BUSINESS CYCLESS Week-08

In this week, we will discuss…. the business cycles introduction to aggregate demand introduction to aggregate supply how the model of aggregate demand and aggregate supply can be used to analyze economic fluctuation effects of macroeconomic policy on aggregate demand

What are Business Cycles? Business cycles are economy wide fluctuations in total national output, income, and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy

What are Business Cycles? recession A recession is a period of declining real GDP, and rising unemployment. – The definition sometimes used is that a recession occurs when real GDP has declined for two consecutive calendar quarters depression A recession that is large in both scale and duration (or a severe recession) is called depression

What are Business Cycles?

Facts about Business Cycles irregular unpredictable The actual pattern are irregular and unpredictable. – No two business cycles are quite the same – No exact formula can be used to predict the duration and timing of business cycles Most macroeconomic variables fluctuate together by different amounts As output falls, unemployment rises.

Exogenous vs. Internal Theories of the Business Cycles Exogenous theories Exogenous theories find the sources of the business cycles in the fluctuation of factors outside the economic system - in war, revolution, elections, oil prices, population migration, technological innovation, climate change, weather, etc. Internal theories Internal theories look for mechanism within the economic system itself. – In this approach, every expansion breeds recession and contraction, and every contraction breed revival and expansion

AGGREGATE DEMAND Aggregate demand (AD) is the total or aggregate quantity of output that is willingly bought at a given level of prices, other thing held constant. AD is sum of spending by consumers, business, government, and foreigner in the economy

AGGREGATE DEMAND

THE AD CURVE is DOWNWARD SLOPING, because the effects of…. Wealth – P   wealth   consumer spending   quantity demanded . Interest Rate – P   interest rate   investment spending   quantity of goods and services demanded . Exchange-Rate – P   interest rate   exchange rate depreciates  net export   quantity of goods and services demanded 

Determinants of Aggregate Demand

AGGREGATE SUPPLY Aggregate supply is the total quantity of goods and services that the nation ’ s business willingly produce and sell in a given period. – AS describe the behavior of the production side of the economy – The AS curve is the schedule showing the level of total national output that will be produced at each possible price level, other thing being equal.

The Short Run AS Curve is upward sloping

Upward Sloping THE AS CURVE are caused by…. Misperceptions of suppliers about relative prices, induce suppliers to decrease the quantity of goods and services supplied. Sticky-Wage – Nominal wages do not adjust immediately to a fall in the price level. P   real wage (W/P)   real cost   employment and production 

Upward Sloping THE AS CURVE are caused by…. Sticky-Price – Prices of some goods and services adjust sluggishly in response to changing economic conditions: An unexpected fall in the price level leaves some firms with higher-than-desired prices  depress firms sales This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

The Long-Run AS Curve is Vertical Output of output Quantity of Natural rate Price Level 0 Long-run aggregate supply P2P2 1. A change in the price level does not affect the quantity of goods and services supplied in the long run. P Copyright © 2004 South-Western

The Long-Run AS Curve The Long-run AS curve is vertical and output is determined by potential output – Potential output is the maximum sustainable output that can be produced without triggering rising inflationary pressure Potential output = natural rate of output = full- employment output Long-run AS is determined by the same factors which influence long-run growth of potential output: the amount and quality of available labor, the quantity of machines and other capital goods, and the level of technology

Determinants of AS The Factors listed in the table would increase AS, shifting the AS curve down or to the right

The distinction between short-run and long-run aggregate supply (AS) is crucial, because…. In the short-run, interaction of aggregate supply (AS) and aggregate demand (AD) determines economic fluctuation, inflation, unemployment, recessions, and booms In the long-run, the growth of potential output working through aggregate supply (AS) which explains the trend in output and living standard

MACROECONOMIC EQUILIBRIUM A macroeconomic equilibrium is a combination of overall price and quantity at which all buyers and sellers are satisfied with their purchases, sales and prices

Two Causes Of Economic Fluctuations 1.Shifts in aggregate demand (AD Shocks) 1.Shifts in aggregate demand (AD Shocks) - Occur as consumers, business, or governments change total spending relative to the economy’s productive capacity – In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. – In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Decrease in Aggregate Demand causes output to fall in the short run But over time, the short- run AS curve shifts…. 1. A decrease in AD…. 4. Output returns to its natural rate….

Two Causes Of Economic Fluctuations 2.Shifts in aggregate supply (AS Shocks) – Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

An Adverse Shift in Aggregate Supply 1. An adverse shift in the short- run aggregate- supply curve… causes output to fall …. 3.. And the price level to rise.

