1. Chapter 11 The Business Cycle and Macroeconomic Policy
Economics
Chapter 11
The Business Cycle and Macroeconomic Policy

2. The business cycle
When ‘unfortunate incidents’ happened …(e.g. SARS in 2003)
Consumption 
Investment 
GDP 
Unemployment 
Price level 
Hong Kong’s economy suffered a downturn. People suffered a lot.
Afterward, many policies helped to build up economy again…(e.g.CEPA)
Hong Kong’s economy recovered and expanded
Consumption 
Investment 
GDP 
Unemployment 
Price level 

3. The business cycle Every economy experiences up and down cycle.
Business cycle means the recurrent short run fluctuations in real GDP around the long run trend.
Real GDP as a major indicator of economic performance.

4. The business cycle Short-run cycle
Four recurrent phrases of economic cycle:
Recession
Trough
Recovery, or expansion
Peak
Real GDP
Time

5. The business cycle 1. Recession
Sustained decline in economic activities from the peak
Slow down or drop in
Consumption
Investment
Production
Real GDP 
Unemployment
Price level   Inflation rate 

6. The business cycle 2. Trough Economic activities sink to a trough
Real GDP: very low
Consumption, Investment and Production are at the lowest level
Unemployment: very high
Price level is at a low level

7. The business cycle 3. Recovery / Expansion
Continual rise in economic activities from the trough
Common interpretation
Early stage: Recovery
Later: Boom
Increase in
Consumption
Investment
Production
Real GDP 
Unemployment 
Price level   Inflation rate 

8. The business cycle 4. Peak Economic activities are at the peak
Real GDP: very high
Consumption, Investment and Production are at the highest level
Unemployment: very low
Price level is at a high level

9. The long run trend of GDP
An overall increase in real GDP in the long run
Reasons:
Capital accumulation
Technological progress
Upward trend

10. Economic indicators at different phases of the business cycle
To identify short run economic fluctuations
Real GDP
Inflation rate
Unemployment rate
Relationship:
Real GDP 
Inflation rate 
Unemployment rate 
Real GDP 
Inflation rate 
Unemployment rate 

11. Economic indicators at different phases of the business cycle
Recession
Trough
Recovery
Peak
Consumption & Investment
Fall from the peak
At a low level
Rising from a low level
At a high level
Real GDP
Falling
Lowest
Rising
Highest
Inflation rate
Falling from a high level
Unemployment rate

12. Identify a business cycle
Beware of different interpretation of y-axis
Real GDP
Actual real GDP figure
Must be positive
Growth rate of real GDP
Percentage change, i.e. comparison with real GDP in last term
Positive  real GDP still rising
Downswing in positive side means real GDP is still rising, but in a lower percentage than that in last term.
Negative real GDP still falling
Upswing in negative side means real GDP is still falling, but in a lower percentage than that in last term.

13. Identify a business cycle
1. Which phrases do point A, B, C and D show?
Point A & B : Recession (Real GDP is falling as compared with previous term)
Point C & D : Recovery (Real GDP is rising as compared with previous term)
2. Does point A illustrate economic recession?
Yes. The real GDP is falling at point A.
3. Does point C illustrate economic recovery?
Yes. The real GDP is rising at point C.

14. Identify a business cycle
1. Change in real GDP
Rising: Point A & D (with +ve growth rate)
Falling: Point B & C (with –ve growth rate)
2. Does point A illustrate economic recession?
No. The real GDP is still growing rapidly at point A. ( ∵+ve growth rate)
3. Does point C illustrate economic recovery?
No. The real GDP is still falling at point C. ( ∵ -ve growth rate)

15. Macroeconomic policy
The measures a government adopts to achieve economic objectives.
Monetary policy
Expansionary monetary policy
Contractionary monetary policy
Fiscal policy (budget)
Expansionary fiscal policy (Deficit budget)
Contractionary fiscal policy (Surplus budget)

16. Objectives of macroeconomic policy
Maintaining full employment and reducing economic fluctuations
In recession
Real GDP 
Unemployment 
Living standard 
Overheated economy
High inflation
End up in a recession (from upswing to downturn)
Policies to stable the economy to prevent
Recession
Economy overheating

17. Objectives of macroeconomic policy
Stabilizing the price level
High inflation
Living standard 
People lose confidence in the domestic currency
Specialization & Exchange 
Cost of production   Unfavourable to exchange
Deflation
Consumption & Investment 
Unfavourable to economic development
Unexpected inflation or deflation
Unfavouable to social stability
Policies to stable the price level are necessary.

