BUSINESS CYCLESS

Week-08
 In this week, we will discuss….
• the business cycles
• introduction to aggregate demand
• introduction to aggregate supply
• how the model of aggregate demand and
aggregate supply can be used to analyze
economic fluctuation
• effects of macroeconomic policy on aggregate
demand
 What are Business Cycles?
• Business cycles are economy wide fluctuations
in total national output, income, and
employment, usually lasting for a period of 2
to 10 years, marked by widespread expansion
or contraction in most sectors of the economy
 What are Business Cycles?
• A recession is a period of declining real GDP,
and rising unemployment.
– The definition sometimes used is that a recession
occurs when real GDP has declined for two
consecutive calendar quarters
• A recession that is large in both scale and
duration (or a severe recession) is called
depression
What are Business Cycles?
 Facts about Business Cycles
• The actual pattern are irregular and
unpredictable.
– No two business cycles are quite the same
– No exact formula can be used to predict the
duration and timing of business cycles
• Most macroeconomic variables fluctuate
together by different amounts
• As output falls, unemployment rises.
Exogenous vs. Internal Theories of the
Business Cycles
• Exogenous theories find the sources of the
business cycles in the fluctuation of factors
outside the economic system - in war, revolution,
elections, oil prices, population migration,
technological innovation, climate change,
weather, etc.
• Internal theories look for mechanism within the
economic system itself.
– In this approach, every expansion breeds recession
and contraction, and every contraction breed revival
and expansion
 AGGREGATE DEMAND
• Aggregate demand (AD) is the total or
aggregate quantity of output that is willingly
bought at a given level of prices, other thing
held constant.
• AD is sum of spending by consumers,
business, government, and foreigner in the
economy
AGGREGATE DEMAND
THE AD CURVE is DOWNWARD SLOPING,
because the effects of….
• Wealth
– P  wealth  consumer spending
quantity demanded.
• Interest Rate
– P  interest rate investment spending 
quantity of goods and services demanded.
• Exchange-Rate
– P  interest rate  exchange rate depreciates
 net export  quantity of goods and services
demanded
Determinants of Aggregate Demand
 AGGREGATE SUPPLY
• Aggregate supply is the total quantity of goods and
services that the nation’s business willingly
produce and sell in a given period.
– AS describe the behavior of the production side of
the economy
– The AS curve is the schedule showing the level of
total national output that will be produced at each
possible price level, other thing being equal.
 The Short Run AS Curve is upward sloping

Price
Level

Short-run
aggregate
supply

P2
1. A decrease 2. . . . reduces the quantity
in the price of goods and services
level . . . supplied in the short run.

0 Y2 Y Quantity of
Output
Upward Sloping THE AS CURVE are caused by….

• Misperceptions of suppliers about relative

prices, induce suppliers to decrease the
quantity of goods and services supplied.
• Sticky-Wage
– Nominal wages do not adjust immediately to a fall
in the price level.
• P real wage (W/P) real cost employment
and production
Upward Sloping THE AS CURVE are caused by….

• Sticky-Price
– Prices of some goods and services adjust
sluggishly in response to changing economic
conditions:
• An unexpected fall in the price level leaves some firms
with higher-than-desired prices  depress firms sales
• This depresses sales, which induces firms to reduce the
quantity of goods and services they produce.
 The Long-Run AS Curve is Vertical

Price
Level

Long-run
aggregate
supply

P2
2. . . . does not affect
1. A change the quantity of goods
in the price and services supplied
level . . . in the long run.

0 Natural rate Quantity of

of output Output

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 The Long-Run AS Curve

• The Long-run AS curve is vertical and output is

determined by potential output
– Potential output is the maximum sustainable
output that can be produced without triggering
rising inflationary pressure
• Potential output = natural rate of output = full-
employment output
• Long-run AS is determined by the same factors which
influence long-run growth of potential output: the
amount and quality of available labor, the quantity
of machines and other capital goods, and the level
of technology
 Determinants of AS

The Factors listed in the table would increase AS, shifting the
AS curve down or to the right
The distinction between short-run and long-run
aggregate supply (AS) is crucial, because….
• In the short-run, interaction of aggregate
supply (AS) and aggregate demand (AD)
determines economic fluctuation, inflation,
unemployment, recessions, and booms
• In the long-run, the growth of potential
output working through aggregate supply (AS)
which explains the trend in output and living
standard
 MACROECONOMIC EQUILIBRIUM

