MACROECONOMICS

Business Cycles and Growth

Kunal Dasgupta
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Definition
Business Cycles are fluctuations about trend in real GDP.

• Persistent positive deviations from trend are booms.

• Persistent negative deviations from trend are recessions.

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Components of a business cycle

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Two facts about business cycles

1. Economic fluctuations are irregular and unpredictable.

2. Most macroeconomic variables fluctuate together.

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Long-term real growth in US GDP per capita

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Two facts about business cycles

1. Economic fluctuations are irregular and unpredictable.

2. Most macroeconomic variables fluctuate together.

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GDP and its correlates (U.S.)

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Leading Indicators of GDP movement

Some key leading indicators are

• Manufacturing activity
• Inventory levels
• Building permits
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Lagging Indicators of GDP movement

Some key lagging indicators are

• Unemployment
• Interest rates
• Exchange rates
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How do we explain economic fluctuations?

• Classical economic theory argued that nominal variables

such as money supply have no e↵ect on real variables such
as output.
• As a result of the so called neutrality of money, we can
examine output determination without introducing money.

How relevant is this argument?

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Today, most economists believe that

• when looking at a long time horizon, changes in money

supply a↵ect the price level but not output,
• but when looking at year-to-year changes, money supply is
not neutral anymore.

Accordingly, we need a new paradigm to explain short-run

fluctuations in output.

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The AD-AS model

The model most mainstream economists and policymakers use

to think about (a) economic fluctuations and (b) policies to
stabilize the economy.

• Shows how price level and aggregate output are

determined.
• Shows how the economy behaves di↵erently in the short
run and the long run.

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The AD-AS model has two components:

• The Aggregate Demand or AD curve shows the quantity of

goods and services that will meet the demands of
households, firms, and the government at each price level.
• The Aggregate Supply or AS curve shows the quantity of
goods and services that firms choose to produce and sell at
each price level.

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In this topic, we shall discuss

• AD curve
• AS curve
• Explaining business cycles

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Aggregate Demand curve
The AD curve

• The IS-LM model developed previously can be used to

derive the AD curve.
• The equilibrium in the IS-LM model is a function of the
price level, among other things.
• A change in the price level will a↵ect interest rate through
the money market, .....
• ..... which, in turn, will a↵ect output demand through the
goods market.

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For a given price level, any exogenous change in the goods
market or the money market causes the AD curve to shift.

• Fiscal policy, by a↵ecting the IS curve, will shift the AD

curve.
• Monetary policy, by a↵ecting the LM curve, will also shift
the AD curve.

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Contractionary fiscal policy

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Expansionary monetary policy

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Aggregate Supply curve
The AS curve

The AS curve has a di↵erent slope depending on whether we

are in the

• Short-Run
• Long-Run

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The Long-Run AS curve

• In the long run, an economy’s production of goods and

services depends on
• its supplies of labour, capital, and natural resources, and
• the productivity of these factors.
• The long-run AS curve is vertical at the natural rate of
output.

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Long-Run AS curve

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Definition
Natural rate or full employment corresponds to a situation
where individuals who want to work at the going wage rate
have jobs available.

• Full employment is consistent with a certain level of

unemployment in the economy.
• Full employment depends on factors like job search
technology, skill gap, etc.
• Any change in the economy that increases full employment
output shifts the long-run AS curve outward.
• Accordingly, we have economic growth.

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Long-Run growth for the world

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Growth Facts

• There is enormous variation in per capita income across

countries.
• There is enormous variation in economic growth across
countries and over time.

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Growth and development in the cross-section
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Growth Facts

• There is enormous variation in per capita income across

countries.
• There is enormous variation in economic growth rates
across countries and over time.

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Cross-sectional growth rates
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Determinants of growth

What causes long-run growth?

Suppose output is given by the following function:

Y = AK ↵ (Lh)1 ↵
,

where

• K is physical capital
• L is labour or worker
• h is the “quality of labour” or human capital
• A is total factor productivity (TFP)
• 0  ↵  1 is the share of capital in production.

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• Define y = Y /L as output per worker. Then

y = Ak ↵ h1 ↵
,

K
where k = L is capital per worker.
• Observe that population growth, by itself, will reduce
output per worker.
• Growth in y occurs due to
• accumulation of physical capital per worker
• accumulation of human capital
• increase in TFP

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Population growth and pc GDP growth

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• An important determinant of physical capital per worker is
the savings rate in an economy.
• Higher savings by households allows
• private firms to build private capital
• governments to build social capital
• Governments can incentivise households to increase savings.
• Examples: tax-free savings instruments, higher yields on
government bonds, etc.

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Economists have studied various fundamental determinants of
TFP. They include:

• Property rights
• Judicial systems
• Corruption
• Policies

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Property rights and development

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Judicial capacity across nations

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Corruption across nations (2010)

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Growth rate across Indian states

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• A recent (and exciting!!) line of research has focussed on
managerial quality as a driver of TFP.
• Economists John Van Reenen, Nicholas Bloom and
co-authors, in collaboration with McKinsey, have developed
a way to define and measure management practices across
countries (worldmanagementsurvey.org).
• They measure management practices along three
dimensions:
1. performance monitoring
2. target setting
3. people management

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Management practise rankings

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Distribution of management practises

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Management practises across ownership types

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Over long periods of time, higher economic growth comes
primarily from technological progress which raises TFP.

• Technological progress, in turn, stems from innovation by

both the public and the private sector.
• Firms’ choice of whether and how much to innovate
depends on private benefits and costs.
• Weak protection of intellectual property discourages
innovation by reducing expected profitability.

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Research spending across countries

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