The Business Cycle

1
The Business Cycle

• How do Keynesians and Monetarists explain
  business cycles?
• How do new classical and new Keynesian economists
  explain business cycles?
• What is Real Business Cycle theory?

2
Business Cycle Averages

• Since 1920 there have been 15 recessions and
  expansions.
• On the average, recessions have lasted just over
  a year.
• During recessions, real GDP falls from its
  previous peak by an average of over 6.
• Expansions have lasted nearly four years with GDP
  increasing 22.

3
Some Business Cycle Patterns
4
The Central Role of Investment and Capital

• Investment plays a crucial role in most business
  cycles.
• During an expansion, investment is high.
• Then the law of diminishing returns sets in and
  there are fewer profitable investment
  opportunities.

5
Recession Effect

• As investment falls, the expansion ends and a
  downturn begins.
• During a recession, the opportunities for
  profitable investment increase.
• Businesses invest in these new profit
  opportunities, increasing investment.

6
The AS-AD Model

• Business cycle theories fall into two categories
• Aggregate demand theories
• Real business cycle theory

7
Aggregate Demand Theories of theBusiness Cycle

• The three types of aggregate demand business
  cycle theory are
• Keynesian theory
• Monetarist theory
• Rational expectations theories

8
Keynesian Theory

• The Keynesian theory of the business cycle
  regards volatile expectations as the main source
  of economic fluctuations.
• The main impulse is expected future sales and
  profits.
• Sometimes referred to as animal spirits

9
Keynesian SAS

• Below full employment, the Keynesian SAS curve is
  fairly flat.
• Wages are sticky in a downward direction.
• At full employment, the SAS curve becomes nearly
  vertical.

10
A Keynesian Recession
LAS
A fall in animal spirits decreases
aggregate demand...
120
Price level (GDP deflator, 1992 100)
a
b
110
SAS
and, with sticky wages, brings recession
AD0
AD1
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
11
A Keynesian Expansion
A rise in animal spirits increases
aggregate demand...
and, with flexible wages, brings an expansion
and rise in the price level
LAS
d
120
Price level (GDP deflator, 1992 100)
b
c
110
SAS
AD1
AD2
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
12
Monetarist Theory

• Monetarist Theory Fluctuations in the money
  stock as the main source of economic
  fluctuations.
• As the money growth rate rises, interest rates
  fall, the foreign exchange rate falls, and real
  balances increase.

13
Changes in employment

• Monetarists believe deviations from full
  employment are temporary.
• Monetarists believe the money wage rate is only
  temporarily sticky.

14
Monetarist Wage Theory

• When aggregate demand decreases and unemployment
  rises, the money wage rate eventually begins to
  fall.
• As the money wage falls, the AS curve shift right
  and the price level falls.

15
Monetarist Equilibrium

• After a period of adjustment, full employment is
  restored when the money wage has fallen
  sufficiently.
• Unemployment is only temporary in this view.

16
A Monetarist Business Cycle
A speedup in money growth increases aggregate
demand and brings expansion...
Expansion
LAS
SAS1
120
e
Price level (GDP deflator, 1992 100)
but a rise in money wages lowers real GDP and
restores full employment
113
d
c
110
AD2
AD1
7.0
8.0
7.5
6.0
Real GDP (trillions of 1992 dollars)
17
A slowdown in money growth decreases aggregate
demand and brings recession...
Recession
LAS
SAS0
SAS1
120
a
b
117
Price level (GDP deflator, 1992 100)
but a fall in money wages eventually brings
an expansion and restores full employment
110
c
AD0
AD1
6.5
7.0
8.0
Real GDP (trillions of 1992 dollars)
18
New Theory of Business Cycles

• New Classical theory of the business cycle
  regards unanticipated fluctuations in AD as the
  main source of economic fluctuations.
• New Keynesian theory of the business cycle
  regards both anticipated and unanticipated
  fluctuations in AD as sources of economic
  fluctuations.

