Title: When you have completed your study of this chapter, you will be able to
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2C 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.
314.1 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).
414.1 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.
514.1 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).
614.1 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.
714.1 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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914.1 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.
10Recent 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.
1114.1 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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1314.1 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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1514.2 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.
1614.2 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
1714.2 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.
1814.2 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.
1914.2 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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2114.2 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.
2214.2 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.
2314.2 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.
2414.2 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.
2514.2 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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2714.2 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.
2814.2 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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3014.3 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.
3114.3 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
3214.3 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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3414.3 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
3514.3 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.
3614.3 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.
3714.3 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.
3814.3 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.
3914.3 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.
4014.3 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.
4114.3 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
4214.3 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.
4314.3 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.
4414.3 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.
4514.3 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.
4614.3 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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4814.3 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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5014.3 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.
5114.3 AGGREGATE DEMAND
- The final increase in aggregate demand is the
initial increase in expenditure plus the induced
increase in consumption expenditure.
5214.3 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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5414.4 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.
5514.4 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,
well 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.
5614.4 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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5814.4 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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6014.4 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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6214.4 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).
6314.4 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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6514.4 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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6714.4 UNDERSTANDING BUSINESS CYCLES
- Adjustment Toward Full Employment
- When the economy is away from full employment,
forces operate that tend to restore full
employment. - Inflationary gap
- A gap that exists when real GDP exceeds potential
GDP and that brings a rising output price level. - Deflationary gap
- A gap that exists when potential GDP exceeds real
GDP and that brings a falling price level.
6814.4 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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7014.4 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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