1. 1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Business Cycles Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth Ingram University of Iowa 2 nd edition

2. 14-2 Key Concepts Business Cycle characterization Recessions and Depressions Frisch-Slutsky Paradigm Real Business Cycle Theory Keynesian Theory

3. 14-3 Business Cycle Deviation from trend growth (i.e. fluctuations in GDP around its trend)

4. 14-4 Business Cycle Trend GDP: for a given level of capital, labor, and technology a certain amount of GDP can be sustainably produced Above trend: labor and/or capital being more intensively used…unsustainable labor must eventually rest or be paid premium (e.g. overtime) capital wears out and breaks down Below trend: labor and/or capital not being fully used. eventually employ more capital and/or labor

5. 14-5 Business Cycle Output Gap: difference between actual and potential (trend) GDP Positive output gap: excess demand => upward price pressures Negative output gap: excess supply (capacity) => downward price pressure Note: you can have negative output gap and positive growth => “growth recession”

6. 14-6 Business Cycle

7. 14-7 Stages of the Business Cycle

8. 14-8 Stages of the Business Cycle There are expansions and contractions Aggregate economic activity declines in a contraction or recession until it reaches a trough Informal recession definition: 2 consecutive quarters or negative GDP growth Then activity increases in an expansion or boom until it reaches a peak A particularly severe recession is called a depression The sequence from one peak to the next, or from one trough to the next, is a business cycle Peaks and troughs are turning points Popular saying: “Recession is when someone you know becomes unemployed; a depression is when you become unemployed.”

9. 14-9 Business Cycle Example

10. 14-10 Business Cycle Example

11. 14-11 Co-movement Across World

12. 14-12 The Changing U.S. Business Cycle?

13. 14-13 Business Cycle Paradigm Impulse/Shock Propagation Business Cycle

14. 14-14 Business Cycle Paradigm Shocks monetary and fiscal shocks consumption and investment shocks technology shocks external shocks: (1) exchange rate shock (2) terms of trade shocks financial system shock

15. 14-15 Fluctuations Increase in aggregate demand Increase in C, I, G, NX Increases prices and output Increase in aggregate supply Increase in labor, capital, TFP Decreases prices and increases output

16. 14-16 Aggregate Demand Aggregate Supply Model Aggregate Demand Curve Inverse relationship between price level and real output: downward slopping Real Balance Effect Interest Rate Effect Exchange Rate Effect Short Run Aggregate Supply Curve Positive relationship between price level and real output: upward slopping sticky input prices, sticky output prices, misperceptions Long Run Aggregate Supply Curve Real output independent of price level: vertical Fundamentals—resources, productivity, trade—only matter

17. 14-17 Real Business Cycle Theory Both growth and business cycles are caused by aggregate supply shocks Business cycles are outcome of optimizing market mechanism aggregate demand is endogenous No role for government in changing the nature of business cycles

18. 14-18 Keynesian View Prices and wages may be sticky … may not adjust to equilibrate markets Conduct countercyclical aggregate demand management Business cycle largely the result of destabilizing movement in aggregate demand New Keynesians also acknowledge aggregate supply shocks matter Government must step in to shore up aggregate demand … policy can alter the business cycle.