CHAPTER 17: The Business Cycle

1. CHAPTER 17:The Business Cycle

2. The business cycle is an irregular up-an-down movement of business activity that takes place around a generally rising trend; neither frequency nor amplitude stays the same from cycle to cycle; each cycle tends to be different from earlier ones.

3. Some Business Cycle Patterns

4. Basic Facts: • On average, recessions have lasted for just over a year and real GDP has fallen from peak to trough by more than 6 percent. • Expansions have lasted for about 4 years on average and real GDP has increased from trough to peak by an average of about 22 percent.

5. Jargon: • An impulse is an event that starts the cycle -- recession or boom. The impulse is what initially moves the economy away from trend. • The propagation mechanism is the internal adjustment process in the economy that causes the impulse to spread to the economy as a whole.

6. Investment, Capital, and Cycles • Recessions often start when investment in new capital stock starts to slow down; • Expansions often start when investment in new capital stock starts to speed up; • Unplanned changes in business inventories are often early signals of a change of direction in the business cycle.

7. Theories of the Business Cycle • We will look at theories that see the initial impulse that starts a cycle coming in different ways, with different propagation mechanisms. • We will look at three kinds of Aggregate Demand-based theories, and one kind of Aggregate Supply-based theory.

8. Aggregate Demand Theoriesof the Business Cycle There are three types of aggregate demand theories. These are: 1) Keynesian Theory 2) Monetarist Theory 3) Rational Expectations Theories

9. Aggregate Demand Theories • Keynesian Theory • The Keynesian theory of the business cycle regards volatile expectations that change planned investment spending as the main source of economic fluctuations.

10. P1 P1 P2 AD2 (I2) GDP2 GDP1 GDP1 Keynesian Theory: Suppose Firms Become More Pessimistic • We begin in long run equilibrium . . . where LAS crosses SAS, and AD, at the price level P1 and output level GDP1. Pricelevel LAS • Suppose business firms become more pessimistic about the economy and investment spending declines? SAS0 • AD shifts left to AD2(I2). P2 • Keynesians believe it will take a long time for wages to fall. Thus we will stay near GDP2for a long time. AD!(I1) • A horizontalSAS curve would make GDP change bigger. GDP2 RealGDP

11. SAS2 P2 P1 AD2 (I2) Keynesian Theory: Suppose Firms Become More Optimistic • Again, we begin in long run equilibrium LAS where LAS crosses SAS, and AD, at the price level P1 and output level GDP1. Pricelevel • Suppose business firm’s become more optimistic about the economy and investment spending increases? SAS0 P1 • AD shifts right to AD2(I2) • Keynesians believe wages are flexible upward, so the SAS curve will move up relatively quickly to SAS2. AD1(I1) RealGDP GDP1 GDP1

12. Aggregate Demand Theories • Milton Friedman and Monetarist Theory • The Monetarist Theory of the business cycle says that fluctuations in the money supply are the main source of business cycles.

13. Aggregate Demand Theoriesof the Business Cycle The Monetarist Cycle Mechanism (cont.) An increase in the money supply leads to: • The quantity of real money increases. • Interest rates fall. • Real money balances increase. • The dollar loses value on the foreign exchange market.

14. Aggregate Demand Theoriesof the Business Cycle The Monetarist Cycle Mechanism (cont.) An increase in the money supply leads to: • Investment demand and exports increase. • Consumers spend more on durable goods. • These initial changes in expenditure have a multiplier effect and an expansion begins. Decreasesin the money supply have similar effects in the opposite direction – i.e. start a contraction.

15. Aggregate Demand Theoriesof the Business Cycle The Monetarist Cycle Mechanism (cont.) Monetarists believe that real GDP deviations from full employment are temporary in both directions. • This is due to their belief that money wages are only temporarily sticky.

16. SAS2 P1 P2 P2 AD2 (M2) P3 GDP2 GDP1 GDP1 GDP2 Monetarist Theory: Suppose the Quantity of Money Decreases • Again, we begin in long run equilibrium LAS where LAS crosses SAS1, and AD, at the price level P1 and output level GDP1. Pricelevel SAS1 • Suppose the quantity of money decreases. This will cause interest rates to increase and AD to fall to AD2(M2). P1 • The decline in money causes GDP to fall to GDP2and prices to P2. AD1(M1) • The recession lasts until money wages fall and the short-run aggregate SAS shifts to SAS2, and the recession ends. RealGDP GDP1

