C H A P T E R C H E C K L I S T

2. 1 2 3 4 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Provide a technical definition of recession and describe the history of the U.S. business cycle. Explain the influences on aggregate supply. • Explain the influences on aggregate demand. Explain how fluctuations in aggregate demand and aggregate supply create the business cycle.

3. 14.1 DEFINITIONS AND FACTS • The business cycle is a periodic but irregular up-and-down movement in production and jobs. • A business cycle has two phases, expansion and recession, and two turning points, a peak and a trough. • Dating Business-Cycle Turning Points • The task of identifying and dating business-cycle phases and turning points is performed by a private research organization, the National Bureau of Economic Research (NBER).

4. 14.1 DEFINITIONS AND FACTS • To date the business-cycle turning points, the NBER needs a definition of recession. • Recession • A decrease in real GDP that lasts for at least two quarters (six months) or a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy.

5. 14.1 DEFINITIONS AND FACTS • U.S. Business-Cycle History • The NBER has identified 32 complete cycles starting from a trough in December 1854. • Over all 32 complete cycles: • The average length of an expansion is 35 months (almost 3 years), the average length of a recession is 18 months. • The average time from trough to trough is 53 months (almost 4 1 ⁄2 years).

6. 14.1 DEFINITIONS AND FACTS • So over the 147 years of the 32 complete cycles since 1854, the U.S. economy has been in: • Recession for about one third of the time • Expansion for about two thirds of the time. • The 147-year averages hide significant changes that have occurred over the 150 years: • in the length of a cycle and • the relative length of the recession and expansion phases.

7. 14.1 DEFINITIONS AND FACTS Figure 14.1 summarizes U.S. recession, expansion, and cycle length since 1854. Recessions have shortened. Expansions have lengthened, and complete cycles have lengthened.

8. 14.1 DEFINITIONS AND FACTS • Recent Cycles • The current cycle began at a trough that followed a recession that ran from July 1990 to March 1991. • The economy expanded from March 1991 until March 2001. • This expansion, which lasted for 120 months, was the longest in U.S. history.

9. Recent Cycles • The NBER determined that the recession that started in March 2001 ended in a trough in November 2001, for an eight month-long recession [slightly shorter than the post-1945 average, eleven months]. Since then we have been in a new expansion, according to the NBER. • However, the expansion is a little unusual, in that although real GDP has resumed growth, real personal income has remained flat, and payroll employment has continued to trend downwards [graphs will be shown in class].

10. 14.1 DEFINITIONS AND FACTS Figure 14.2(a) shows the recent cycles in real GDP. Recessions began in mid-1990 and in March 2001. The longest expansion in U.S. history ran from March 1991 to March 2001.

11. 14.1 DEFINITIONS AND FACTS When real GDP decreased in the recession (part a), The unemployment rate increased (part b). And a little later, the inflation rate decreased (part c). As real GDP increased back toward potential GDP, the unemployment rate fell toward the natural unemployment rate and the inflation rate fell.

12. 14.2 AGGREGATE SUPPLY • Aggregate supply, AS, is the relationship between the quantity of real GDP supplied and the output price level [GDP deflator] when all other influences on production plans remain the same. • Other things remaining the same, • When the price level rises, the quantity of real GDP supplied increases. • When the price level falls, the quantity of real GDP supplied decreases.

13. 14.2 AGGREGATE SUPPLY • Aggregate Supply Basics • The quantity of real GDP supplied (Y), depends on: • The quantity of labor employed • The quantities of capital and human capital and the technologies they embody • The quantities of land and natural resources used • The amount of entrepreneurial talent available • The organization and structure of the economy

14. 14.2 AGGREGATE SUPPLY • At full employment [potential GDP]: • The real wage rate makes the quantity of labor demanded equal to the quantity of labor supplied. • Real GDP equals potential GDP. • Over the business cycle: • The quantity of labor employed fluctuates around the natural unemployment rate [full employment]. • The quantity of real GDP supplied fluctuates around potential GDP.

15. 14.2 AGGREGATE SUPPLY • Aggregate Supply and Potential GDP • Along the aggregate supply curve, the only influence on production plans that changes is the price level. • All the other influences on production plans remain constant. Among these other influences are: • The money wage rate • The money prices of other resources [inputs] • Up and down the potential GDP line [which is vertical], when the price level changes the money wage rate changes to keep the real wage rate at the full-employment level.

16. 14.2 AGGREGATE SUPPLY Figure 14.3 shows a change in the quantity of real GDP supplied. Other things remaining the same, 1.A fall in the price level increases the quantity of real GDP supplied. 2.A rise in the price level increases the quantity of real GDP supplied.

17. 14.2 AGGREGATE SUPPLY • Why the AS Curve Slopes Upward • When the price level rises and the money wage rate is constant, the real wage rate falls and employment increases. The quantity of real GDP supplied increases. • When the price level falls and the money wage rate is constant, the real wage rate rises and employment decreases. The quantity of real GDP supplied decreases.