Accommodating an Adverse Shift in Aggregate Supply 1. When short- run AS falls…. 2.. policymakers can accommodate the shift by expanding AD…. 3...which causes the price level to rise further…. 4…. But keeps output at its natural rate.

EFFECTS OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND

The Theory of Liquidity Preference Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money.

The Theory of Liquidity Preference Money Supply – The money supply is controlled by the Central Bank through: Open-market operations Changing the reserve requirements Changing the discount rate – Because it is fixed by the Central Bank, the quantity of money supplied does not depend on the interest rate. – The fixed money supply is represented by a vertical supply curve.

The Theory of Liquidity Preference Money Demand – According to the theory of liquidity preference, one of the most important factors is the interest rate. – People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. – The opportunity cost of holding money – The opportunity cost of holding money is the interest that could be earned on interest-earning assets. – An increase in the interest rate raises the opportunity cost of holding money. – As a result, the quantity of money demanded is reduced.

The Theory of Liquidity Preference Equilibrium in the Money Market – According to the theory of liquidity preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

The Theory of Liquidity Preference Equilibrium in the Money Market – Assume the following about the economy: The price level is stuck at some level. For any given price level, the interest rate adjusts to balance the supply and demand for money. The level of output responds to the aggregate demand for goods and services.

Equilibrium in the Money Market Quantity of Money Interest Rate 0 Money demand Quantity fixed by the CB Money supply r2r2 M2M2 d M d r1r1 Equilibrium interest rate Copyright © 2004 South-Western

The Money Market and the Slope of the Aggregate-Demand Curve Quantity of Money Quantity fixed by the CB 0 Interest Rate Money demand at price levelP2P2,MD 2 Money demand at price levelP,MD Money supply (a) The Money Market(b) The Aggregate-Demand Curve which increases the equilibrium interest rate increases the demand for money... Quantity of Output 0 Price Level Aggregate demand P2P2 Y2Y2 Y P which in turn reduces the quantity of goods and services demanded. 1. An increase in the price level... r r2r2 Copyright © 2004 South-Western

Changes in the Money Supply The Central Bank can shift the aggregate demand curve when it changes monetary policy. – An increase in the money supply shifts the money supply curve to the right. – Without a change in the money demand curve, the interest rate falls. – Falling interest rates increase the quantity of goods and services demanded.

Monetary Injection MS 2 Money supply, MS Aggregate demand,AD Y Y P Money demand at price levelP AD 2 Quantity of Money 0 Interest Rate r r2r2 (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level which increases the quantity of goods and services demanded at a given price level the equilibrium interest rate falls When the Fed increases the money supply... Copyright © 2004 South-Western

Changes in the Money Supply When the Central Bank increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. When the Central Bank contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate- demand to the left.

EFFECTS OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Changes in Government Purchases When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households. When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

Changes in Government Purchases There are two macroeconomic effects from the change in government purchases: – The multiplier effect – The crowding-out effect

The Multiplier Effect Government purchases are said to have a multiplier effect on aggregate demand. – Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

The Multiplier Effect The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

The Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $20 billion AD 2 AD 3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western

A Formula for the Spending Multiplier The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume (MPC). – It is the fraction of extra income that a household consumes rather than saves.

A Formula for the Spending Multiplier If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

Multiplier Model and AS-AD Approach

The Crowding-Out Effect Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending.

The Crowding-Out Effect This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

The Crowding-Out Effect Quantity of Money Quantity fixed by the Fed 0 Interest Rate r Money demand,MD Money supply (a) The Money Market which increases the equilibrium interest rate the increase in spending increases money demand... MD2D2 Quantity of Output 0 Price Level Aggregate demand, AD 1 (b) The Shift in Aggregate Demand which in turn partly offsets the initial increase in aggregate demand. AD 2 AD 3 1. When an increase in government purchases increases aggregate demand... r2r2 $20 billion Copyright © 2004 South-Western

The Crowding-Out Effect When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Changes in Taxes When the government cuts personal income taxes, it increases households’ take-home pay. – Households save some of this additional income. – Households also spend some of it on consumer goods. – Increased household spending shifts the aggregate-demand curve to the right.

Changes in Taxes The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. It is also determined by the households’ perceptions about the permanency of the tax change.

The Case against Active Stabilization Policy Some economists argue that monetary and fiscal policy destabilizes the economy. Monetary and fiscal policy affect the economy with a substantial lag. They suggest the economy should be left to deal with the short-run fluctuations on its own.

Automatic Stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Automatic stabilizers include the tax system and some forms of government spending.

THANK YOU Assignments-8: 1.Questions for discussion – SAM. chapter 22 2.Questions for review, problems and application – M. chapter 20, 21