14'1 DEFINITIONS AND FACTS

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14.1 DEFINITIONS AND FACTS

• The business cycle is a periodic but irregular
  up-and-down movement in production and jobs.
• A business cycle has two phases, expansion and
  recession, and two turning point, a peak and a
  trough.
• Dating Business-Cycle Turning Points
• The task of identifying and dating business-cycle
  phases and turning points is performed by a
  private research organization, the National
  Bureau of Economic Research (NBER).

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14.1 DEFINITIONS AND FACTS

• To date the business-cycle turning points, the
  NBER needs a definition of recession.
• Recession
• A decrease in real GDP that lasts for at least
  two quarters (six months) or a period of
  significant decline in total output, income,
  employment, and trade, usually lasting from six
  months to a year and marked by widespread
  contractions in many sectors of the economy.

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14.1 DEFINITIONS AND FACTS

• U.S. Business-Cycle History
• The NBER has identified 32 complete cycles
  starting from a trough in December 1854.
• Over all 32 complete cycles
• The average length of an expansion is 35 months
  (almost 3 years), the average length of a
  recession is 18 months.
• The average time from trough to trough is 53
  months (almost 4 1 /2 years).

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14.1 DEFINITIONS AND FACTS

• So over the 147 years since 1854, the U.S.
  economy has been in
• Recession for about one third of the time
• Expansion for about two thirds of the time.
• The 147-year averages hide significant changes
  that have occurred in the length of a cycle and
  the relative length of the recession and
  expansion phases.

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14.1 DEFINITIONS AND FACTS

• Recent Cycles
• The current cycle began at a trough that followed
  a recession that ran from July 1990 to March
  1991.
• The economy expanded from March 1991 until March
  2001.
• This expansion, which lasted for 120 months, is
  the longest in U.S. history.

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14.2 AGGREGATE SUPPLY

• Aggregate supply is the relationship between the
  quantity of real GDP supplied and the price level
  when all other influences on production plans
  remain the same.
• Other things remaining the same,
• When the price level rises, the quantity of real
  GDP supplied increases.
• When the price level falls, the quantity of real
  GDP supplied decreases.

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14.2 AGGREGATE SUPPLY

• Aggregate Supply Basics
• The quantity of real GDP supplied (Y), depends
  on
• The quantity of labor employed
• The quantities of capital and human capital and
  the technologies they embody
• The quantities of land and natural resources used
• The amount of entrepreneurial talent available

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14.2 AGGREGATE SUPPLY

• At full employment
• The real wage rate makes the quantity of labor
  demanded equal to the quantity of labor supplied.
• Real GDP equals potential GDP.
• Over the business cycle
• The quantity of labor employed fluctuates.
• The quantity of real GDP supplied fluctuates
  around potential GDP.

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14.2 AGGREGATE SUPPLY

• Aggregate Supply and Potential GDP
• Along the aggregate supply curve, the only
  influence on production plans that changes is
  the price level.
• All the other influences on production plans
  remain constant. Among these other influences
  are
• The money wage rate
• The money prices of other resources
• Along the potential GDP line, when the price
  level changes the money wage rate changes to keep
  the real wage rate at the full-employment level.

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14.2 AGGREGATE SUPPLY

• Why the AS Curve Slopes Upward
• When the price level rises and the money wage
  rate is constant, the real wage rate falls and
  employment increases. The quantity of real GDP
  supplied increases.
• When the price level falls and the money wage
  rate is constant, the real wage rate rises and
  employment decreases. The quantity of real GDP
  supplied decreases.

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14.2 AGGREGATE SUPPLY

• Changes in Aggregate Supply
• Aggregate supply changes when any influence on
  production plans other than the price level
  changes.
• In particular, aggregate supply changes when
• Potential GDP changes.
• The money wage rate changes.
• The money prices of other resources change.

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14.2 AGGREGATE SUPPLY

• Changes in Potential GDP
• Anything that changes potential GDP shifts the
  potential GDP line and shifts the aggregate
  supply curve.

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14.2 AGGREGATE SUPPLY

• Changes in Money Wages and Other Resource Prices
• A change in the money wage rate or the money
  price of another resource changes aggregate
  supply because it changes firms costs.
• The higher the money wage rate, the higher are
  firms costs and the smaller is the quantity that
  firms are willing to supply at each price level.
• So an increase in the money wage rate decreases
  aggregate supply.

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14.3 AGGREGATE DEMAND

• Aggregate demand is the relationship between the
  quantity of real GDP demanded and the price level
  when all other influences on expenditure plans
  remain the same.

• Other things remaining the same,
• When the price level rises, the quantity of real
  GDP supplied increases.
• When the price level falls, the quantity of real
  GDP supplied decreases.