18. Objectives of macroeconomic policy
Narrowing wealth gap
Alleviating poverty (滅貧)
Maintain social stability
Enhance overall economic welfare
Method
Collecting tax from high-income groups
Providing social welfare to low-income groups
Stabilizing exchange rate
Enable stable international trade
Lower the risk of foreign investment
Strengthen people’s confidence in the domestic currency
Avoid import inflation

19. Relationship between money market and aggregate demand
Interest rate (%)
Increase in money demand
Real income 
Md (from Md1 to Md2)
r  (from r1 to r2)
Consumption & Investment 
AD  (from AD1 to AD2)
In the short run,
Price level  (from P1 to P2)
Aggregate output  (from YF to Y2) [assume full employment achieve beforehand]
Result
Md   P  and Y  Ms r2 r1
Md2
Md1
Quantity of money
Price level
SAS P1 P2
AD1
AD2
Aggregate output Y2 YF

20. Relationship between money market and aggregate demand
Interest rate (%)
Decrease in money demand
Real income 
Md  (from Md1 to Md3)
r  (from r1 to r3)
Consumption & Investment 
AD  (from AD1 to AD3)
In the short run,
Price level  (from P1 to P3)
Aggregate output  (from YF to Y3) [assume full employment achieve beforehand]
Result
Md   P  and Y  Ms r1 r3
Md1
Md3
Quantity of money
Price level
SAS P3 P1
AD3
AD1
Aggregate output YF Y3

21. Relationship between money market and aggregate demand
Interest rate (%)
Increase in money supply
Require reserve ratio (RRR) 
Ms (from Ms1 to Ms2)
r  (from r1 to r2)
Consumption & Investment 
AD  (from AD1 to AD2)
In the short run,
Price level  (from P1 to P2)
Aggregate output  (from YF to Y2) [assume full employment achieve beforehand]
Result
Ms   P  and Y 
Ms1
Ms2 r1 r2 Md
Quantity of money
Price level
SAS P2 P1
AD2
AD1
Aggregate output YF Y2
Short run QTM

22. Relationship between money market and aggregate demand
Interest rate (%)
Decrease in money supply
Require reserve ratio (RRR) 
Ms  (from Ms1 to Ms3)
r  (from r1 to r3)
Consumption & Investment 
AD  (from AD1 to AD3)
In the short run,
Price level  (from P1 to P3)
Aggregate output  (from YF to Y3) [assume full employment achieve beforehand]
Result
Ms   P  and Y 
Ms3
Ms1 r3 r1 Md
Quantity of money
Price level
SAS P1 P3
AD1
AD3
Aggregate output Y3 YF
Short run QTM

23. Relationship between money market and aggregate demand
Conclusion
Money market
Md 
Ms 
Excess money demand
 Interest rate 
Money market
Md 
Ms 
Excess money supply
 Interest rate 
Goods market (short run)
AD 
Aggregate output 
Price level 
Goods market (short run)
AD 
Aggregate output 
Price level 

24. Monetary policy
The government’s control of the money supply and interest rate to achieve certain economic objectives.
1. Expansionary monetary policy
Ms  and r 
AD 
2. Contractionary monetary policy
Ms  and r 
AD 

25. Monetary policy 1. Expansionary monetary policy
Suppose in economic downturn, Y1 < YF i.e. the economy cannot achieve full employment
Central bank  Ms and r 
Consumption & Investment 
AD  (from AD1 to AD2)
Price level  (from P1 to P2)
Eliminate deflationary gap
Economic recovery
Aggregate output  (from Y1 to YF)
Examples: QEII in U.S.A.
Price level
LAS
SAS P2 P1
AD2
AD1
Aggregate output Y1 YF

26. Monetary policy 1. Expansionary monetary policy Policy tools
Issuing banknotes
Open market: Purchasing or redeeming gov’t bonds
Lowering the discount rate
Lowering the required reserve ratio

27. Monetary policy 2. Contractionary monetary policy
Suppose in overheated economy, Y1 > YF Central bank  Ms  and r 
Consumption & Investment 
AD  (from AD1 to AD2)
Price level  (from P1 to P2)
Eliminate inflationary gap
Control / Curb inflation
Cool down overheated economy
Aggregate output  (from Y1 to YF)
Examples: Macro-economic control in China (宏觀調控)
Price level
LAS
SAS P1 P2
AD1
AD2
Aggregate output YF Y1

28. Monetary policy 2. Contractionary monetary policy Policy tools
Reducing the quantity of banknotes
Open market: Selling gov’t bonds
Raising the discount rate
Raising the required reserve ratio