19
A Rational ExpectationsBusiness Cycle
LAS
Expansion
SAS
c
Aggregate demand greater than expected brings
expansion
113
a
110
Price level (GDP deflator, 1992 100)
107
b
AD1
EAD
AD0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
20
New Classical Wage Theory

• If the decrease in aggregate demand is
  anticipated, the fall in the price level will be
  expected and both firms and workers will agree to
  a lower money wage to keep the real wage
  constant.
• This leaves real GDP and unemployment unchanged.

21
New Keynesian Wage Theory

• After firms and workers have made a long-term
  wage agreement, they are locked into a wage rate
  for the duration of that agreement.
• That makes money wages sticky for the term of
  labor contracts.
• Even anticipated changes in aggregate demand
  change real GDP.

22
New Classical Responseto New Keynesian Theory

• New classical economists believe that long-term
  contracts will be renegotiated when conditions
  change to make them outdated.

23
AS-AD General Theory

• All these business cycle theories are special
  cases of the more general AS-AD theory.
• Aggregate demand fluctuations are the normal
  ongoing sources of fluctuations.

24
Real Business Cycle Theory is Different

• Real business cycle theory (RBC theory) regards
  random fluctuations in productivity as the main
  source of economic fluctuations.
• The impulse in RBC theory is the growth rate of
  productivity that results from technological
  change.

25
The Real Business Cycle Impulse
26
Technological Changeand Investment Demand.

• Technological change varies, sometimes fast and
  sometimes slow and this has effects on investment
  demand.
• Two immediate effects follow from a change in
  productivity
• Investment demand changes.
• The demand for labor changes.

27
Labor Supply Decisions

• Suppose a wave of technological change makes some
  existing capital obsolete and temporarily lowers
  productivity and wage rates.
• Workers would supply fewer hours, sometimes zero
  hours, if the real wage rate is temporarily low,
  and they would work more hours when the real wage
  rate is high.

28
Criticisms of RealBusiness Cycle Theory

• Swings in productivity are more likely to be
  caused by changes in AD rather than by
  technological change.
• Fluctuations in productivity do not cause
  business cycles but are caused by them.
• Intertemporal substitution is too weak to account
  for the fluctuations in employment.

29
Two Recent Recessions

• The OPEC recession of 1974-1975
• The 1990-1991 recession

30
The OPEC Recession

• Near the end of 1973, OPEC raised oil prices from
  2.60 to 11.65 per barrel.
• As the price of oil increases, so do prices of
  other energy sources.
• Oil is also used as a factor of production in
  many industries such as artificial fibers (nylon
  and rayon).

31
The OPEC Recession
SAS75
1975
Oil price rise decreases SAS
SAS73
42.2
Price level (GDP deflator, 1992 100)
1973
35.4
AD75
AD73
0
3.90
3.87
Real GDP (trillions of 1992 dollars)
32
The 1990-1991 Recession

• While fiscal policy became more expansionary to
  pay for the Gulf War, increased uncertainty
  reduced planned investment. On balance,
  aggregate demand decreased.
• The price of oil more than doubled between April
  and October, 1990.

33
The 1990-1991 Recession
SAS93
SAS91
94
Price level (GDP deflator, 1992 100)
94
1990
1991
fall in investment decreases AD
AD90
0
6.14
6.08
Real GDP (trillions of 1992 dollars)
34
Did you learn?

• What is the impulse, and what is the mechanism of
  the business cycle in the Keynesian theory?
• What is the impulse, and what is the mechanism of
  the business cycle in the Monetarist theory?
• What is the impulse of the business cycle in the
  Rational Expectations theory?
• How the new Classical and new Keynesian theory
  differ on the mechanisms of business cycles?
• What is the impulse of Real Business cycle
  theory?
• What is the impact of a change in productivity on
  investment demand and demand for labor according
  to the Real Business cycle theory?