13e

Chapter 08:
The Business Cycle

McGraw-Hill/Irwin

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

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?

8-2

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.
8-3

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.
8-4

A Self-Regulating Economy
Classical economics: the economy selfadjusts to any deviations from its long-term
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.

8-5

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.

8-6

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.
8-7

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.

8-8

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.
8-9

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.
8-10

The Great Recession of 2008-2009

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).
8-11

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.

8-12

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.

8-13

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, marketdriven economies are inherently stable or

unstable.
Keynes said unstable.
Classical economists said stable.
8-14

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.

8-15

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.
8-16

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.

8-17

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.
8-18

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.

8-19

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.

8-20

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.
8-21

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 fullemployment GDP.

8-22

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 fullemployment GDP.
8-23

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.
8-24

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.
8-25

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.

8-26

Demand-Side Theories

8-27

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.

8-28

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 self-adjust.
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.
8-29

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 short-run.
In the short run, AS slopes upward.

The macro model we will use to describe policy

implementation will have an upward-sloping
AS curve.
8-30