18. 14.2 Aggregate Supply • On an AS curve, input prices are constant, only output prices change as we move on the AS curve. • When we go up the AS curve to the right, output prices rise while input prices stay constant. So the real wage falls, it is less costly to produce, and employment and output supplied rise. • When we go down the AS curve to the left, output prices fall while input prices stay constant. So the real wage rises, it is more costly to produce, and employment and output supplied fall. • Real wages are the money wage [an input price] divided by the output price level.

19. 14.2 AGGREGATE SUPPLY • Changes in Aggregate Supply • Aggregate supply changes [the AS curve shifts] when any influence on production plans other than the price level changes. • In particular, aggregate supply changes when: • Potential GDP changes. • The money wage rate changes. • The money prices of other resources change.

20. 14.2 AGGREGATE SUPPLY • Changes in Potential GDP • Anything that changes potential GDP shifts the potential GDP line and shifts the aggregate supply curve. • The AS curve moves left or right so that it cuts the vertical potential GDP line at the same height, corresponding to the same output price level and real wage that produces full employment as before.

21. 14.2 AGGREGATE SUPPLY Figure 14.4 shows an increase in potential GDP. Point C at the intersection of the potential GDP line and AS curve is an anchor point. 1.An increase in potential GDP shifts the potential GDP line rightward and ... 2. The aggregate supply curve shifts rightward from AS0 to AS1.

22. 14.2 AGGREGATE SUPPLY • Changes in Money Wages and Other Resource Prices • A change in the money wage rate or the money price of another resource changes aggregate supply because it changes firms’ costs. • The higher the money wage rate, the higher are firms’ costs and the smaller is the quantity that firms are willing to supply at each price level. • So an increase in the money wage rate decreases aggregate supply – shifts it left so it cuts potential GDP higher up, corresponding to a higher output price level to again give us the previous real wage, consistent with full employment.

23. 14.2 AGGREGATE SUPPLY Figure 14.5 shows the effect of a change in the money wage rate. A rise in the money wage rate decreases aggregate supply and the aggregate supply curve shifts leftward from AS0 to AS2. A rise in the money wage rate does not change potential GDP.

24. 14.3 AGGREGATE DEMAND • Aggregate demand, AD, is the relationship between the quantity of real GDP demanded and the output price level [GDP deflator] when all other influences on expenditure plans remain the same. • Other things remaining the same, • When the price level rises, the quantity of real GDP demanded decreases. • When the price level falls, the quantity of real GDP demanded increases.

25. 14.3 AGGREGATE DEMAND • Aggregate Demand Basics • The quantity of real GDP demanded is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy. • This quantity is the sum of the real consumption expenditure (C), investment (I), government purchases (G), and exports (X) minus imports (M). • That is, • Y = C + I + G + X – M

26. 14.3 AGGREGATE DEMAND Figure 14.6 shows a change in the quantity of real GDP demanded. Other things remaining the same, 1. A rise in the price level decreases the quantity of real GDP demanded. 2. A fall in the price level increases the quantity of real GDP demanded.

27. 14.3 AGGREGATE DEMAND • Aggregate Demand and the AD Curve • The output price level influences the quantity of real GDP demanded because a change in the output price level brings changes in: • The buying power of money • The real interest rate • The relative real prices of exports and imports

28. 14.3 AGGREGATE DEMAND • The Buying Power of Money • A rise in the output price level lowers the buying power of money and decreases the quantity of real GDP demanded. • For example, if the price level rises and other things remain the same, a given quantity of money will buy less goods and services, so people cut their real spending. • So the quantity of real GDP demanded decreases.

29. 14.3 AGGREGATE DEMAND • The Real Interest Rate • When the price level rises, the real interest rate rises. • An increase in the price level increases the amount of money that people want to hold — increases the demand for money. • When the demand for money increases, the nominal interest rate rises [the quantity of money has not changed]. • In the short run, the expected inflation rate has not changed, so a rise in the nominal interest rate brings a rise in the real interest rate.

30. 14.3 AGGREGATE DEMAND • Faced with a higher real interest rate, businesses and people delay plans to buy new capital and consumer durable goods and cut back on spending. • So the quantity of real GDP demanded decreases.

31. 14.3 AGGREGATE DEMAND • The Real Prices of Exports and Imports • When the U.S. price level rises and other things remain the same, the prices in other countries do not change. • So a rise in the U.S. price level makes U.S.-made goods and services more expensive relative to foreign-made goods and services. • This change in real prices encourages people to spend less on U.S.-made items and more on foreign-made items.

32. 14.3 AGGREGATE DEMAND • In the long run, when the price level changes by more in one country than in other countries, the exchange rate will tend to change to offset the price level change, so this international price effect on buying plans is likely to be a short-run effect only. • But the short-run effect can be powerful.

33. 14.3 AGGREGATE DEMAND • Changes in Aggregate Demand • A change in any factor that influences expenditure plans other than the output price level brings a change in aggregate demand. • When aggregate demand increases, the aggregate demand curve shifts rightward. • When aggregate demand decreases, the aggregate demand curve shifts leftward.

