Macroeconomics

Unit 8
The Business Cycle
The Top 5 Concepts
 Introduction

In this unit you learn about the factors which influence the slope
and position of the demand and supply curves.

You are also exposed to the main economic theories about the
demand and supply curves.

When the economy is at equilibrium, everything is not always

OK. In this unit you will begin to understand that our economy
moves through cycles and those cycles may not always be at a
desirable level of output.
 Business Cycles

The United States economy has had frequent periods of growth

and decline in its history. The periods of growth and decline
are called business cycles.

Business cycles are alternating periods of economic growth

and contraction.

In this chapter we will discuss the causes of business cycles

and some of the theories that economists use to explain cycle
changes.
Concept 1: Classical View of Business Cycles

General belief of classical or laissez-faire economists prior

to 1930s was that the economy was inherently stable.

The economy at times “self-adjusts” to deviations from

long-term growth. Short periods of output declines and
layoffs may occur, but the economy would correct itself.

A key component of the classical theory was that wages

and prices were flexible.
Concept 1: Classical View of Business Cycles

Flexible prices refers to the belief that when demand for

goods and services slows, the prices will drop until
demand rises again.

Flexible wages refers to the belief that as demand falls and

more workers are laid off, the increased competition for
jobs will cause wages to fall. More workers can then be
hired for lower wages.

The classical view of the macro economy is stated in Say’s

Law: supply creates its own demand. The view stated
that whatever was produced will be sold.
 Concept 1: Classical View of Business Cycles

Say’s law further stated that all workers

who sought employment will be
employed.

Unsold goods and unemployed labor

could occur, but adjustments to wages
and prices would eventually eliminate
them.

The Great Depression proved the

classical theory wrong.
 Concept 2: Keynesian View of Business Cycles

John Maynard Keynes was a British economist whose theories

were popular during the 1930s and beyond.

Keynes believed that a market-driven economy is inherently

unstable. Changes in output, prices, or unemployment would
be magnified by the invisible hand.

Keynes believed that an economy can’t rely upon the

market mechanism to correct the problem.
 Concept 2: Keynesian View of Business Cycles

Keynes believed that government intervention was needed to

control the instability of a market economy.

If the economy slows down, the government should buy more

output, employ more people, increase income transfers, and
make more money available.

If the economy overheats, then the role of government is to

slow the economy down by increasing taxes, reducing
government spending, and by making money less available.
 Business Cycles

A recession is a decline in total output (real GDP) for two or

more consecutive quarters.

A growth recession is a period in which real GDP grows, but

at a rate below the long-term trend of 3 percent.

Recent recessions: 1990 – 1991, 2001. The economy of 2002

– 2003 was considered to be in a growth recession.
 Concept 3: Aggregate Demand

Aggregate demand (AD) is the total quantity of output (real

GDP) demanded at alternative price levels in a given time
period, ceteris paribus.

AD reflects the behavior of all buyers in the marketplace.

The AD curve indicates how the real value of purchases varies

with the average level of prices.
 Aggregate Demand Curve

PRICE LEVEL (average price)

Aggregate demand

REAL OUTPUT (quantity per year)

 Concept 3: Aggregate Demand

The downward slope and angle of the AD curve is explained by

three factors:

• The real-balances effect

• The foreign-trade effect

• The interest-rate effect

 Real-Balances Effect
The real-balances effect refers to the real value of
money. The real value of money is determined by how
many goods and services each dollar will buy.

Periods of high inflation and/or high prices reduce your

ability to purchase goods and services. Periods of low
inflation and/or price reductions increase your ability to
purchase goods and services.

The real-balances effect then is dependent upon changes

in average prices. As inflation declines the AD curve
would shift to the right as more output is consumed.
 Foreign-Trade Effect
The foreign-trade effect refers to the relative price of
imports compared to the price of U.S. produced goods.

If U.S. produced goods prices are rising, more imports will

be purchased. If U.S. produced goods prices are falling,
more domestic goods will be purchased.

Consumers in other countries also buy more U.S. exports

when the prices fall, and buy less when the prices
increase.
 Interest-Rate Effect
Prices of goods and services tend to
affect the demand for money. As prices
fall, the demand for money is lower.
Why? Because goods and services cost
less, therefore less borrowing is needed.
When the demand for money is lower,
interest rates fall.

Lower interest rates eventually produce

more borrowing to purchase goods and
services. This process is known as the
Interest-Rate Effect.
 Concept 4: Aggregate Supply

Aggregate supply (AS) is 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.

Producers of goods and services determine how much

they are willing to supply by the price they receive, along
with their costs and production capabilities.

The AS curve indicates the varying levels of output

producers will supply at different price levels.
 Aggregate Supply Curve
PRICE LEVEL (average price)

Aggregate
supply

REAL OUTPUT (quantity per year)

 Concept 4: Aggregate Supply

The AS curve slopes upward

because of:

• The Profit Effect

• The Cost Effect

 The Profit Effect

Producers can only make a profit on the goods and services

they sell if the prices they receive are greater then the costs to
produce the good or service.

The rate of output, or the amount of product that sellers will

produce, will increase when the price level rises. This is the
profit effect.
 Cost Effect
Many costs associated with producing a good or service
are not constant.

The cost of renting a building may remain the same

regardless of output, but the price of labor may increase if
more people are employed or more overtime is paid.

The cost effect refers to the increase in costs as output is

increased.

