When you have completed your study of this chapter, you will be able to

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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.
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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 point, 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).

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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.

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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).

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14.1 DEFINITIONS AND FACTS

• So over the 147 years 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 in the length of a cycle and
  the relative length of the recession and
  expansion phases.

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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.
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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, is
  the longest in U.S. history.

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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.
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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.
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14.2 AGGREGATE SUPPLY

• Aggregate supply is the relationship between the
  quantity of real GDP supplied and the price level
  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.

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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

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14.2 AGGREGATE SUPPLY

• At full employment
• 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.
• The quantity of real GDP supplied fluctuates
  around potential GDP.

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14.2 AGGREGATE SUPPLY

• Aggregate Supply and Potential GDP
• Along the aggregate supply curve, the only
  influence that 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
• Along the potential GDP line, when the price
  level changes the money wage rate changes to keep
  the real wage rate at the full-employment level.

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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.
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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.

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14.2 AGGREGATE SUPPLY

• Changes in Aggregate Supply
• Aggregate supply changes 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.

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14.2 AGGREGATE SUPPLY

• Changes in Potential GDP
• Anything that changes potential GDP shifts the
  potential GDP line and shifts the aggregate
  supply curve.

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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.
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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.

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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.
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14.3 AGGREGATE DEMAND

• Aggregate demand is the relationship between the
  quantity of real GDP demanded and the price level
  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 supplied increases.
• When the price level falls, the quantity of real
  GDP supplied decreases.

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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

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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.
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14.3 AGGREGATE DEMAND

• Aggregate Demand and the AD Curve
• The price level influences the quantity of real
  GDP demanded because a change in the price level
  brings changes in
• The buying power of money
• The real interest rate
• The real prices of exports and imports

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14.3 AGGREGATE DEMAND

• The Buying Power of Money
• A rise in the 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 less goods and services, so people cut their
  spending.
• So the quantity of real GDP demanded decreases.

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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
  holdincreases the demand for money.
• When the demand for money increases, the nominal
  interest rate rises.
• In the short run, the inflation rate doesnt
  change, so a rise in the nominal interest rate
  brings a rise in the real interest rate.

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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.

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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.

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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 changes.
• The exchange rate neutralizes the price level
  change, so this international price effect on
  buying plans is a short-run effect only.
• But the short-run effect is powerful.

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14.3 AGGREGATE DEMAND

• Changes in Aggregate Demand
• A change in any factor that influences
  expenditure plans other than the 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.

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14.3 AGGREGATE DEMAND

• The factors that change aggregate demand are
• Expectations about the future
• Monetary policy and fiscal policy
• The state of the world economy

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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.

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14.3 AGGREGATE DEMAND

• Fiscal Policy and Monetary Policy
• Government can influence aggregate demand by
  set-ting and changing taxes, transfer payments,
  and government purchases of goods and services.
• The Federal Reserve can influence aggregate
  demand by changing the quantity of money and the
  interest rate.

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14.3 AGGREGATE DEMAND

• A tax cut or an increase in either transfer
  payments or government purchases increases
  aggregate demand.
• A cut in the interest rate or an increase in the
  quantity of money increases aggregate demand.

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14.3 AGGREGATE DEMAND

• The World Economy
• The foreign exchange arte and foreign income
  influence aggregate demand.
• Other things remaining the same, a rise in the
  foreign exchange rate decreases aggregate demand.
• An increase in foreign income increases U.S.
  exports and increases U.S. aggregate demand.

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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.

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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.

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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.

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14.3 AGGREGATE DEMAND

• The increase in aggregate demand is the initial
  increase in expenditure plus the induced increase
  in consumption expenditure.

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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.
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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.

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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.
• Over time, potential GDP grows and the
  full-employment price level rises.
• To focus on the business cycle, well ignore
  economic growth and inflation and suppose that
  potential GDP and the full-employment price level
  is constant.

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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).
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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.
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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.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate Supply Fluctuations
• Aggregate supply fluctuates for two types of
  reasons.
• Potential GDP grows at an uneven pace.
• The money price of a major resource, such as
  crude oil, might change.
• Stagflation
• A combination of recession (falling real GDP) and
  inflation (rising price level).

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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.
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14.4 UNDERSTANDING BUSINESS CYCLES

• A fall in the price of oil increases aggregate
  supply and shifts the AS curve rightward to AS2.

The price level falls and real GDP increases.
The economy experiences an expansion.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Adjustment Toward Full Employment
• When the economy is away from full employment,
  forces operate to restore full employment.
• Inflationary gap
• A gap that exists when real GDP exceeds potential
  GDP and that brings a rising price level.
• Deflationary gap
• A gap that exists when potential GDP exceeds real
  GDP and that brings a falling price level.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Figure 14.11 shows adjustments toward full
  employment.

Real GDP exceeds potential GDP there is an
inflationary gap.
As the money wage rate gradually rises, aggregate
supply decreases, real GDP decreases, and the
price level rises.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Potential GDP exceeds real GDP there is a
  deflationary gap.

The money wage rate eventually starts to fall,
aggregate supply increases, real GDP increases,
and the price level falls.
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