Schiller TET 15e Chap008 PPT

8
CHAPTER
The Business Cycle

LEARNING OBJECTIVES
After learning about this chapter, you should know
LO8-1 The nature and history of business cycles.
LO8-2 The difference between Classical and Keynesian views of macro
stability.
LO8-3 The major macro outcomes and their determinants.
LO8-4 The nature of aggregate demand (AD) and aggregate supply (AS).
LO8-5 How changes in AD and AS affect macro outcomes.
Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education
The Business Cycle
• The Great Depression
(1929-1933) disrupted
the world’s
conventional way of
thinking about
economic activity.
• What about now? Can
a market-driven
economy be stable? If
not, can government
action stabilize it?
08-02
The Business Cycle II
• Macroeconomics explains how and why
economies grow and what causes the
recurrent ups and downs known as the
business cycle.
• Business cycle: alternating periods of
economic growth and contraction.
• Three central questions
– How stable is a market-driven economy?
– What forces cause instability?
– What, if anything, can the government do to
promote steady economic growth?
08-03
Stable or Unstable?
• Prior to the 1930s, conventional wisdom

was a market-driven economy was
inherently stable.
– Business cycles were short-lived, and the
market seemed to correct (regulate) itself.
– There was no need for government intervention
– that is, the prevailing policy was laissez faire.
• Laissez faire: the doctrine of “leave it
alone,” of nonintervention by government in
the market mechanism.
08-04
A Self-Regulating Economy
• Classical economics: the economy

“self-adjusts” to any deviations from its
long-term growth.
• Wages and prices are flexible. The
producer can:
• lower prices to sell off excess goods.
• decrease output and lay off workers. Laid-off
workers compete for jobs by asking for lower
wages. At lower wages, firms will hire more
workers.
08-05
A Self-Regulating Economy II
• Say’s Law: supply creates its own demand.
– Whatever was produced would be sold.
– All workers who sought employment
would be hired.
– This would occur because people have
time to adjust prices and wages
downward.
• The economy, therefore, is self-regulating.
08-06
Macro Failure
• The self-adjustment mechanism did not
work during the Great Depression.
– John Maynard Keynes analyzed the
situation and concluded that self-
adjustment could not occur because of “an
insufficiency of effective demand”.
– He asserted that a market-driven economy
was, in fact, inherently unstable.
– He concluded that the government must
intervene by increasing aggregate demand.
08-07
Government Intervention
• For an underperforming economy, Keynes
proposed that the government intervene to:
– buy more output.
– employ more people.
– provide more income transfers.
– make more money available.
• For an overheated economy, Keynes proposed
the opposite action of:
– raising taxes.
– cutting government spending.
– reducing the availability of money.
08-08
Business Cycle
• The four parts of a modern
business cycle are
– The peak, where GDP
maximizes.
– Contraction, where
GDP declines.
– The trough, where GDP
minimizes.
– Recovery, where GDP
increases.
• These are variations around
a growth trend that slopes
upward.
08-09
The Business Cycle in
U.S. History
The growth rate averages 3%, but the economy fluctuates

around that average, occasionally achieving negative GDP
growth, or decline.
08-10
Terms Associated with the
Business Cycle
• Economic growth: real GDP grows
faster than 3%. (Expansion)
• Growth recession: real GDP grows, but
slower than 3%. The economy expands
too slowly.
• Recession: real GDP contracts (for two
or more consecutive quarters).
• Depression: an extremely deep
recession.
08-11
The Great Recession of 2008-2009
• A recession began as falling home and stock
prices sapped consumer wealth and
confidence. This was coupled with a credit
crisis.
– Sales plummeted and GDP contracted.
– Unemployment reached 10%.
• The Great Recession reached its trough in
June 2009, but economic growth since then
was so slow that unemployment stayed high
for another five years; the slowest recovery in
modern U. S. history.
08-12
A Model of the Macro Economy
08-13
A Model of the Macro Economy II
• Macro outcomes
– Output: total value of goods and services
produced (real GDP).
– Jobs: levels of employment and
unemployment.
– Prices: average price of goods and services
(inflation).
– Growth: year-to-year expansion in
production capacity.
– International balances: value of the dollar;
trade balances.
08-14
A Model of the Macro Economy III
• Determinants of macro performance
– Internal market forces: population
growth, spending behavior, invention and
innovation.
– External shocks: wars, natural disasters,
terrorist attacks, trade disruptions.
– Policy levers: tax policy, government
spending, changes in the availability of
money, regulation.
08-15
The Crucial Controversy
• The crucial macro controversy is
whether pure, market-driven economies
are inherently stable or unstable.
– Keynes said “unstable.”
– Classical economists said “stable.”
• Also controversial is whether the policy
levers are effective and necessary.
– Keynes said “yes.”
– Classical economists said “no.”
08-16
Aggregate Demand and Supply
• The forces of supply and demand are at

