What causes the business cycle? Why did U.S. economy go into recession in 2008?

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2 What causes the business cycle? Why did U.S. economy go into recession in 2008?

3 Aggregate Supply and 13 Aggregate Demand When you have completed your study of this chapter, you will be able to CHAPTER CHECKLIST 1 Define and explain the influences on aggregate supply. 2 Define and explain the influences on aggregate demand. 3 Explain how fluctuations in aggregate demand and aggregate supply create the business cycle Pearson Education

4 13.1 AGGREGATE SUPPLY The quantity of real GDP supplied is the total amount of final goods and services that firms in the United States plan to produce. The quantity of real GDP supplied DP depends on the quantities of Labor employed Capital, human capital, and the state of technology Land and natural resources Entrepreneurial talent

5 13.1 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 around its full employment level. Real GDP fluctuates around potential GDP.

6 13.1 AGGREGATE SUPPLY Aggregate Supply Basics 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.

7 13.1 AGGREGATE SUPPLY 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 In contrast, 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.

8 13.1 AGGREGATE SUPPLY Figure 13.1 shows the aggregate supply schedule and aggregate supply curve. Each point A to E on the AS curve corresponds to a row of the schedule.

9 13.1 AGGREGATE SUPPLY 1. Potential GDP is $13 trillion and when the price level is 110, real GDP equals potential GDP. 2. If the price level is above 110, real GDP exceeds potential GDP. 3. If the price level is below 110, real GDP is less than potential GDP.

10 13.1 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.

11 13.1 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.

12 13.1 AGGREGATE SUPPLY Changes in Potential GDP Anything that changes potential GDP changes aggregate supply and shifts the aggregate supply curve. Figure 13.2 on the next slide illustrates.

13 13.1 AGGREGATE SUPPLY Point C at the intersection of the potential GDP line and AS curve is an anchor point. 1. An increase in potential GDP shifts the potential GDP line rightward and The aggregate supply curve shifts rightward from AS 0 to AS 1.

14 13.1 AGGREGATE SUPPLY Change in Money Wage Rate A change in the money wage rate 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.

15 13.1 AGGREGATE SUPPLY Figure 13.3 shows the effect of a change in the money wage rate. A rise in the money wage rate decreases aggregate supply and the aggregate supply curve shifts leftward from AS 0 to AS 2. A rise in the money wage rate does not change potential GDP.

16 13.1 AGGREGATE SUPPLY Change in Money Prices of Other Resources A change in the money prices of other resources changes aggregate supply because it changes firms costs. The higher the money prices of other resources, 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 prices of other resources decreases aggregate supply.

17 13.2 AGGREGATE DEMAND 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 expenditure on goods and services (G), and exports (X) minus imports (M). That is, Y = C + I + G + X M

18 13.2 AGGREGATE DEMAND Aggregate Demand Basics 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 demanded decreases. When the price level falls, the quantity of real GDP demanded increases.

19 13.2 AGGREGATE DEMAND Figure 13.4 shows the aggregate demand schedule and aggregate demand curve. Each point A to E on the AD curve corresponds to a row of the schedule.

20 13.2 AGGREGATE DEMAND The quantity of real GDP demanded 1. Decreases when the price level rises. 2. Increases when the price level falls.

21 13.2 AGGREGATE DEMAND 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

22 13.2 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 buy less goods and services, so people cut their spending. So the quantity of real GDP demanded decreases.

23 13.2 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 hold increases the demand for money. When the demand for money increases, the nominal interest rate rises. In the short run, the inflation rate doesn t change, so a rise in the nominal interest rate brings a rise in the real interest rate.

24 13.2 AGGREGATE DEMAND Faced with a higher real interest rate, businesses and people delay plans to buy new capital goods and consumer durable goods and cut back on spending. So the quantity of real GDP demanded decreases.

25 13.2 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 foreignmade goods and services. This change in real prices encourages people to spend less on U.S.-made items and more on foreign-made items.

26 13.2 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.

27 13.2 AGGREGATE DEMAND Changes 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.

28 13.2 AGGREGATE DEMAND The factors that change aggregate demand are Expectations about the future Fiscal policy and monetary policy The state of the world economy

29 13.2 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 now before their prices rise. An increase in expected future profit increases the investment that firms plan to undertake today and increases aggregate demand.

30 13.2 AGGREGATE DEMAND Fiscal Policy and Monetary Policy Government can use fiscal policy to influence aggregate demand. Fiscal policy is changing taxes, transfer payments, and government expenditure on goods and services. The Federal Reserve can use monetary policy to influence aggregate demand. Monetary policy is changing the quantity of money and the interest rate.