Long-run AS
Price
A macroeconomic Level
Short-run AS
equilibrium
is a combination of overall
price and quantity at which Equilibrium
Price
all buyers and sellers are
satisfied with their
purchases, sales and prices
AD

0 Natural rate Quantity of

of output output
 Two Causes Of Economic Fluctuations

1. Shifts in aggregate demand (AD Shocks) - Occur as

consumers, business, or governments change total
spending relative to the economy’s productive
capacity
– In the short run, shifts in aggregate demand cause
fluctuations in the economy’s output of goods
and services.
– In the long run, shifts in aggregate demand affect
the overall price level but do not affect output.
 Decrease in Aggregate Demand

Long-run AS
Price
Level 3. . . . But over
time, the short- AS1
run AS curve
2. . . . causes
shifts….
output to fall in
the short run . . AS2

P1
P2 1. A decrease
in AD….
P3
4. Output
returns to its
natural rate…. AD1 AD

0 Y2 Y1 Quantity of
output
 Two Causes Of Economic Fluctuations

2. Shifts in aggregate supply (AS Shocks)

– Adverse shifts in aggregate supply cause
stagflation—a period of recession and inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand
cannot offset both of these adverse effects
simultaneously.
An Adverse Shift in Aggregate Supply

Long-run AS
Price
Level
AS2

AS1
3. . And the price
level to rise.
1. An adverse
P2 shift in the short-
run aggregate-
P1 supply curve….

2. . . . causes
output to fall ….
AD
0 Y2 Y1 Quantity of
output
Accommodating an Adverse Shift in
Aggregate Supply
Long-run AS
Price
Level
1. When short-
run AS falls…. AS2
3...which causes
the price level to AS1
rise further….
C
P3
2. . policymakers can
P2 accommodate the
A shift by expanding
P1 AD….
4…. But keeps
output at its
natural rate. AD1 AD2

0 Y1 Quantity of
output
EFFECTS OF MONETARY AND FISCAL
POLICY ON AGGREGATE DEMAND

HOW MONETARY POLICY

INFLUENCES AGGREGATE DEMAND
 The Theory of Liquidity Preference

• Keynes developed the theory of liquidity

preference in order to explain what factors
determine the economy’s interest rate.
• According to the theory, the interest rate
adjusts to balance the supply and demand for
money.
 The Theory of Liquidity Preference

• Money Supply
– The money supply is controlled by the Central Bank
through:
• Open-market operations
• Changing the reserve requirements
• Changing the discount rate
– Because it is fixed by the Central Bank, the quantity of
money supplied does not depend on the interest rate.
– The fixed money supply is represented by a vertical
supply curve.
 The Theory of Liquidity Preference

• Money Demand
– According to the theory of liquidity preference, one of the
most important factors is the interest rate.
– People choose to hold money instead of other assets that
offer higher rates of return because money can be used to
buy goods and services.
– The opportunity cost of holding money is the interest that
could be earned on interest-earning assets.
– An increase in the interest rate raises the opportunity cost
of holding money.
– As a result, the quantity of money demanded is reduced.
 The Theory of Liquidity Preference

• Equilibrium in the Money Market

– According to the theory of liquidity preference:
• The interest rate adjusts to balance the supply
and demand for money.
• There is one interest rate, called the
equilibrium interest rate, at which the quantity
of money demanded equals the quantity of
money supplied.
 The Theory of Liquidity Preference

• Equilibrium in the Money Market

– Assume the following about the economy:
• The price level is stuck at some level.
• For any given price level, the interest rate
adjusts to balance the supply and demand for
money.
• The level of output responds to the aggregate
demand for goods and services.
 Equilibrium in the Money Market
Interest
Rate
Money
supply

r1

Equilibrium
interest
rate
r2
Money
demand

0 Md Quantity fixed M2d Quantity of

by the CB Money

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 The Money Market and the Slope of the
Aggregate-Demand Curve

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money Price

Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the CB of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.

Copyright © 2004 South-Western

 Changes in the Money Supply

• The Central Bank can shift the aggregate demand

curve when it changes monetary policy.
– An increase in the money supply shifts the money
supply curve to the right.
– Without a change in the money demand curve,
the interest rate falls.
– Falling interest rates increase the quantity of
goods and services demanded.
 Monetary Injection

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the Fed P

increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.