work in the macro economy.
– Any influence on macro outcomes must be
transmitted through supply or demand.
• The macro model shows how the macro

economy works and it consists of
aggregate demand (AD) and aggregate
supply (AS).
08-17
Aggregate Demand
• Aggregate demand (AD): the total quantity of
output (real GDP) demanded at alternative
price levels in a given time period, ceteris
paribus.
– The collective behavior of all buyers in the
marketplace.
– It comprises all goods and services.
• AD slopes downward; people will buy more

goods and services at lower price levels, and
vice versa.
08-18
Aggregate Demand (AD)
• Why does AD slope downward?
– Real balances effect: the cash you hold is worth
more when the price level falls, so you can buy
more.
– Foreign trade effect: lower price levels in the

United States convince customers to buy more
American goods and fewer foreign goods.
– Interest rate effect: lower interest rates promote

more borrowing and more spending.
08-19
Aggregate Supply
• Aggregate supply (AS): 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.
– The collective behavior of all suppliers (sellers) in
the marketplace.
– It comprises all goods and services.
• AS slopes upward; suppliers will bring more

goods and services to market at higher price
levels, and vice versa.
08-20
Aggregate Supply (AS)
• Why does AS slope upward?
– Profit effect: if there is no change in the cost of
operating a business, rising prices will improve
profits and suppliers will bring more products to the
market.
– Cost effect: cost increases make producing

products more expensive. Producers will be willing
to supply more only if prices also rise to cover those
added costs.
• At high rates of output (near productive capacity), costs
rise steeply and AS steepens sharply.
08-21
Aggregate Demand and Supply
08-22
Macro Equilibrium
• AS and AD summarize
the market activity of the
macro economy.
• Macro equilibrium: the
combination of price
level and real output that
is compatible with both
AD and AS.
– Where AD and AS
intersect.
– At PE and QE.
08-23
Macro Failures
• Let QF be the goal of
full-employment GDP.
• The equilibrium output

QE is too low; it does
not reach our macro
goal.
• Also, AD and AS can

shift, meaning that any
equilibrium can be
unstable.
08-24
AS Shifts
• AS will shift left if:
– business costs rise.
– business taxes rise.
– natural disaster occurs.
• AS will shift right if:

– business costs fall.
– business taxes fall.
– bounteous harvests occur.
• On the graph, AS shifts left

away from full-employment
GDP.
08-25
AD Shifts
• AD will shift left if:
– spending decreases.
– expectations get worse.
– taxes increase.
• AD will shift right if:

– spending increases.
– expectations improve.
– taxes decrease.
• On the graph, AD shifts

left away from full-
employment GDP.
08-26
Results of Shifts in AD and AS
• A shift in either AD or AS can cause the

economy to:
– go into recession.
– recover from a recession.
– stagnate or overheat.
• Business cycles likely result from
recurrent shifts of AS and AD.
08-27
Short-Run Instability: Theories
• Classical economists believe the
economy will self-regulate and gravitate
toward full employment.
• Keynes and his followers do not believe
this. They believe the economy might get
worse without government intervention.
• In addition, there are controversies about
the shape of AS and AD curves and the
potential to shift these curves.
08-28
Keynesian Theory
• This is a demand-side theory.
• A recession originates with a deficiency of
spending.
– AD is too far to the left.
– Policy: increase government spending to shift AD
back to the right.
• Inflation originates with an excess in spending.

– AD is too far to the right.
– Policy: increase taxes to shift AD back to the left.
08-29
Monetary Theory
• This is also a demand-side theory.
– Emphasizes the role of money in financing
AD.
• “Tight” money might cause AD to shift too
far to the left.
– Policy: increase money supply and lower
interest rates to shift AD back to the right.
• “Easy” money might cause AD to shift too
far to the right.
– Policy: decrease money supply and raise
interest rates to shift AD back to the left. 08-30
Demand-Side Theories
08-31
Supply-Side Theory
• A shift in AS to the left causes output and
employment to decrease and inflation to
increase.
– This problem cannot be corrected by shifting
AD.
• Shift AD right and unemployment falls but inflation
worsens.
• Shift AD left and inflation is reduced but
unemployment rises.
– Policy: devise ways to shift AS back to the
right.
08-32
Supply-Side Theory II
08-33
Long-Run Self-Adjustment
• Some economists argue that short-run
instability is not as important as the long-run
trend in economic growth.
– Relies on the view that the economy can self-adjust.
– Once it adjusts to a short-run deviation, the
economy will return to its long-run growth path.
• There is a “natural” rate of output determined by

