BUSINESS CYCLES AND AGGREGATE DEMAND

BUSINESS CYCLES AND AGGREGATE DEMANDWHAT ARE BUSINESS CYCLES?

EXPANSION(boom)Aneconomic expansionis an increase in the level ofeconomic activity, and of the goods and services available.RECESSIONArecessionis abusiness cyclecontraction. It is a general slowdown in economic activity.DEPRESSIONA depression is an unusual and extreme form of recessionRECOVERYImpact of recessionInvestments fall sharplyEmployment usually falls sharplyBusiness profits fall sharplyAs output falls, inflation slows AGGREGATE DEMANDThe total amount of goods and services demanded in the economy at a given overall price level and in a given time period.

Aggregate demand is the demand for the gross domestic product (GDP) of a country.

Aggregate Demand (AD) = C + I + G + (X-M)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 CurveREAL OUTPUT (quantity per year)PRICE LEVEL (average price)Aggregate demand10A line graph showing the aggregate demand curve. The line slopes downward and to the right.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 effectReal-Balances EffectThe 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 EffectThe 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 EffectPrices 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.

GROSS DOMESTIC PRODUCTGross Domestic Product(GDP) is how much a place produces in some amount of time.

Fornations, the GDP can be calculated by adding up itsoutputinside the borders of thatcountry.

To know the GDP of a country, you need to add upconsumer spending,investment spending,government spendingand the value of theexportsand subtract the value of theimports.MEASURING GDP THROUGH SPENDINGConsumptionInvestmentGovernment purchasesNet ExportsAdd one point of each item.16Aggregate Demand Theories of the Business CycleThree types of aggregate demand theories have been proposed: Keynesian Monetarist Rational expectations18It is worth quickly reviewing the AS-AD model, because this becomes the organizing principle for distinguishing between the alternative theories: all can be cast into the AS-AD framework, with the differences between them being what moves, how, and why. The Keynesian model is relatively straightforward and easy for students to grasp, being based on business sentiment shifts changing investment. Similarly, monetarist theory is based on changes in the growth rate of money. An obvious question students will think of is why would the Fed change monetary policy in ways that produce a cycle? Point out that this may not be deliberate, but may be caused by miscalculations of what is going on in the economy, or changes in the relationship between monetary policy and aggregate demand arising from financial innovation or events elsewhere in the world. Rational expectations theories to a large extent broaden the Keynesian explanation by seeing the impulse as arising from unpredictable errors in forecasting aggregate demand, rather than fluctuations in investment alone. Aggregate Demand Theories of the Business CycleKeynesian TheoryThe Keynesian theory of the business cycle regards volatile expectations as the main source of business cycle fluctuations.19Aggregate Demand Theories of the Business CycleKeynesian ImpulseThe impulse in the Keynesian theory is expected future sales and expected future profits.A change in expected future sales and expected future profits changes investment.Keynes described these expectations as animal spirits, which means that because such expectations are hard to form, they may change radically in response to a small bit of new information.20Aggregate Demand Theories of the Business CycleKeynesian Cycle MechanismThe mechanism of the business cycle is the initial change in investment, which affects aggregate demand, combined with a flat (or nearly so) SAS curve.An increase in investment has multiplier effects that shift the AD curve rightward; a decrease has similar multiplier effects that shift the AD curve leftward.21Aggregate Demand Theories of the Business CycleThe asymmetry of money wages means that leftward shifts of AD lower real GDP but, without some other change, money wages do not fall and so the economy remains in a below full-employment equilibrium.The Keynesian theory is most like the tennis match, in which cycles are the result of outside forces applied at the turning points.22Aggregate Demand Theories of the Business CycleFigure 15.1 illustrates a Keynesian recession.

23Aggregate Demand Theories of the Business CycleFigure 15.2 illustrates a Keynesian expansion.

