CHAPTER 8 - THE BUSINESS CYCLE

A central concern of macroeconomics is the business cycle – recurrent bouts of expansion and contraction of the nation’s output. The Great Depression gave impetus to the study of macroeconomics, in particular the business cycle and policies that may alter the business cycle. This chapter investigates historical cycles in our nation’s economy and the consequences of these fluctuations.
The important questions to keep in mind while reviewing this chapter are:

1. How stable is a market-driven economy?

2. What forces cause instability?

3. What, if anything, can the government do to promote steady economic growth?

I. Introduction
A. In The News: “Market in Panic as Stocks Are Dumped in 12,894,600 Share Day; Bankers Halt It”
An excerpt from The World, October 25, 1929 captures the atmosphere. Stock markets are a barometer of confidence in the economy. The crash of 1929 mirrored and worsened consumer confidence.

B. The Great Depression shook not only the foundations of the world economy but also the economics profession. No one had predicted the Depression and few could explain it. 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?

C. Macroeconomics – The study of aggregate economic behavior, of the economy as a whole.

D. Business cycles - Alternating periods of economic growth and contraction.

E. Macroeconomic theories try to explain the business cycle, economic policies try to control it.

II. Stable or Unstable?
A. Prior to 1930s, macroeconomists thought there could never be a Great Depression, that a market-driven economy was inherently stable and that government intervention was unnecessary.

B. Classical Theory

1. Laissez faire - The doctrine of “leave it alone,” of nonintervention by government in the market mechanism.

2. This seemed reasonable since the U.S. economy had only had a few bad years and those years were short-lived.

3. 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.

• Law of Demand –The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus.

• 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

• Say’s Law - Supply creates its own demand.

• Unsold goods and unemployed labor could emerge in this Classical system, but both would disappear as soon as people had time to adjust prices and wages.

4. Macro Failure (Figure 8.1, Page 153)

• The Great Depression was a stunning blow to Classical economists.

• Unemployment grew and persisted despite falling prices and wages

C. The Keynesian Revolution.

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

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

III. Historical Cycles
A. Swings in the business cycle are gauged in terms of changes in total output. (Figure 8.2, Page 154)

1. Actual business cycles are measured by changes in real GDP.

2. Real GDP – The value of final output produced in a given period, adjusted for changing prices.

3. The growth path of the U.S. economy is not a smooth rising trend, but instead a series of steps, stumbles and setbacks. (Figure 8.3, Page 154)

B. The Great Depression:

1. Was the most prolonged departure from long-term growth-path.

2. Between 1929 and 1933, real GDP contracted a total of nearly 30%. See Figure 8.3.

3. The economy rebounded again in 1933 and continued to expand until 1937, but was still below that of 1929.

4. It got worse again in 1938 and 1939 and at the end of the decade GDP per capita was lower than it had been in 1929.

5. World View: “Global Depression”
   The Great Depression was not confined to the U.S. economy. Most other countries suffered substantial losses of output and employment over a period of many years. This World View offers statistics on the decline in industrial output for several nations. When the U.S. economy tumbled in the 1930s, other nations lost export sales and the Great Depression became a worldwide calamity.

C. World War II

1. Greatly increased the demand for goods and services, ending the Great Depression.

2. Real GDP grew an unprecedented 19% in 1942.

3. Virtually everyone was employed throughout the war and America’s productive capacity was strained to the limit.

D. The Postwar Years (Table 8.1, Page 156)

1. The U.S. economy resumed a pattern of alternating growth and contractions (recessions).

2. Recession - A decline in real GDP that continues for at least two or more consecutive quarters.

3. Most severe postwar recession occurred immediately after World War II.

• Sudden cutbacks in defense production caused GDP to decline sharply in 1945.

• This recession was relatively brief, pent-up demand for consumer goods and a surge in investment spending helped restore full employment.

4. Korean War (1950-1953) further increased demands for goods, accelerating growth.

E. The 1980s

1. The 1980s started with two recessions, the second lasting 16 months (July 1981 - November 1982).

• Despite recession starting midyear, the economy’s output increased in 1981 (1.9%).

• The economy’s growth rate was slower than the growth in labor force so unemployment rose.

• 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.

2. In November 1982, the U.S. economy began expansion that lasted over 7 years.

• Real GDP increased by over $1 trillion and 20 million new jobs were created.

• Longest peacetime expansion in history.

• As expansion continued, rate of growth diminished and another recession occurred at the end of the decade.

F. The 1990s

1. The growth recession of 1989 became a full recession in July 1990.

• The recession officially ended in February 1991, but growth was so slow unemployment kept increasing, destroying 2 million jobs and decreasing total output by nearly 2%.

2. In 1992, the economy started growing faster but unemployment rates stayed high the entire year peaking at 7.7% in June.

3. The unemployment rate of 7.7% was the peak unemployment rate during the1990s expansion.

4. From 1992 through the end of 1998 total output kept increasing.

5. Growth wasn’t very impressive, but it did create millions of new jobs.

6. The unemployment rate fell to 4.3 percent, the lowest in over two decades, in the summer of 1998.

7. In fall of 2000 unemployment feel to 3.9 percent, but by 2001 the US experienced another recession.

IV. A Model of the Macro Economy
A. Keynes and the Classical economists were not debating whether business cycles occur, but whether they are an appropriate target for government intervention.

B. The primary measures of the macroeconomic outcomes include: (Figure 8.4, page 158)

1. Output - total value of goods and services produced.

2. Jobs - levels of employment and unemployment.

3. Prices - average price of goods and services.

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

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

C. Determinants of macro performance include:

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

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

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

D. The crucial macro controversy is whether such pure, market-driven economies are inherently stable or unstable

V. Aggregate Demand and Supply.
A. Any influence on macro outcomes must be transmitted through supply or demand.

B. Aggregate Demand (Figure 8.5, Page 159)

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

2. Used to refer to the collective behavior of all buyers in the marketplace.

3. Aggregate demand curve illustrates how the real value of purchases varies with the average level of prices.

4. Several 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.

• 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.

