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

3. 29.1 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).

4. 29.1 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. 29.1 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. 29.1 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.

7. 29.1 DEFINITIONS AND FACTS Figure 29.1 summarizes U.S. recession, expansion, and cycle length since 1854. Recessions have shortened. Expansions have lengthened, and complete cycles have lengthened.

8. 29.1 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.

9. 29.1 DEFINITIONS AND FACTS Figure 29.2(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.

10. 29.1 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.

11. 29.2 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.

12. 29.2 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

13. 29.2 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.

14. 29.2 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.

15. 29.2 AGGREGATE SUPPLY Figure 29.3 shows a change in the quantity of real GDP supplied. Other things remaining the same, 2. A rise in the price level increases the quantity of real GDP supplied. 1. A fall in the price level increases the quantity of real GDP supplied.

16. 29.2 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.

17. 29.2 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.

18. 29.2 AGGREGATE SUPPLY Changes in Potential GDP Anything that changes potential GDP shifts the potential GDP line and shifts the aggregate supply curve.

19. 29.2 AGGREGATE SUPPLY Figure 29.4 shows an increase in potential GDP. 1. An increase in potential GDP shifts the potential GDP line rightward and... 2. The aggregate supply curve shifts rightward from AS 0 to AS 1. Point C at the intersection of the potential GDP line and AS curve is an anchor point.

20. 29.2 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.

21. 29.2 AGGREGATE SUPPLY Figure 29.5 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 AS 0 to AS 2. A rise in the money wage rate does not change potential GDP.

22. 29.3 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.

23. 29.3 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

24. 29.3 AGGREGATE DEMAND Figure 29.6 shows a change in the quantity of real GDP demanded. 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. Other things remaining the same,

25. 29.3 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

26. 29.3 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.

27. 29.3 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. In the short run, the inflation rate doesn’t change, so a rise in the nominal interest rate brings a rise in the real interest rate.

28. 29.3 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.

29. 29.3 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.

30. 29.3 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.

31. 29.3 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.

32. 29.3 AGGREGATE DEMAND The factors that change aggregate demand are: Expectations about the future Monetary policy and fiscal policy The state of the world economy

33. 29.3 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.

34. 29.3 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.

35. 29.3 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.

36. 29.3 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.

37. 29.3 AGGREGATE DEMAND Figure 29.7 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.

38. 29.3 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.

39. 29.3 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.

40. 29.3 AGGREGATE DEMAND The increase in aggregate demand is the initial increase in expenditure plus the induced increase in consumption expenditure.

41. 29.3 AGGREGATE DEMAND Figure 29.8 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.

42. 29.4 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.

43. 29.4 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, we’ll ignore economic growth and inflation and suppose that potential GDP and the full-employment price level is constant.

44. 29.4 UNDERSTANDING BUSINESS CYCLES Figure 29.9 shows an aggregate demand cycle. Real GDP is $9.5 trillion at the intersection of AS and AD 0 in part (a), and the economy is in a trough at point A in part (c).

45. 29.4 UNDERSTANDING BUSINESS CYCLES The economy moves from A through full employment at B to a cycle peak at C. An increase in investment increases aggregate demand through AD 1 to AD 2.

46. 29.4 UNDERSTANDING BUSINESS CYCLES The economy moves from C through full employment at D to a cycle trough at E. A decrease in investment decreases aggregate demand trough AD 3 to AD 4.

47. 29.4 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).

48. 29.4 UNDERSTANDING BUSINESS CYCLES Figure 29.10 shows an oil price cycle. A rise in the price of oil decreases aggregate supply and shifts the AS curve leftward to AS 1. Real GDP decreases, and the price level rises. The economy experiences stagflation.

49. 29.4 UNDERSTANDING BUSINESS CYCLES A fall in the price of oil increases aggregate supply and shifts the AS curve rightward to AS 2. The price level falls and real GDP increases. The economy experiences an expansion.

50. 29.4 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.

51. 29.4 UNDERSTANDING BUSINESS CYCLES Figure 29.11 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.

52. 29.4 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.