31 13.2 AGGREGATE DEMAND A tax cut or an increase in either transfer payments or government expenditure on goods and services increases aggregate demand. A cut in the interest rate or an increase in the quantity of money increases aggregate demand.

32 13.2 AGGREGATE DEMAND The World Economy The foreign exchange rate and foreign income influence aggregate demand. Foreign exchange rate is the amount of foreign currency you can buy with a U.S. dollar. 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.

33 13.2 AGGREGATE DEMAND Figure 13.6 shows changes in aggregate demand. 1. Aggregate demand increases if Expected future income, inflation, or profits increase. Fiscal policy or monetary policy increase planned expenditure. The exchange rate falls or foreign income increases.

34 13.2 AGGREGATE DEMAND 2. Aggregate demand decreases if Expected future income, inflation, or profits decrease. Fiscal policy or monetary policy decrease planned expenditure. The exchange rate rises or foreign income decreases.

35 13.2 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.

36 13.2 AGGREGATE DEMAND The increase in aggregate demand is the initial increase in expenditure plus the induced increase in consumption expenditure.

37 13.2 AGGREGATE DEMAND Figure 13.6 shows the aggregate demand multiplier. 1. An increase in investment increases aggregate demand and increases income. 2..The increase in income induces an increase in consumption expenditure, so 3. Aggregate demand increases by more than the initial increase in investment.

38 13.3 UNDERSTANDING THE BUSINESS CYCLE Aggregate supply and aggregate demand determine real GDP and the price level. Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the AS curve. Figure 29.9(a) on the next slide illustrates macroeconomic equilibrium.

39 13.3 UNDERSTANDING THE BUSINESS CYCLE Suppose that the price level is 120 and that real GDP is $14 trillion, at point E. The quantity of real GDP demand is less than $14 trillion and firms cannot sell all they produce, so they cut production and lower prices.

40 13.3 UNDERSTANDING THE BUSINESS CYCLE Suppose that the price level is 100 and that real GDP is $12 trillion, at point A. The quantity of real GDP demand exceeds $12 trillion and firms cannot meet the demand for their output, so they increase production and raise prices.

41 13.3 UNDERSTANDING THE BUSINESS CYCLE Macroeconomic equilibrium occurs when the price level is 110 and real GDP is $13 trillion.

42 13.3 UNDERSTANDING THE BUSINESS CYCLE Three possible macroeconomic equilibriums are 1. Below full-employment equilibrium, when potential GDP exceeds equilibrium real GDP. 2. Full-employment equilibrium, when equilibrium real GDP equals potential GDP. 3. Above full-employment equilibrium, when equilibrium real GDP exceeds potential GDP.

43 13.3 UNDERSTANDING THE BUSINESS CYCLE Aggregate Demand Fluctuations Fluctuations in aggregate demand are one of the sources of the business cycle. To focus on the business cycle, we ll ignore economic growth and inflation and suppose that potential GDP and the full-employment price level is constant. Figure 13.8 in the next slide illustrates the business cycle.

44 13.3 UNDERSTANDING THE BUSINESS CYCLE Fluctuations in aggregate demand bring fluctuations in actual real GDP around potential GDP. In year 1, real GDP equals potential GDP. The economy is at full employment.

45 13.3 UNDERSTANDING THE BUSINESS CYCLE In year 2, at a business cycle peak, real GDP exceeds potential GDP. The economy is operating at above full employment. In year 3, real GDP equals potential GDP. The economy is back at full employment.

46 13.3 UNDERSTANDING THE BUSINESS CYCLE In year 4, at a business cycle trough, real GDP is below potential GDP. The economy is operating at below full employment. In year 5, real GDP equals potential GDP. The economy is back at full employment.

47 13.3 UNDERSTANDING THE BUSINESS CYCLE Adjustment Toward Full Employment When the economy is away from full employment, forces operate to restore full employment. Inflationary gap is a gap that exists when real GDP exceeds potential GDP and that brings a rising price level. Recessionary gap is a gap that exists when potential GDP exceeds real GDP and that brings a falling price level.

48 13.3 UNDERSTANDING THE BUSINESS CYCLE Figure 13.9 shows adjustments toward full employment. Real GDP exceeds potential GDP there is an inflationary gap and the price level rises. As the money wage rate gradually rises, aggregate supply decreases, real GDP decreases, and the price level rises farther.

