The Business Cycle Chapter 8 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

8-2 Macroeconomics Macroeconomics: The study of aggregate economic behavior, of the economy as a whole Business cycle: Alternating periods of economic growth and contraction Macro theories try to explain the business cycle, economic policies try to control it

8-3 The Business Cycle Trough Peak REAL GDP TIME Growth trend Peak Trough

8-4 The Business Cycle Recession: A decline in total output (real GDP) for two or more consecutive quarters Growth recession: A period during which real GDP grows, but at a rate below the long-term trend of 3 percent

8-5 The Macro Economy MACRO ECONOMY Internal market forces External shocks Policy levers DETERMINANTS Output Jobs Prices Growth International balances OUTCOMES

8-6 Aggregate Demand and Supply Any influence on macro outcomes must be transmitted through supply or demand Aggregate demand: The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus

8-7 Aggregate Demand Three reasons for the downward slope: –Real-balances effect - A change in the price level affects the purchasing power of money –Foreign-trade effect - Balance of trade depends on domestic price level relative to foreign –Interest-rate effect - Change in price level affects demand for loan-financed purchases

8-8 Aggregate Supply Aggregate supply: The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus Two reasons for upward sloping curve: –The profit effect –The cost effect

8-9 Macro Equilibrium PRICE LEVEL REAL OUTPUT QEQE PEPE Aggregate demand Aggregate supply E D1D1 S1S1 P1P1 Macro equilibrium

8-10 Macro Disturbances F P* QFQF AS 0 PRICE LEVEL REAL OUTPUT (b) Demand shifts AD 0 AD 1 F P* QFQF AD 0 AS 0 PRICE LEVEL REAL OUTPUT (a) Supply shifts AS 1 G P1P1 Q1Q1 P2P2 Q2Q2 H

8-11 Demand-Side Theories P* (b) Excessive demand AS 0 PRICE LEVEL REAL OUTPUT PRICE LEVEL REAL OUTPUT (a) Inadequate demand AS AD 1 E1E1 Q1Q1 AD 0 E0E0 QFQF AD 2 P2P2 Q2Q2 E2E2 E0E0 P* QFQF

8-12 Supply-Side Theories AD 0 Q3Q3 P3P3 QFQF E0E0 AS 0 REAL OUTPUT PRICE LEVEL P0P0 AS 1 E3E3

8-13 Long-Run Self Adjustment Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations They assert a long-run aggregate supply curve anchored at the natural rate of output (Q N ) –Flexible prices (and wages) enable the economy to maintain the natural rate of output Q N

8-14 REAL OUTPUT PRICE LEVEL The “Natural” Rate of Output QNQN AS AD 2 AD 1 P2P2 P1P1 Fluctuations in aggregate demand affect the price level but not real output.

8-15 Policy Strategies Shift the aggregate demand curve: Use policy tools that affect total spending Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output Laissez-faire: Don’t interfere with the market; let markets self adjust

8-16 Selecting Policy Tools There are a host of tools available: –Classical laissez faire –Fiscal policy –Monetary policy –Supply-side policy –Trade policy

The Business Cycle End of Chapter 8 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin