An Overview of Business Cycle Theories & The Circular Flow Model peak trough recovery contraction Dr. Dennis Foster

Characteristics & Features Rise and fall in Gross Domestic Product (GDP) around some long term trend. Unemployment generally lags ∆GDP Inflation generally inversely related and lags during the expansion. Four phases: peak, contraction, trough, recovery Contraction aka “recession” or “downturn” or “depression” [old days – “panic”]

National Bureau of Economic Research Identifies dates of business cycles (here). Dec. 2007 peak called in Dec. of 2008 (here). A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. June 2009 trough called in Sept. 2010 (here). The recession lasted 18 months, which makes it the longest of any recession since World War II.

The Data on U.S. Business Cycles

Problematic Recovery Ave. = 2.8% Ave. = 2.25% 2001 2008

Thomas Malthus Joseph Schumpeter Workers paid < the value of their production. Excess supply develops across the economy. Depression. FYI – long run wages at subsistence. Joseph Schumpeter Business cycles form patterns: Inventory adjustments – 3 to 5 yrs. Fixed investment – 7 to 11 yrs. Infrastructure building – 15 to 25 yrs. Major innovations – 45 to 60 yrs.

Lord John Maynard Keynes Karl Marx Capitalism produces surplus value. Production goes unsold. Crisis ensues; depression. Worsens over time!! Lord John Maynard Keynes Lack of confidence reduces spending. Wages (and prices) don’t fall  depression. Solution – replace private spending with public spending.

Milton Friedman Ludwig von Mises Emphasizes the role of money. Depressions preceded by fall in MS. In a depression, raise MS to counter. Ludwig von Mises Depressions due to “credit bubbles.” Bubbles perpetuated by the Fed. Depression allows reallocation. Say’s Law

Circular Flow Model I: 2 sectors & no saving Consumption Expenditures Goods and Services Households (HH) Businesses (Bus) Factor “rental” – land, labor, capital Income to factors Real flows. Money flows.

Financial Intermediaries Factor “rental” – land, labor, capital Circular Flow Model II: 2 sectors with saving Consumption Expenditures Goods and Services Investment Saving Financial Intermediaries Households (HH) Businesses (Bus) Factor “rental” – land, labor, capital Income to factors Real flows. Money flows.

Financial Intermediaries Factor “rental” – land, labor, capital Circular Flow Model II*: 2 sectors with saving Consumption Expenditures Goods and Services Investment Saving Financial Intermediaries Households (HH) Businesses (Bus) I Investment Goods Factor “rental” – land, labor, capital Income to factors Real flows. Money flows.

Circular Flow Model III: 3 sectors with saving Gov’t. Taxes Government Expenditures Gov’t. G & S C Goods and Services Investment Saving Financial Intermediaries Businesses (Bus) Households (HH) I Investment Goods Factor “rental” – land, labor, capital Income to factors Real flows. Money flows.

Government Expenditures Financial Intermediaries Circular Flow Model III: 3 sectors – money flows Gov’t. Taxes Government Expenditures C Investment Saving Financial Intermediaries Households (HH) Businesses (Bus) I Income to factors Money flows.

Government Expenditures Financial Intermediaries Circular Flow Model IV: 4 sectors – money flows Gov’t. Taxes Government Expenditures C Imports Foreign Sector Households (HH) Exports Businesses (Bus) I Saving Investment Financial Intermediaries Income to factors Imports spending Exports spending Money flows.

Why the Circular Flow Model? 1. To show how the different sectors of the economy interact with one another. 2. To measure the level of economic activity. --Can’t measure physical flows. --Can measure money flows. --Can measure expenditures or income.

An Overview of Business Cycle Theories & The Circular Flow Model peak trough recovery contraction Dr. Dennis Foster