The Business Cycle

ECONOMICS CYCLE

.
 The Business Cycle
• Basic purpose of macroeconomics is to explain
how and why economies grow and what
causes recurrent ups and downs
– How stable is a market-driven economy?
– What forces cause instability?
– What, if anything, can the government do to
promote steady economic growth?

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 Macroeconomics
• Macroeconomics: The study of aggregate
economic behavior, of the economy as a whole
• Business cycle: Alternating periods of
economic growth and contraction
• Macro theories try to explain the business
cycle, economic policies try to control it

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 Stable or Unstable?
• Prior to the 1930s, macroeconomists thought
there could never be a Great Depression
• They believed a market-driven economy was
inherently stable
• Laissez faire: The doctrine of “leave it alone,”
of nonintervention by government in the
market mechanism

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 Classical Theory
• According to the classical view, the economy
“self-adjusts” to deviations from its long-term
growth trend – a self-regulating economy
• The cornerstones of classical optimism were
flexible prices and flexible wages

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 Classical Theory
• Say’s Law: Supply creates its own demand
– Whatever was produced would be sold
– All workers seeking employment would be hired
• Unsold goods and unemployed labor could
emerge, but both would disappear once people
had time to adjust prices and wages

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 THE QUR’ANIC RULE IN ECONOMIC CYCLE
• In Surah Yusuf Ayat 43 to 56
• Prophet Yusuf was asked to interpret the Egyptian
king’s dream on the seven fats cows being eaten
by seven thin cows… seven green wheat bunch
and seven dried wheat bunch…
• Prophet Yusuf interpreted the dream as an
economic policy for the state :
– “ It is for us to grow wheat for seven years in a row
and whatever we harvest are to be left on their bunch,
except for small part that will be consumed….

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• After that there will come seven hard year, that
will vanish whatever you have saved earlier..
Except for a little… Then rain will fall and you
will be able to grow your wheat again and
produce grapes for good consumption…
• For his ability, Prophet Yusuf had been
appointed as the Minister of Finance for Egypt
and steered the economics for an outstanding
growth for years ahead.
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 Macro Failure
• The Great Depression was a stunning blow
– Unemployment grew and persisted despite falling
prices and wages
– The classical self-adjustment mechanism simply
didn’t work

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Inflation and Unemployment: 1900-1940
24
20
Unemployment
16
12
8
4
0
–4 Inflation
–8

1900 1910 1920 1930 1940

Source: U.S. Bureau of the Census, The Statistics of the United States, 1957

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 The Keynesian Revolution
• John Maynard Keynes developed an alternate
view of the macro economy, asserting that a
market-driven economy is inherently unstable
– Small disturbances in output, prices, or
unemployment were likely to be magnified by the
invisible hand of the marketplace

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 Government Intervention
• In Keynes’ view, the inherent instability of the
marketplace required government intervention
– We can’t afford to wait for some assumed self-
adjustment mechanism
– Must intervene to protect jobs and income

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 Historical Cycles
• Upswings and downturns of the business cycle
are gauged in terms of changes in total output
• Real GDP: The value of final output produced
in a given period, adjusted for changing prices
• Changes in employment typically mirror
changes in production

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 The Business Cycle
Peak

Growth trend
Peak

Peak
REAL GDP

Trough

Trough

TIME

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 The Business Cycle
• An economic upswing (expansion) is an
increase in the volume of goods and services
produced
• An economic downturn (contraction) occurs
when the volume of production declines
• Successive short-run contractions and
expansions are the essence of business cycles

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 The Business Cycle
• Recession: A decline in total output (real
GDP) for two or more consecutive quarters
• Growth recession: A period during which real
GDP grows, but at a rate below the long-term
trend of 3 percent

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The Business Cycle in U.S. History

Source: U.S. Department of Commerce (2009)

From 1929 to 2009, real GDP increased at an average rate of 3 percent a year.