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14.3 AGGREGATE DEMAND

• Aggregate Demand Basics
• The quantity of real GDP demanded is the total
  amount of final goods and services produced in
  the United States that people, businesses,
  governments, and foreigners plan to buy.
• This quantity is the sum of the real consumption
  expenditure (C), investment (I), government
  purchases (G), and exports (X) minus imports (M).
• That is,
• Y C I G X M

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14.3 AGGREGATE DEMAND

• Aggregate Demand and the AD Curve
• The price level influences the quantity of real
  GDP demanded because a change in the price level
  brings changes in
• The buying power of money
• The real interest rate
• The real prices of exports and imports

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14.3 AGGREGATE DEMAND

• The Buying Power of Money
• A rise in the price level lowers the buying power
  of money and decreases the quantity of real GDP
  demanded.
• For example, if the price level rises and other
  things remain the same, a given quantity of money
  will less goods and services, so people cut their
  spending.
• So the quantity of real GDP demanded decreases.

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14.3 AGGREGATE DEMAND

• The Real Interest Rate
• When the price level rises, the real interest
  rate rises.
• An increase in the price level increases the
  amount of money that people want to
  holdincreases the demand for money.
• When the demand for money increases, the nominal
  interest rate rises.
• In the short run, the inflation rate doesnt
  change, so a rise in the nominal interest rate
  brings a rise in the real interest rate.

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14.3 AGGREGATE DEMAND

• Faced with a higher real interest rate,
  businesses and people delay plans to buy new
  capital and consumer durable goods and cut back
  on spending.
• So the quantity of real GDP demanded decreases.

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14.3 AGGREGATE DEMAND

• The Real Prices of Exports and Imports
• When the U.S. price level rises and other things
  remain the same, the prices in other countries do
  not change.
• So a rise in the U.S. price level makes U.S.-made
  goods and services more expensive relative to
  foreign-made goods and services.
• This change in real prices encourages people to
  spend less on U.S.-made items and more on
  foreign-made items.

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14.3 AGGREGATE DEMAND

• In the long run, when the price level changes by
  more in one country than in other countries, the
  exchange rate changes.
• The exchange rate neutralizes the price level
  change, so this international price effect on
  buying plans is a short-run effect only.
• But the short-run effect is powerful.

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14.3 AGGREGATE DEMAND

• Shifts in Aggregate Demand
• A change in any factor that influences
  expenditure plans other than the price level
  brings a change in aggregate demand.
• When aggregate demand increases, the aggregate
  demand curve shifts rightward.
• When aggregate demand decreases, the aggregate
  demand curve shifts leftward.

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14.3 AGGREGATE DEMAND

• The factors that change aggregate demand are
• Expectations about the future
• Monetary policy and fiscal policy
• The state of the world economy

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14.3 AGGREGATE DEMAND

• Expectations
• An increase in expected future income increases
  the amount of consumption goods that people plan
  to buy today and increases aggregate demand.
• An increase in expected future inflation
  increases aggregate demand today because people
  decide to buy more goods and services before
  their prices rise.
• An increase in expected future profit increases
  the investment that firms plan to undertake today
  and increases aggregate demand.

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14.3 AGGREGATE DEMAND

• Fiscal Policy and Monetary Policy
• Government can influence aggregate demand by
  set-ting and changing taxes, transfer payments,
  and government purchases of goods and services.
• The Federal Reserve can influence aggregate
  demand by changing the quantity of money and the
  interest rate.

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14.3 AGGREGATE DEMAND

• A tax cut or an increase in either transfer
  payments or government purchases increases
  aggregate demand.
• A cut in the interest rate or an increase in the
  quantity of money increases aggregate demand.

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14.3 AGGREGATE DEMAND

• The World Economy
• The foreign exchange arte and foreign income
  influence aggregate demand.
• Other things remaining the same, a rise in the
  foreign exchange rate decreases aggregate demand.
• An increase in foreign income increases U.S.
  exports and increases U.S. aggregate demand.

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14.3 AGGREGATE DEMAND

• The Aggregate Demand Multiplier
• The aggregate demand multiplier is an effect that
  magnifies changes in expenditure plans and brings
  potentially large fluctuations in aggregate
  demand.
• When any influence on aggregate demand changes
  expenditure plans
• The change in expenditure changes income.
• And the change in income induces a change in
  consumption expenditure.

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14.3 AGGREGATE DEMAND

• The increase in aggregate demand is the initial
  increase in expenditure plus the induced increase
  in consumption expenditure.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate supply and aggregate demand determine
  real GDP and the price level.
• Changes in aggregate supply and aggregate demand
  bring changes in real GDP and the price level.
• These changes generate the business cycle.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate Demand Fluctuations
• Consider a business cycle that results from
  fluctuations in aggregate demand with no changes
  in aggregate supply.
• Over time, potential GDP grows and the
  full-employment price level rises.
• To focus on the business cycle, well ignore
  economic growth and inflation and suppose that
  potential GDP and the full-employment price level
  is constant.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate Supply Fluctuations
• Aggregate supply fluctuates for two types of
  reasons.
• Potential GDP grows at an uneven pace.
• The money price of a major resource, such as
  crude oil, might change.
• Stagflation
• A combination of recession (falling real GDP) and
  inflation (rising price level).

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14.4 UNDERSTANDING BUSINESS CYCLES

• Adjustment Toward Full Employment
• When the economy is away from full employment,
  forces operate to restore full employment.
• Inflationary gap
• A gap that exists when real GDP exceeds potential
  GDP and that brings a rising price level.
• Deflationary gap
• A gap that exists when potential GDP exceeds real
  GDP and that brings a falling price level.

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