institutional factors, illustrated as the long-run
aggregate supply (LRAS) curve.
08-34
LRAS: The “Natural”
Rate of Output
Vertical LRAS implies that
shifts in AD will affect prices
but not output in the long
run.
• If AD1 shifts to AD2, prices
rise but output stays at
QN.
• Why no increase in
output? As prices rise,
short-run profits grow, but
so do costs, wiping out
the new profits. This kills
the incentive to increase
output. 08-35
Short- and Long-Run
Perspectives
• We live in the short run.
– Short-run variations affect our current economic
situation.
– We call on government to “fix” short-run
problems – now!
– Implemented policies take effect in the short-
run.
– In the short run, AS slopes upward.
• The macro model we will use to describe
policy implementation will have an upward-
sloping AS curve.
08-36
Application: The Economy
Tomorrow
• Policy options during the Great Recession,

2008-2014.
• Presidents Bush and Obama had several
strategies available.
1. Shift AD right: stimulate total spending.
• Fiscal policy: the use of government tax and
spending powers to alter macroeconomic outcomes.
• Monetary policy: the use of money and credit
controls to influence macroeconomic outcomes.
08-37
Tomorrow II
2. Shift AS right: reduce the costs of
production or otherwise stimulate more
output.
• Supply-side policy: the use of tax incentives,
deregulation, and other mechanisms to
increase the ability and willingness to produce.
• Trade policy: reduce trade barriers and lower
the value of the dollar to lower input costs.
3. Laissez faire: let the market self-adjust.
08-38
Tomorrow III
• Laissez faire was never considered.
• President Bush implemented a stimulus package

that had a brief and small counteracting effect.
• President Obama implemented a massive fiscal

stimulus package, driving up the deficit. It was
not enough to turn the left-shifting AD curve
around until the economy began picking up
steam on its own.
08-39
Tomorrow IV
• The Federal Reserve implemented an extremely
“easy” money policy with low interest rates.
• The Treasury and the Fed “bailed out” faltering
companies and banks.
• Some of this activist policy worked – shifted AD
right – and some didn’t. In any event, recovery
was very sluggish.
• These policy levers will be used again to combat
future economic problems in the economy.
08-40
Revisiting the Learning Objectives
• LO8-1 Know the nature and history

of business cycles.
– Long-term growth rate of the U.S. economy
is approximately 3 percent a year.
– Some years GDP grows much faster; in
other years growth is slower.
– Macro theory tries to explain the alternating
periods of growth and contraction that
characterize the business cycle.
08-41
Revisiting the Learning Objectives II
• LO8-2 Know the difference between

Classical and Keynesian views of
macro stability.
– Classical economists thought the
economy would self-adjust, eliminating
the need for government intervention.
– Keynes said the market economy was
inherently unstable, necessitating
government intervention.
08-42
III
• LO8-3 Know the major macro
outcomes and their determinants.
– Outcomes: output, prices, jobs, and
international balances.
– Determinants: internal market
forces, external shocks, and policy
levers.
08-43
IV
• LO8-4 Know the nature of aggregate
demand (AD) and aggregate supply
(AS).
– AD is a downward-sloping line on the macro
model (buyers buy more at lower price levels).
– Short-run AS is an upward-sloping line on the
macro model (producers supply more at
higher price levels).
– Long-run AS is vertical at the “natural” rate of
output.
08-44
V
• LO8-5 Know how changes in AD and
AS affect macro outcomes.
– An increase in AD (shift right) will increase
output, decrease unemployment, and
increase inflation. Vice versa for a
decrease in AD (shift left).
– An increase in AS (shift right) will increase
output, decrease unemployment, and
decrease inflation. Vice versa for a
decrease in AS (shift left).
08-45
Looking Ahead: Chapter 9
Aggregate Demand
After learning about this chapter, you should know;
• What the major components of aggregate demand
are.
• What the consumption function tells us.
• The determinants of investment spending.
• How and why AD shifts occur.
• How and when macro failure occurs.
08-46

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8

The Business Cycle

• Prior to the 1930s, conventional wisdom

• Classical economics: the economy

The growth rate averages 3%, but the economy fluctuates

• The forces of supply and demand are at

• The macro model shows how the macro

• AD slopes downward; people will buy more

– Foreign trade effect: lower price levels in the

– Interest rate effect: lower interest rates promote

• AS slopes upward; suppliers will bring more

– Cost effect: cost increases make producing

• The equilibrium output

• Also, AD and AS can

• AS will shift right if:

• On the graph, AS shifts left

• AD will shift right if:

• On the graph, AD shifts

• A shift in either AD or AS can cause the

• Inflation originates with an excess in spending.

• There is a “natural” rate of output determined by

• Policy options during the Great Recession,

• President Bush implemented a stimulus package

• President Obama implemented a massive fiscal

• LO8-1 Know the nature and history

• LO8-2 Know the difference between

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