17. P3 SAS2 P2 P2 P1 AD2 (M2) GDP2 GDP1 GDP1 GDP2 • Again, we begin in long run equilibrium Monetarist Theory: Suppose the Quantity of Money Increases where LAS crosses SAS1, and AD1, at the price level P1 and output level GDP1. LAS Pricelevel • Suppose the quantity of money increases. Interest rates fall and AD increases to AD2(M2). SAS1 P1 • GDP increases to GDP2and prices to P2. • This expansion will be short lived, as wages will increase. SAS shifts up to SAS2. AD1(M1) • In the long-run, the expansion of the money supply only creates a higher price level. RealGDP GDP1 GDP1

18. Monetarist Policy • This view basically believes that cycles result from errors made by the monetary authorities trying to respond to the condition of the economy. • Milton Friedman advocates the Fed follow a constant money supply rule. • The argument is that because time lags are variable, trying to offset outside influences by changing monetary policy is more likely to destabilize than stabilize -- make cycles worse, not better.

19. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Theories • A “rational expectation” [jargon] is a forecast that is based on all the available relevant information. It is not necessarily ‘right,’ just based on all info and therefore ‘unbiased.’ • Rational expectations theories are based on the view that money wages are determined by a “rational expectation” of the future price level.

20. Rational Expectations Theories There are two different rational expectations theories: 1) New classical theory of the business cycle. • Regards unanticipatedfluctuations in aggregate demand as the main source of economic fluctuations. 2) New Keynesian Theory of the Business Cycle • Is similar to the new classical theory, but also leaves room for anticipateddemand fluctuations to play a role.

21. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Impulse The impulse in the rational expectations theories is an unanticipated change in aggregate demand. • A larger than anticipated increase in aggregate demand brings expansion. • A smaller than anticipated increase in aggregated demand brings recession.

22. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Impulse Unanticipated impulses such as a fiscal policy change, a monetary policy change, or a change in the world economy that influences exports, can change real GDP.

23. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Cycle Mechanisms New Classical Version • If firms and workers anticipated an increase in aggregate demand, they expect the price level to rise and will agree to a higher money wage rate. • This can prevent the real wage rate from falling and avoid a fall in the unemployment rate below the natural rate.

24. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Cycle Mechanisms New Keynesian Version • Also, argues that money wages are influenced by rational expectations of the price level. • Emphasizes the significance of long-term contracts, e.g. by unions, which also make wages sticky downwards.

25. Aggregate Demand Theoriesof the Business Cycle Rational Expectations Cycle Mechanisms New Keynesian Version • Firms and workers are unable to quickly adjust real money wages to changes in aggregate demand. • This leads to sticky wages.

26. b AD0 0 A Rational ExpectationsBusiness Cycle LAS SAS Recession Aggregate demand less than expected brings recession 110 a Price level (GDP deflator, 1992 = 100) 107 EAD 6.5 7.0 8.0 Real GDP (trillions of 1992 dollars)

27. c a AD1 EAD 0 A Rational ExpectationsBusiness Cycle LAS SAS Expansion 113 Aggregate demand greater than expected brings expansion 110 107 Price level (GDP deflator, 1992 = 100) b AD0 6.5 7.0 7.5 8.0 Real GDP (trillions of 1992 dollars)

28. Aggregate Supply Theories - The Real Business Cycle Theory • Real Business Cycle Theory (RBC) regards random fluctuations in productivity as the main source of economic fluctuations. • In order to see how the real business cycle theory works, suppose an increase in productivity as a new generation of micro-processing chips are developed.

29. r2 LF2 Real Business Cycle Theory: increase in productivity Supply of Loanable Funds InterestRate • Firms will demand funds to finance investment spending. r1 Demand For Loanable Funds QuantityLoanable Funds LF1

30. P1 SAS2 AD2 GDP1 Real Business Cycle Theory: increase in productivity • Again, we begin in long run equilibrium. LAS1 Pricelevel • The increase in investment spending causes the AD curve to shift to the right to AD2. SAS1 • The increase in the interest rate (previous slide) tends to shift SAS up, but the increased productivity from the new technology simultaneously moves SAS to the right, to say SAS2, increasing output. P1 AD1 • This causes the SAS curve to shift to the right, from SAS1 to SAS2. RealGDP GDP1

31. LAS2 SAS2 P2 AD2 GDP2 Real Business Cycle Theory: increase in productivity LAS1 Pricelevel • The short-run impact is for output to increase. • The long-run supply curve will also shift to the right as the increase in investment spending creates a larger capital stock . . . SAS1 P1 P1 changing “full-employment output,” and thus long-run equilibrium, to GDP2. AD1 • Business Cycles are due to real impulses, and not monetary impulses. RealGDP GDP1 GDP1

32. Real Business Cycle Theory Criticisms of Real Business Cycle Theory • Money wages are sticky. • ‘Intertemporal substitution’ is too weak to account for large fluctuations in labor supply and employment with small real wage changes. • Technology shocks are not capable of creating the swings in productivity indicated by growth accounting. The conclusion of critics of Real Business Cycle theory is that: Fluctuations in productivity do not cause the business cycle, but are caused by it.