29. HK’s monetary policy
Main objective: Stabilize the (linked) exchange rate
The HKMA buys or sells HKD to stabilize the exchange rate between HKD and USD
Because of the linked exchange rate system
MS and r will change according to capital inflow / outflow
The HKSAR Gov’t cannot use monetary policy to achieve economic objective.
Should HK give up using linked exchange rate system?
If there’s inflow of capital
Demand of HKD increases
 HKD rises against USD
 The HKMA sells HKD
 Monetary base  and Ms
 Interest rate 
 Reduce capital inflow
If there’s outflow of capital
Supply of HKD increases
 HKD falls against USD
 The HKMA buys HKD
 Monetary base  and Ms
 Interest rate 
 Increase capital inflow

30. Fiscal policy
The government uses its expenditure and taxation to achieve certain economic objectives.
1. Expansionary fiscal policy
Usually means “Deficit budget”, i.e. Revenue < Expenditure
Government expenditure 
Tax 
AD  and SAS 
2. Contractionary fiscal policy
Usually means “Surplus budget”, i.e. Revenue > Expenditure
Government expenditure 
Tax 
AD  and SAS 

31. The effects of fiscal policy on AD
1. Expansionary fiscal policy
The government boosts the economy by increasing expenditure or cutting tax.
AD  (from AD1 to AD2)
In the short run,
Price level  (from P1 to P2)
Aggregate output  (from Y1 to Y2)
Gov’t Exp. 
Transfer payments (e.g.CSSA) 
Salaries tax 
Disposable income 
Investment 
Profit tax 
Consumption 
AD 
Price level
SAS P2 P1
AD2
AD1
Aggregate output Y1 Y2

32. The effects of fiscal policy on AD
1. Expansionary fiscal policy
Make real GDP return to potential output (YF)
Eliminate a deflationary gap
Suppose economic fluctuation causes the real GDP to deviate from YF
Economy is at point A
Output level = Y1 and deflationary gap = YF - Y1
By using expansionary fiscal policy
AD  (from AD1 to AD2)
Economy is at equilibrium point B
Price level  (from P1 to P2)
Aggregate output  (from Y1 to YF)
Price level
LAS
SAS P2 B P1 A
AD2
AD1
Aggregate output Y1 YF

33. The effects of fiscal policy on AD
2. Contractionary fiscal policy
The government cools down the economy by reducing expenditure or raising tax.
AD  (from AD1 to AD2)
In the short run,
Price level  (from P1 to P2)
Aggregate output  (from Y1 to Y2)
Gov’t Exp. 
Transfer payments (e.g. travel subsidy) 
Salaries tax 
Disposable income 
Investment 
Profit tax 
Consumption 
AD 
Price level
SAS P1 P2
AD1
AD2
Aggregate output Y2 Y1

34. The effects of fiscal policy on AD
2. Contractionary fiscal policy
Make real GDP return to potential output (YF)
Eliminate a inflationary gap
Suppose overheated economic activities causes the real GDP to deviate from YF
Economy is at point A
Output level = Y1 and inflationary gap = Y1 - YF
By using contractionary fiscal policy
AD  (from AD1 to AD2)
Economy is at equilibrium point B
Price level  (from P1 to P2)
Aggregate output  (from Y1 to YF)
Price level
LAS
SAS A P1 P2 B
AD1
AD2
Aggregate output YF Y1

35. The effects of fiscal policy on AS
The supply-side effects of taxation
1. Expansionary fiscal policy
Lowering income tax
Workers are more willing to work
Labour supply 
SAS 
SAS curve shifts rightward (from SAS1 to SAS2)
2. Contractionary fiscal policy
Raising income tax
Workers will have lower working incentive
Labour supply 
SAS 
SAS curve shifts leftward (from SAS1 to SAS3)
Price level
SAS3
SAS1
SAS2
Aggregate output

36. The effects of fiscal policy on AS
The supply-side effects of government expenditure
1. Gov’t expenditure on public health, education, infrastructure……etc.
Accumulate capital
Raise productivity
SAS  and LAS 
In the short-run, SAS curve shifts rightward (from SAS1 to SAS2)
2. Gov’t expenditure on unemployment assistance
Lower the cost of unemployment
Unemployed will have lower incentive to find a job
Labour force 
SAS  and LAS 
In the short-run, SAS curve shifts leftward (from SAS1 to SAS3)