Copyright © 2004 South-Western

 Changes in the Money Supply

• When the Central Bank increases the money

supply, it lowers the interest rate and
increases the quantity of goods and services
demanded at any given price level, shifting
aggregate-demand to the right.
• When the Central Bank contracts the money
supply, it raises the interest rate and reduces
the quantity of goods and services demanded
at any given price level, shifting aggregate-
demand to the left.
EFFECTS OF MONETARY AND FISCAL
POLICY ON AGGREGATE DEMAND

HOW FISCAL POLICY INFLUENCES

AGGREGATE DEMAND
 HOW FISCAL POLICY INFLUENCES
AGGREGATE DEMAND
• Fiscal policy refers to the government’s
choices regarding the overall level of
government purchases or taxes.
• Fiscal policy influences saving, investment,
and growth in the long run.
• In the short run, fiscal policy primarily affects
the aggregate demand.
 Changes in Government Purchases

• When policymakers change the money supply

or taxes, the effect on aggregate demand is
indirect—through the spending decisions of
firms or households.
• When the government alters its own
purchases of goods or services, it shifts the
aggregate-demand curve directly.
 Changes in Government Purchases

• There are two macroeconomic effects from

the change in government purchases:
– The multiplier effect
– The crowding-out effect
 The Multiplier Effect

• Government purchases are said to have a

multiplier effect on aggregate demand.
– Each dollar spent by the government can raise the
aggregate demand for goods and services by more
than a dollar.
 The Multiplier Effect

• The multiplier effect refers to the additional

shifts in aggregate demand that result when
expansionary fiscal policy increases income
and thereby increases consumer spending.
 The Multiplier Effect
Price
Level

2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.

$20 billion

AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of $20 billion initially increases aggregate
demand by $20 billion . . .

Copyright © 2004 South-Western

 A Formula for the Spending Multiplier

• The formula for the multiplier is:

Multiplier = 1/(1 - MPC)
• An important number in this formula is the
marginal propensity to consume (MPC).
– It is the fraction of extra income that a household
consumes rather than saves.
 A Formula for the Spending Multiplier

• If the MPC is 3/4, then the multiplier will be:

Multiplier = 1/(1 - 3/4) = 4
• In this case, a $20 billion increase in
government spending generates $80 billion of
increased demand for goods and services.
Multiplier Model and AS-AD
Approach
 The Crowding-Out Effect

• Fiscal policy may not affect the economy as

strongly as predicted by the multiplier.
• An increase in government purchases causes
the interest rate to rise.
• A higher interest rate reduces investment
spending.
 The Crowding-Out Effect

• This reduction in demand that results when a

fiscal expansion raises the interest rate is
called the crowding-out effect.
• The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
 The Crowding-Out Effect

(a) The Money Market (b) The Shift in Aggregate Demand

Interest Price
Money 4. . . . which in turn
Rate Level
supply partly offsets the
2. . . . the increase in $20 billion initial increase in
spending increases aggregate demand.
money demand . . .
r2

3. . . . which
increases AD2
the r
AD3
equilibrium M D2
interest
rate . . . Aggregate demand, AD1
Money demand, MD
0 Quantity fixed Quantity 0 Quantity
by the Fed of Money 1. When an increase in government of Output
purchases increases aggregate
demand . . .

Copyright © 2004 South-Western

 The Crowding-Out Effect

• When the government increases its purchases

by $20 billion, the aggregate demand for
goods and services could rise by more or less
than $20 billion, depending on whether the
multiplier effect or the crowding-out effect is
larger.
 Changes in Taxes

• When the government cuts personal income

taxes, it increases households’ take-home pay.
– Households save some of this additional income.
– Households also spend some of it on consumer
goods.
– Increased household spending shifts the
aggregate-demand curve to the right.
 Changes in Taxes

• The size of the shift in aggregate demand

resulting from a tax change is affected by the
multiplier and crowding-out effects.
• It is also determined by the households’
perceptions about the permanency of the tax
change.
 The Case against Active Stabilization Policy

• Some economists argue that monetary and

fiscal policy destabilizes the economy.
• Monetary and fiscal policy affect the economy
with a substantial lag.
• They suggest the economy should be left to
deal with the short-run fluctuations on its
own.
 Automatic Stabilizers

• Automatic stabilizers are changes in fiscal

policy that stimulate aggregate demand when
the economy goes into a recession without
policymakers having to take any deliberate
action.
• Automatic stabilizers include the tax system
and some forms of government spending.
Assignments-8:
1. Questions for discussion – SAM. chapter 22
2. Questions for review, problems and
application – M. chapter 20, 21

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