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 Business Slumps
Percentage Peak
Duration
Dates Decline in Unemployment
(months)
Real GDP Rate
Aug. ‘29–Mar. ‘33 43 53.4% 24.9%
May ‘37 –June ‘38 13 32.4 20.0
Feb. ‘45 –Oct. ‘45 8 38.3 4.3
Nov. ‘48–Oct. ‘49 11 9.9 7.9
July ‘53–May ‘54 10 10.0 6.1
Aug. ‘57–Apr. ‘58 8 14.3 7.5
Apr. ‘60–Feb. ‘61 10 7.2 7.1
Dec. ‘69–Nov. ‘70 11 8.1 6.1
Nov. ‘73–Mar. ‘75 16 14.7 9.0
Jan. ‘80–July ’80 6 8.7 7.6
July ‘81–Nov. ‘82 16 12.3 10.8
July ‘90–Feb. ‘91 8 2.2 6.5
Mar. ‘01–Nov. ‘01 8 0.6 5.6
Dec 07– ? ? ?

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 A Model of the Macro Economy
• Both Keynes and the Classical economists
agreed that business cycles occur, but
disagreed on whether they’re an appropriate
target for government intervention
• Need to understand origins of the business
cycle

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 Macroeconomic Performance
• Macro outcomes include:
– Output - Value of goods and services produced
– Jobs - Levels of employment and unemployment
– Prices - Average price of goods and services
– Growth - Year-to-year expansion in production
– International balances - International value of the
dollar; trade and payments balances with other
countries

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 Macroeconomic Performance
• Determinants of macro performance include:
– Internal market forces - Population growth,
spending behavior, intervention & innovation, etc.
– External shocks - Wars, natural disasters, terrorist
attacks, trade disruptions, and so on
– Policy levers - Tax policy, government spending,
changes in the availability of money, and
regulation, for example

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 The Macro Economy
DETERMINANTS OUTCOMES
Internal
market Output
forces
Jobs

External MACRO Prices

shocks ECONOMY
Growth

Policy International
levers balances

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 Aggregate Demand and Supply
• Any influence on macro outcomes must be
transmitted through supply or demand
• Aggregate demand: The total quantity of
output (real GDP) demanded at alternative
price levels in a given time period, ceteris
paribus

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 Aggregate Demand
• The aggregate demand curve illustrates how
the real value of purchases varies with the
average level of prices
• The downward slope suggests that with a
given (constant) income, at lower price levels
people will buy more goods and services

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 Aggregate Demand
PRICE LEVEL

Aggregate demand

REAL OUTPUT

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 Aggregate Demand
• Three reasons for the downward slope:
– Real-balances effect - a change in the price level
affects the purchasing power of money
– Foreign-trade effect - balance of trade depends on
domestic price level relative to foreign
– Interest-rate effect - change in price level affects
demand for loan-financed purchases

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 Aggregate Supply
• Aggregate supply: 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
• Two reasons for upward sloping curve:
– The profit effect
– The cost effect

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 Aggregate Supply
Aggregate supply
PRICE LEVEL

REAL OUTPUT

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 Macro Equilibrium
• Aggregate supply and demand curves
summarize the market activity of the whole
(macro) economy
• Equilibrium (macro): The combination of
price level and real output that is compatible
with both aggregate demand and aggregate
supply

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 Macro Equilibrium
Aggregate
supply

P1
PRICE LEVEL

E
PE Macro equilibrium

Aggregate
demand
D1 QE S1

REAL OUTPUT

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 Macro Failures
• Potential problems with macro equilibrium:
– Undesirability - the equilibrium price or output
level may not satisfy policy goals
– Instability - even if the designated macro
equilibrium is optimal, it may not last long

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 An Undesired Equilibrium
Aggregate Aggregate
demand supply
PRICE LEVEL

E
PE

F
P*

Equilibrium
output Full-employment output

QE QF

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 An Undesired Equilibrium
Aggregate Aggregate
demand supply
PRICE LEVEL

E
PE
Desired
price level
F
P*

Equilibrium
output

QE QF

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 Instability
• Macroeconomic equilibrium changes
whenever the aggregate supply and/or demand
curves shift
• Business cycles are likely to result from
recurrent shifts of aggregate supply and
demand curves

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 AS and AD Shifts
• Shifts in aggregate supply can be caused by
changes in costs of production due to import
prices, natural disasters, changed tax policies,
or other events
• Shifts in aggregate demand can be caused by
changes in export demand, expectations, taxes,
or other events

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 Macro Disturbances
(a) Supply shifts (b) Demand shifts
AS1
AS0 AS0