49 13.3 UNDERSTANDING THE BUSINESS CYCLE Potential GDP exceeds real GDP recessionary gap and the price level falls. Eventually, the money wage rate starts to fall, aggregate supply increases, real GDP increases, and the price level falls farther.

50 13.3 UNDERSTANDING THE BUSINESS CYCLE 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 is a combination of recession (falling real GDP) and inflation (rising price level).

51 13.3 UNDERSTANDING THE BUSINESS CYCLE Figure shows an oil price cycle. A rise in the price of oil decreases aggregate supply and shifts the AS curve leftward to AS 1. Real GDP decreases, and the price level rises. The economy experiences stagflation.

52 13.3 UNDERSTANDING THE BUSINESS CYCLE A fall in the price of oil increases aggregate supply and shifts the AS curve rightward to AS 2. The price level falls and real GDP increases. The economy experiences an expansion.

53 EYE on the BUSINESS CYCLE What Causes the Business Cycle? What causes the business cycle and what in particular caused the recession? Business Cycle Theory The mainstream business cycle theory is that potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate. Because the money wage rate is slow to change, if aggregate demand grows more quickly than potential GDP, real GDP increases above potential GDP and an inflationary gap emerges. The inflation rate rises and real GDP is pulled back toward potential GDP.

54 EYE on the BUSINESS CYCLE What Causes the Business Cycle? If aggregate demand grows more slowly than potential GDP, real GDP falls below potential GDP and a recessionary gap emerges. The inflation rate slows, but the money wage rate responds very slowly to the recessionary gap and real GDP does not return to potential GDP until another increase in aggregate demand occurs. Fluctuations in investment are the main source of aggregate demand fluctuations. A recession can occur if aggregate supply decreases to bring stagflation. Also, a recession might occur because both aggregate demand and aggregate supply decrease.

55 EYE on the BUSINESS CYCLE What Causes the Business Cycle? The Recession At the peak in 2008, real GDP was $13.4 trillion and the price level was 108. In the second quarter of 2009, real GDP had fallen to $12.9 trillion and the price level had risen to 110. A recessionary gap appeared in 2009.

56 EYE on the BUSINESS CYCLE What Causes the Business Cycle? Recession in the global economy lowered the demand for U.S. exports, so this component of aggregate demand also decreased. The decrease in aggregate demand was moderated by a large injection of spending by the U.S. government, but this move was not enough to stop aggregate demand from decreasing.

57 EYE on the BUSINESS CYCLE What Causes the Business Cycle? We cannot account for the combination of a rise in the price level and a fall in real GDP with a decrease in aggregate demand alone. Aggregate supply must also have decreased. The rise in oil prices in 2007 and a rise in the money wage rate were two factors that brought a decrease in aggregate supply.

58 13.3 UNDERSTANDING THE BUSINESS CYCLE Deflation and the Great Depression When a financial crisis hit in October 2008, many people feared a repeat of the events of the 1930s. During the Great Depression (1929 through 1933), the price level fell by 22 percent and real GDP decreased by 31 percent. During the recession, real GDP fell by less than 4 percent and the price level continued to rise, although more slowly. Why was the Great Depression so bad? Why was so mild in comparison?

59 13.3 UNDERSTANDING THE BUSINESS CYCLE During the Great Depression, banks failed and the quantity of money fell by 25 percent. The Fed stood by and took no action to counteract the fall of buying power, so aggregate demand collapsed. Because the money wage rate didn t fall immediately, the decrease in aggregate demand brought a large fall in real GDP. The money wage rate and price level fell eventually, but not until employment and real GDP had shrunk to 75 percent of their 1929 levels.

60 13.3 UNDERSTANDING THE BUSINESS CYCLE During the 2008 financial crisis, the Fed bailed out troubled financial institutions and doubled the monetary base. The quantity of money kept growing. Also, the government increased its own expenditures, which added to aggregate demand. The combined effects of continued growth in the quantity of money and increased government expenditure limited the fall in aggregate demand and prevented a large decrease in real GDP.

61 13.3 UNDERSTANDING THE BUSINESS CYCLE The challenge that now lies ahead is to unwind the monetary and fiscal stimulus as the components of private expenditure consumption expenditure, investment, and exports begin to increase. As these components return to more normal levels, aggregate demand will increase. Too much monetary and fiscal stimulus will bring an inflationary gap and faster inflation. Too little monetary and fiscal stimulus will leave a recessionary gap.