33. Real Business Cycle Theory Defense of Real Business Cycle Theory • It explains and is consistent with most macroeconomic facts about the business cycle and economic growth. • It is consistent with a wide range of microeconomic evidence. • It views the relation between money and GDP as reverse causation. Believers in Real Business Cycle theory conclude that: It raises the possibility that the business cycle is efficient.

34. The 1990-1991 Recession 1) At the beginning of 1990, the unemployment rate was just above 5% and the inflation rate was at 4%. We were at [or close to] what was then full-employment. 2) In 1990, the Persian Gulf crisis occurred followed by the Gulf War. 3) By the end of 1991, inflation was 3.1% and output had fallen by -.1%. A recession had started.

35. SAS91 98 1990 1991 AD91 6.04 An Application: The 1990-1991 Recession Pricelevel(‘92=100) • Again, we begin in long run equilibrium. • Fiscal policy became less restrained in order to pay for the war, but the war created uncertainty that reduced investment demand . . . SAS90 shifting aggregate demand back. 94 • The price of crude oil more than doubled . . . shifting aggregate supply back. • Result, the 1990-1991 recession . . . AD90 output fell and the price level increased. RealGDP 6.14

36. Recessions and Expansions During the 1990s The U.S. expansion of the 1990s By end 2000, the U.S. economy had completed 117 months of uninterrupted expansion -- the longest expansion for which we have records. Real GDP had grown by over 25 percent during this period.

37. Recessions and Expansions During the 1990s The U.S. expansion of the 1990s (cont.) Productivity Growth in the Information Age • Internet • Personal computer • Biotechnology Fiscal Policy and Monetary Policy • Fiscal policy has been restrained, with since 1994 a full-employment surplus. • Monetary policy has mostly been passive.

38. LAS2000 SAS2000 SAS91 Full employment in 2000 Recessionary gap in 1991 AD2000 0 The 1990s Expansion LAS91 114 Price level (GDP deflator, 1992 = 100) 97 AD91 6.08 7.5 Real GDP (trillions of 1992 dollars)

39. The Great Depression • The 1920s were a time of prosperity in the US. • During the Great Depression [1929-1940], twenty-five percent of the work force was unemployed. • There was then no social security or unemployment compensation. • Employed workers actually were better off because of a rise in real wages -- money prices fellmore than money wages did.

40. The Great Depression Why the Great Depression Happened • The patterns of world trade were changing. • Changing international currency fluctuations and trade restrictions added to firms’ uncertainties. • People began to fear a slowdown. • These factors led to a slowdown in consumer spending.

41. The Great Depression Why the Great Depression Happened • The stock market crash heightened those fears. • Investment collapsed. • Banks failed as people withdrew their funds -- not enough reserves, no deposit insurance. • Bank failures fed on themselves -- one failure implied worse reserve shortages for other banks.

42. The Facts: • The 1920’s were a time of prosperity. In 1929 real GDP exceeded potential GDP and the unemployment rate was 3.2%. • In October 1929, the stock market collapsed. • By 1933, real GDP had decreased by 29% and prices fell by 24%. The unemployment rate increased to 25%. • Further, the economy suffered from a large number of bank failures.

43. AD1930 SAS1930(w2) 15.0 14.6 SAS1933(w3) AD1933 11.4 1028 734 936 An Application: The Great Depression AD1929 • We begin in equilibrium, in 1929 at w1. Pricelevel(‘92=100) SAS1929(w1) • The equilibrium in 1930 is at a lower output level, and after macro adjustment, a lower equilibrium wage in the resources market, w2. • The equilibrium in 1933, is at an even lower output level, and after another macro adjustment, an even lower equilibrium wage, w3. • By 1933, output has decreased by 29% and unemployment has increased to 25%. GDP‘92$

44. Why did aggregate Demand fall? • Peter Temin argued that spending fell due to increasing pessimism and uncertainty in the market. • Milton Friedman argues that the fall in demand was due to bad policy and points to a 20% decline in the money supply.

45. Could a Great Depression happen again in the early 2000s? Unlikely. • Bank Deposit Insurance minimizes the contractionary effect of bank failures. • The Fed better understands its role as “lender of last resort” -- e.g. its reaction in 1997-1999 to the Russian and Asian financial crises. • More automatic stabilizers and government purchases mean less multiplier effects of changes in spending. • Multi-income families have greater security than single-income families.