34. 14.3 AGGREGATE DEMAND • The factors that change aggregate demand are anything that changes C, I, G, or (X – M), i.e. the planned purchases of consumers, investment by business, government purchases, or exports minus imports. Obvious examples are: • Expectations about the future • Monetary policy and fiscal policy • The state of the world economy

35. 14.3 AGGREGATE DEMAND • Expectations • An increase in expected future income increases the amount of consumption goods that people plan to buy today and increases aggregate demand. • An increase in expected future inflation increases aggregate demand today because people decide to buy more goods and services before their prices rise. • An increase in expected future profit increases the investment that firms plan to undertake today and increases aggregate demand.

36. 14.3 AGGREGATE DEMAND • Fiscal Policy and Monetary Policy • Government can influence aggregate demand by fiscal policy, setting and changing taxes, transfer payments, and government purchases of goods and services. • The Federal Reserve can influence aggregate demand by monetary policy, changing the quantity of money and the interest rate.

37. 14.3 AGGREGATE DEMAND • A tax cut or an increase in either transfer payments or government purchases increases aggregate demand. Shifts in the incidence of taxes or transfers, who pays or gets them, may also change aggregate demand. • A cut in the interest rate or an increase in the quantity of money increases aggregate demand.

38. 14.3 AGGREGATE DEMAND • The World Economy • The foreign exchange rate and foreign income both influence aggregate demand. • Other things remaining the same, a rise in the foreign exchange rate [the $ becomes worth more foreign currency] decreases aggregate demand. • An increase in foreign income increases U.S. exports and increases U.S. aggregate demand.

39. 14.3 AGGREGATE DEMAND Figure 14.7 shows changes in aggregate demand. • 1. Aggregate demand increases if • Expected future income, inflation, or profits increase. • Fiscal policy or monetary policy increase planned expenditure. • The exchange rate falls or foreign income increases.

40. 14.3 AGGREGATE DEMAND • 2.Aggregate demand decreases if: • Expected future income, inflation, or profits decrease. • Fiscal policy or monetary policy decrease planned expenditure. • The exchange rate rises or foreign income decreases.

41. 14.3 AGGREGATE DEMAND • The Aggregate Demand Multiplier • The aggregate demand multiplier is an effect that magnifies changes in expenditure plans and brings potentially large fluctuations in aggregate demand. • When any influence on aggregate demand changes expenditure plans: • The change in expenditure changes income. • And the change in income induces a change in consumption expenditure, which of course is part of aggregate demand.

42. 14.3 AGGREGATE DEMAND • The final increase in aggregate demand is the initial increase in expenditure plus the induced increase in consumption expenditure.

43. 14.3 AGGREGATE DEMAND Figure 14.8 shows the aggregate demand multiplier. 1. An increase in investment increases aggregate demand and increases income. 2..The increase in income induces an increase in consumption expenditure, so 3. Aggregate demand increases by more than the initial increase in investment.

44. 14.4 UNDERSTANDING BUSINESS CYCLES • Aggregate supply and aggregate demand determine real GDP and the price level. • Changes in aggregate supply and aggregate demand bring changes in real GDP and the price level. • These changes generate the business cycle.

45. 14.4 UNDERSTANDING BUSINESS CYCLES • Aggregate Demand Fluctuations • Consider a business cycle that results from fluctuations in aggregate demand with no changes in aggregate supply. • In the real world, over time, potential GDP grows and the full-employment price level rises. • To simplify and focus on the business cycle, we’ll ignore economic growth and inflation and pretend that potential GDP and the full-employment price level are constant. [This is like taking out the trend growth and inflation].

46. 14.4 UNDERSTANDING BUSINESS CYCLES Figure 14.9 shows an aggregate demand cycle. Real GDP is $9.5 trillion at the intersection of AS and AD0 in part (a), and the economy is in a trough at point A in part (c).

47. 14.4 UNDERSTANDING BUSINESS CYCLES An increase in investment increases aggregate demand through AD1 to AD2. The economy moves from A through full employment at B to a cycle peak at C.

48. 14.4 UNDERSTANDING BUSINESS CYCLES A decrease in investment decreases aggregate demand trough AD3 to AD4. The economy moves from C through full employment at D to a cycle trough at E.

49. 14.4 UNDERSTANDING BUSINESS CYCLES • Aggregate Supply Fluctuations • Aggregate supply might fluctuate for two types of reasons. • Potential GDP grows at an uneven pace [the trend growth we are taking out fluctuates]. • The money price of a major input, such as crude oil, might change. • Stagflation • A combination of recession (falling real GDP) and inflation (rising price level).

50. 14.4 UNDERSTANDING BUSINESS CYCLES Figure 14.10 shows an oil price cycle. A rise in the price of oil decreases aggregate supply and shifts the AS curve leftward to AS1. Real GDP decreases, and the price level rises. The economy experiences stagflation.