24Aggregate Demand Theories of the Business CycleMonetarist TheoryThe monetarist theory of the business cycle regards fluctuations in the quantity of money as the main source of business cycle fluctuations in economic activity.Monetarist ImpulseThe initial impulse is the growth rate of the money supply.25Aggregate Demand Theories of the Business CycleMonetarist Cycle MechanismThe mechanism is a change in the monetary growth rate that shifts the AD curve combined with an upward sloping SAS curve.An increase in the growth rate of the money supply lowers interest rates and the foreign exchange rate, both of which have multiplier effects that shift the AD curve rightward. A decrease in the monetary growth rate has opposite effects.26Aggregate Demand Theories of the Business CycleMoney wages are only temporarily sticky, so an increase in aggregate demand eventually raises money wage rates and a decrease in aggregate demand eventually lowers money wage rates.Rightward shifts in the AD curve cause an initial expansion in real GDP, but money wages rise and the expansion ends as GDP returns to potential GDP.Decreases in AD are similar: they cause an initial decrease in real GDP, but money wages fall and the recession ends as GDP returns to potential GDP.27Aggregate Demand Theories of the Business CycleThe monetarist theory is like a rocking horse, in that an initial force is required to set it in motion, but once started the cycle automatically moves to the next phase.28Aggregate Demand Theories of the Business CycleFigure 15.3 illustrates a monetarist business cycle.Part (a) shows a recession phase.

29Aggregate Demand Theories of the Business CyclePart (b) shows an expansion phase.

30Aggregate Demand Theories of the Business CycleRational Expectations TheoriesA rational expectation is a forecast based on all the available relevant information.There are two distinctly different rational expectations theories.The new classical theory of the business cycle regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations.31Aggregate Demand Theories of the Business CycleThe new Keynesian theory of the business cycle also regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations but also leaves room for anticipated fluctuations in aggregate demand to play a role.32Aggregate Demand Theories of the Business CycleRational Expectations ImpulseBoth rational expectations theories regard unanticipated fluctuations in aggregate demand as the impulse of the business cycle.But the new Keynesian theory says that workers are locked into long-term contracts, so even though a fluctuation in aggregate demand is today anticipated, if it was unanticipated when the contract was signed, it will create a fluctuation in economic activity.33Aggregate Demand Theories of the Business CycleRational Expectations Cycle MechanismsThe mechanism in both theories stresses that changes in aggregate demand affect the price level and hence the real wage, which then leads firms to alter their levels of employment and production.In both theories, a recession occurs when a decrease in aggregate demand lowers the price level and thereby raises the real wage rate.This change causes firms to reduce employment so that unemployment rises.34Aggregate Demand Theories of the Business CycleIn both theories, eventually money wages fall so that the recession ends.The new classical theory asserts that only unanticipated changes in aggregate demand affect real wages; anticipated changes affect the nominal wage rate and have no effect on real wage rates.Anticipated changes in aggregate demand have no effect on real GDP.35Aggregate Demand Theories of the Business CycleThe new Keynesian theory asserts that long-term labor contracts prevent anticipated changes from affecting the nominal wage rate, so even if a change is correctly anticipated today, if it was unanticipated when the labor contract was signed, it affects the real wage rate. Hence, both anticipated and unanticipated changes in aggregate demand affect real GDP.36Aggregate Demand Theories of the Business CycleBoth theories are like rocking horses, in which an initial force starts the business cycle but then the fluctuation automatically proceeds to the end of the cycle.37Aggregate Demand Theories of the Business CycleFigure illustrates a rational expectations business cycle.Part (a) shows a recession.

38Aggregate Demand Theories of the Business CyclePart (b) shows an expansion.

39Aggregate Demand Theories of the Business CycleAS-AD General TheoryAll three of these types of business cycle explanations can be thought of as special cases of a general AS-AD theory of the business cycle, in which fluctuations in aggregate demand (and sometimes aggregate supply) cause the business cycle.40