37. Combined effects on changes in AD and AS
For expansionary fiscal policy
Income tax   AD  and AS 
Conclusion:
Lowering the income tax,
Real GDP must be increased
Change of price level is uncertain (depends on the magnitude of the change in AD and AS)
1. If AD  > AS 
Real GDP 
Price level 
2. If AD  < AS 
Real GDP 
Price level 
3. If AD  = AS 
Real GDP 
Price level remains unchanged

38. Check yourself… Fill in the table below. Raising income tax
Lowering income tax
Aggregate demand (AD)
Falls
Rises
Shifting of AD curve
Leftward
Rightward
Short run aggregate supply (SAS)
Shifting of SAS curve
Aggregate output (Y)
Price level (P)
Uncertain
Price level [ If AD > AS ]

39. Limitations of macroeconomic policy
1. Risk of mis-judgement
Generally rules:
During recession: Adopt expansionary policy
Overheated: Adopt contractionary policy
However, economic situation changes rapidly
Enough information to make judgement?
Some policies might even make the problem worst.
Example
Provision of 85,000 public housing flats
Tremendous drop in the price of flats
Hinder the economic recovery in the late 20th and early 21st century

40. Limitations of macroeconomic policy
2. Problem of time lag
Gov’t needs time to decide…
Whether the economy is in danger of recession or overheating
Action to be taken
Policy formulation
Policy implementation
As time goes by, decisions might not be suitable.
Market might resolve the problem itself, and so gov’t decision might worsen the fluctuation
Example: The re-launch of Home Ownership Scheme
Price of residential flat is too high now
Gov’t plans to provide residential flat. Time is needed for planning.
When the scheme is implemented, market price might drop.
Increase in flat supply will worsen the market of private flat.
Worsen the economic recession.

41. Limitations of macroeconomic policy
2. Problem of time lag
Monetary policy
Implemented by the monetary authority
Adjust money supply and interest rate at any time
Shorter time lag of policy implementation
Fiscal policy
Implemented after the approval from the Legislative Council
Comprehensive discussion and adjustments
Longer time lag of policy implementation

42. Limitations of macroeconomic policy
3. Low reversibility of fiscal policy
Monetary policy
Implemented by the monetary authority
The monetary authority can reverse the policy by changing money supply and interest rate at any time
Fiscal policy
Implemented after the approval from the Legislative Council
Right of policy implementation is granted after voting
Difficult to reverse after the right is granted

43. Limitations of macroeconomic policy
4. Conflicting economic objectives
Unemployment vs. Inflation
E.g. High oil price leads to stagflation
If using expansionary policy
Favourable outcome
Increase incentive to work  Labour supply   Aggregate output 
Unfavourable outcome
Higher production  Demand of sources   Price of oil 
Even worsen inflation
If using contractionary policy
Able to lower the oil price  Control inflation
Discourage production  Worsen unemployment  Aggregate output 

44. Case study
Given that Country A suffers from recession due to a fall in AD.
Before recession: Point A, P1 and Y1
After recession: Point B, P2 and Y2
Choice to make:
(I) Let the economy adjusts
Market adjustment: SAS  (from SAS1 to SAS2)
Economy goes to point C
Price level  (from P2 to P3)
Aggregate output goes back to Y1
(II) Adopt expansionary monetary policy
Market adjustment: AD  (from AD2 to AD1)
Economy goes back to point A
Price level goes back to P1
Conclusion
Policy helps stabilize both price level and aggregate output if the recession is caused by decrease in AD.
Price level
LAS
SAS1
SAS2 P1 A B P2 P3
AD1 C
AD2
Aggregate output Y2 Y1
Price level
LAS
SAS1 P1 A B P2
AD1
AD2 Y2 Y1

45. Case study
Given that Country B suffers from recession due to a fall in SAS.
Before recession: Point Q, P1 and Y1
After recession: Point R, P2 and Y2
Choice to make:
(I) Let the economy adjusts
Market adjustment: SAS  (from SAS2 to SAS1)
Economy goes back to point Q
Price level goes back to P1
Aggregate output goes back to Y1
(II) Adopt expansionary monetary policy
Market adjustment: AD  (from AD1 to AD2)
Economy goes back to point S
Price level  (from P2 to P3)
Conclusion
Policy helps stabilize only aggregate output.
It may cause inflation if the recession is caused by decrease in SAS.
Price level
LAS
SAS2
SAS1 R P2 P1 Q
AD1
Aggregate output Y2 Y1
Price level
LAS
SAS2
SAS1 P3 S R P2 P1 Q
AD2
AD1 Y2 Y1