At high rates of output cost pressures are very high which

leads to the supply curve bending straight up. Examples of
cost pressures include paying overtime wages and
expedited shipping costs.
 Concept 5: Macro Equilibrium

The aggregate supply and demand curves represent the market

activity of the whole economy.

Macro equilibrium occurs at the point at which AD and AS

cross. At this point, the combination of price level and real
output is compatible with both buyers and sellers.
 Macro Equilibrium

PRICE LEVEL (average price)

Aggregate
Supply

Equilibrium Point

Aggregate
Demand

REAL OUTPUT (quantity per year)

 Concept 5: Macro Equilibrium

The macro equilibrium point is unique, but it is generally not a

constant point.

Changes in the determinants of demand and supply will cause

the AD and AS curves to shift. For example an increase
production costs can shift the AS curve to the left. An increase
in consumer income can shift the AD curve to the right.

Changes in prices will cause movements along the AD and AS

curves.
 Concept 5: Macro Equilibrium

There are two potential problems with Macro Equilibrium:

Undesirability – The price and output choices may not

satisfy our macroeconomic goals; we may not be at full
employment GDP output or the inflation rate is too high.

Instability – Macro disturbances may change the

equilibrium point. A change in any determinants can
cause a shift in AD or AS which can change the
equilibrium point.
 An Undesired Equilibrium Point

Price Level (average price) Aggregate

Demand Aggregate
Supply

E
PE

F
PF
Equilibrium
Output Full employment
QE QF
Real Output (quantity per year)
 Undesired Equilibrium Point

The preceding chart illustrates a macro equilibrium point that is

not desired.

At point E, average prices are higher and the quantity of output

is not sufficient to reach full employment output.

A rightward shift of the AS curve to intersect the demand curve

at point F would produce lower prices and higher output.

The new macro equilibrium point would be at full employment

output.
 Short-Run Instability

Most economic theories concentrate on shifting the AD and/or

AS curves to correct economic problems.

Classical theorists believed that the economy would naturally

gravitate towards full employment.

If the economy was not at full employment, then prices and

wages fall until full employment is restored.
Short-Run Instability – Demand-Side Theories

Keynes believed that inadequate aggregate demand

would cause persistently high unemployment.

Government policies should be directed at increasing

aggregate demand to reduce unemployment.

Increased government spending, decreasing taxes, or

increasing transfer payments are ways to increase AD;
shift AD right. Decreased government spending, higher
taxes, or decreasing transfer payments are ways to
decrease AD; shift AD left.
 Short-Run Instability – Demand-Side Theories

Monetary theory is another economic theory used to change

aggregate demand.

Increasing the supply of money by reducing interest rates and

changing bank reserve requirements, can cause AD to shift
right.

Decreasing the supply of money by increasing rates, changing

bank reserve requirements, can cause AD to shift left.
 Short-Run Instability – Supply-Side Theory

The basis of supply-side theory is that economic downturns

may be caused by an inadequate amount of aggregate supply.
As a result, inflation and/or unemployment may result from
inadequate AS.

The focus is to shift AS to the right.

Government’s role is to reduce taxes and regulation, invest in

infrastructure, increase human capital investment, and provide
incentives for capital investment. These steps will shift AS to
the right.
 Short-Run Instability – Eclectic Explanations

Eclectic explanations for economic problems are based upon

the assumption that the problems may be both AD and AS
based.

Since the problems likely occurred because of AD and AS

failures, the solutions must adjust both the AD and AS curves.

Therefore eclectic theorists use both demand side and supply

side policies to correct economic problems.
 Long-Run Self-Adjustment

Classical and monetary theorists believe that the long-run AS

curve is vertical. This means that shifts in AD would only affect
price, not output.

There is considerable disagreement as to whether or not this is

true. The important concept may be to concentrate economic
policies on the short-run to maintain stability.

In the short-run there is general agreement that the AS curve is

upward sloping and shifts in the AS curve will produce changes
in prices and output.
 Economic Policy and Theory – An Overview

• Classical Theory – Laissez-faire and the natural gravitation

towards full employment. Flexible wages and prices.

• Fiscal Policy – The use of government taxes and spending

to alter macroeconomic outcomes. This is Keynesian policy.

• Monetary Policy – The use of money and credit controls to

influence macroeconomic outcomes. In the U.S., monetary
policy is controlled by the Federal Reserve.
 Economic Policy and Theory – An Overview.

• Supply-Side Policy – The use of tax incentives, regulation

or deregulation, infrastructure and human capital investment,
and other mechanisms to increase the ability and willingness
to produce goods and services.

• Trade Policy – Not a basic economic theory but often used

with other theories. Changing trade barriers like tariffs and
quotas can increase/decrease the supply of goods and can
affect the price. Lower priced imported goods can reduce
inflationary price pressures domestically.
 Economic Policy and Theory – An Overview

• Eclecticism – Mixing both demand-side and supply-side

policies to solve economic problems. This theory recognizes
that both AD and AS may cause problems. Solutions to
economic problems use both demand side and supply side
tools.
 Summary
• Business cycles, Say’s law, classical view and
Keynesian view.
• Recession and growth recession.
• Aggregate demand, AD curve.
• Real-balances, foreign-trade, interest-rate effect.
• Aggregate supply, AS curve.
• Profit effect, cost effect.
• Macro equilibrium and problems.
• Full Employment GDP.
 Summary

• AD shifts, AS shifts.
• Short-run instability theories: Keynesian, Monetary, Supply-
side, Eclectic.
• Fiscal Policy, monetary policy, supply-side policy.
• Eclecticism.