SAME AS A TEMPORARY OIL SHOCK

2. This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the event, long-run aggregate supply may also shift. We will assume that it does not.)

3. In the short run, output will fall and the price level will rise. The economy is experiencing stagflation.

4. Definition of Stagflation: a period of falling output and rising prices.

5. Policymakers will have a more difficult time with this situation. Policymakers can shift the aggregate-demand curve, but cannot simultaneously offset the drop in output and the rise in the price level. If they increase aggregate demand, the recession will end, but the price level will be permanently higher.

6. If policymakers do nothing, price expectations will adjust, causing the short-run aggregate-supply curve to shift back to the right.