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

C. Aggregate Supply (Figure 8.6, Page 161)
The total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

1. 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.

D. Macro Equilibrium (Figure 8.7, Page 162)

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

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

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

E. Macro failures.

1. Two potential problems with macro equilibrium are:

• 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.

2. Undesirability (Figure 8.8, Page 163)

• The macroeconomic equilibrium may be more or less than our full employment capacity.

Full-employment GDP – The total market value of final goods and services that could be produced in a given time period at full employment; potential GDP

• If equilibrium is below full-employment GDP, we have failed to achieve our goal of full employment.

• Similar problems may arise from the equilibrium price level.

If equilibrium is above full-employment GDP, we have failed to achieve our goal of price stability due to Inflation – An increase in the average level of prices of goods and services.

3. Instability (Figure 8.9, Page 164)

• The macroeconomic equilibrium will change given macroeconomic disturbances.

• An increase in production costs, such as those caused by OPEC doubling the world price of oil in 1974 accompanied with further increases in 1979 and 1980, cause the aggregate supply curve to shift to the left.

• Volatility in currencies, such as the 1997-98 currency crisis’s in Thailand, Indonesia, South Korea, and Malaysia can cause significant changes in import and export prices causing aggregate demand to shift.

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

VI. Competing Theories of Short-Run Instability
A. Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

B. Demand-side theories.

1. 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.

2. 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 their credit purchases.

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

3. Both Keynesian and monetarist theories emphasize the potential of aggregate- demand shifts to alter some macro outcomes.

4. World View: “Economy Expands, Barely”
   In July 2001 the US ‘skirted the edge of a recession,’ while GDP dropped in Japan and China experienced 7.9% growth.

C. Supply-Side Theories (Figure 8.11, Page 168)
Decreases in aggregate supply can cause multiple macro problems while increases can move us closer to both our price stability and full employment goals.

D. 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.

VII. Long-Run Self Adjustment
A. Some economists argue that short-run theories are pointless. In their view, short-run fluctuations in real output or prices are just statistical ‘noise’.

B. This argument is based on Classical and monetarist views of long-run stability.

C. Their argument asserts a vertical aggregate supply curve. If the long-run AS is vertical, then aggregate-demand shifts affect prices, but not output in the long-run.

D. Short vs. Long-run Perspectives (Figure 8.12, Page 169)

• Even if the long-run AS is vertical, Keynes pointed out it is also true that “in the long-run we are all dead.”

• What ever is true in the long-run, it is in the short-run that we must consume, invest, and find a job.

• Long-run aggregate supply curve is likely to be vertical while the short-run aggregate supply curve is likely to be upward-sloping.

IX. The Economy Tomorrow: Macro Policy Options.
A. The real challenge for macro theory is to determine which curve best represents market reality.

B. Basic Policy Strategies. Three distinct macro policy strategies are:

1. Shift the aggregate demand curve - Find and use policy tools that stimulate or restrain total demand.

2. Shift the aggregate supply curve - Find and implement policy levers that reduce the costs of production or otherwise stimulate more output at every price level.

3. Laissez-faire - if we can’t identify or control the determinants of aggregate supply and demand, then we shouldn’t interfere with the market.

C. Specific Policy Options.

1. Classical approach:

• Embraced the laissez-faire approach prior to the Great Depression.

• New Classical economics stresses market’s “natural” ability to self-adjust to long-run equilibrium and the government inability to improve short-run market outcomes.

2. Fiscal Policy

• Fiscal Policy – The use of government taxes and spending to alter macroeconomic outcomes.

• Fiscal policy is an integral part of modern economic policy.

3. Monetary Policy

• Monetary Policy – The use of money and credit controls to influence macroeconomic outcomes.

• The Federal Reserve is an independent regulatory body with direct control over monetary policy charged with maintaining an “appropriate” supply of money.

4. Supply-Side Policy

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

• Seeks to shift aggregate supply curve.

• Uses tax cuts and deregulation to increase willingness to supply more output.

5. Eclecticism:

• Presidents are often willing to embrace a mix of policies.

• Eclecticism, in part, reflects a “do-whatever-it-takes-to-win” attitude on the part of politicians.

• Different economic theories provide important insights into how the economy works, however, each falls short in explaining one or more of our economic problems.

• Economists prefer a more flexible mix of all policies.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. The full-employment GDP is the same as the equilibrium GDP. The full-employment GDP refers to the capacity of the economy to produce goods and services. When resources are fully employed no additional goods and services can be produced without significant levels of inflation. The equilibrium GDP refers to the equality between the aggregate demand for goods and services and the aggregate supply of those goods and services, not to any particular level of resource employment.
    

2. Aggregate demand (supply) and market demand (supply) are the same. Market demand and supply can be found for specific markets only. Aggregate demand and aggregate supply represents goods and services in all markets combined.
    

3. A downward-sloping trend of the economic growth rate indicates a recession. The economic growth rate is measured by the percentage change in the real GDP. A recession is defined to occur whenever that percentage change is negative for two consecutive quarters. As long as the economic growth rate is positive, the economy is not defined to be in a recession even if the growth rate is less than in the previous quarter.
    

4. The AD and AS curves can be drawn anywhere on the graph. Although this statement is true, the curves need to be drawn in a position which represents the state of economy you are trying to describe, i.e., full-employment, recession, inflation, or stagflation.