AD0
PRICE LEVEL

PRICE LEVEL
G
P1 F
F P*
P* H
P2
AD0
AD1

Q1 QF Q 2 QF
REAL OUTPUT REAL OUTPUT

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 Competing Theories of Short-Run
Instability
• Macro controversies focus on the shape of
aggregate supply and demand curves and the
potential to shift them
• Demand-side theories, such as Keynesian and
Monetary, emphasize aggregate-demand shifts
• Supply-side theories center on shifts in supply

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 Demand-Side Theories
(a) Inadequate demand (b) Excessive demand

AS AS0

E2
P2
PRICE LEVEL

PRICE LEVEL
E0
E0 P*
P*
E1
AD2

AD0 AD0
AD1

Q1 QF QF Q2
REAL OUTPUT REAL OUTPUT

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 Keynesian Theory
• Keynes argued that a deficiency of spending
tends to depress an economy and cause
persistently high unemployment
• Advocated increasing government spending –
a rightward AD shift – to move the economy
toward full employment

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 Monetary Theories
• Monetary Theories emphasize the role of
money in financing aggregate demand
• Money and credit affect ability and willingness
to buy goods and services
• If credit isn’t available or is too expensive
consumers reduce spending and businesses
curtail investment

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 Supply-Side Theories
• Inadequate supply can keep the economy
below its full-employment potential and cause
prices to rise as well
• Increases in aggregate supply move us closer
to goals of price stability and full employment

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 Supply-Side Theories
AS1

AS0

P3 E3
PRICE LEVEL

E0
P0

AD0

Q3 QF
REAL OUTPUT

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 Long-Run Self Adjustment
• Some economists argue that the long-run trend
of the economy is what really matters, not
short-run fluctuations
• They assert a long-run aggregate supply
curve anchored at the natural rate of output
(QN)
– Flexible prices (and wages) enable the economy to
maintain the natural rate of output QN

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 The “Natural” Rate of Output
AS
PRICE LEVEL

P2

P1
AD2
AD1

QN
REAL OUTPUT

Fluctuations in aggregate demand affect the price level but not real output.

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 Short vs. Long-run Perspectives
• The long-run aggregate supply curve is likely
to be vertical at QN
• The short-run aggregate supply curve is likely
to be upward-sloping
• Both aggregate supply and aggregate demand
influence short-run macro outcomes

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 Policy Strategies
• Shift the aggregate demand curve: Use policy
tools that affect total spending
• Shift the aggregate supply curve: Implement
policy levers that influence the costs of
production or otherwise affect output
• Laissez-faire: Don’t interfere with the market;
let markets self adjust

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 Selecting Policy Tools
• There are a host of tools available:
– Classical laissez faire
– Fiscal policy
– Monetary policy
– Supply-side policy
– Trade policy

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 Policy Tools
• The laissez-faire approach requires no tools,
as the economy naturally self-adjusts to full
employment
• Fiscal policy: The use of government taxes
and spending to alter macroeconomic
outcomes

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 Policy Tools
• Monetary policy: The use of money and
credit controls to influence macroeconomic
outcomes
• Supply-side policy: The use of tax incentives,
(de)regulation, and other mechanisms to
increase the ability and willingness to produce
goods and services

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 Policy Tools
• Trade policy can be used to affect
international trade and money flows and shift
the aggregate demand and/or the aggregate
supply curve

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 NORMAL ECONOMIC CYCLE
Properties prices peak

High
PEAK Interest
FULL
High rate
RECOVERIE
Liquidity RECESSION
S

SELECTIVE Shares
Shares RECOVERIES CORPORATE Prices
Market FAILURES tumbled
peak
DOUBTFUL
CONTRACTION
STAGE Foreign
Low RECOVERY Reserve
Interest rate BEGIN declined
Properties market
tumbled

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 20
40
60
80
100
120

01
2012
2 013
2 014
2 015
2 016
2 017
2 01 8
2019
2020
2 021
2022
2023
2 024
2025
2 026
2 027
2 028
2 029
2 030
2031
2032
2033
2034
2 035
2 036
2 037
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2 039
2 040
2041
2 042
2043
2044
2 045
2046
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2 048
2 049
2 050
2 051
2052
2053
2054
2 05 5
2056
2057
Business Cycle

The business cycle

2 058
2 059
2 060
2 061
2 06 2
2 063
2 06 4
Ser ies1
number

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The Planning

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The Graph of Economic Cycle until Retirement (66
years old).

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