THE BUSINESS CYCLE* *

Transcription

1 C h a p t e r 14 THE BUSINESS CYCLE* * Chapter Key Ideas Outline Must What Goes Up Always Come Down? A. In ways, the 1990s were like the 1920s: rapid economic growth and unprecedented prosperity B. From 1929 through 1933, real GDP fell 30 percent and the economy entered the Great Depression, which lasted until World War II C. There have been ten recessions since 1945; must the cycle continue? I. Cycle Patterns, Impulses, and Mechanisms A. Business Cycle Patterns 1. The business cycle is an irregular and nonrepeating up-and-down movement of business activity that takes place around a generally rising trend and that shows great diversity. 2. Table 14.1 (on the next page) dates business cycles since 1920 and the magnitude of the fall in real GDP from peak to trough. B. Cycle Impulses and Mechanisms 1. Cycles can be like the ball in a tennis match, the light of night and day, or a child s rocking horse. 2. These cycles differ according to the role of outside force and basic system design. In a tennis match, an outside force is applied at each turning point; in the night and day cycle, no outside force is applied and the cycle results from the design of the solar system; and, in the rocking horse, an outside force must be applied to start the cycle but then the cycle proceeds automatically until it needs another outside force. 3. The business cycle is a combination of all three types of cycles; that is, both outside forces (the impulse ) and design (the mechanism ) are important. * * This is Chapter 30 in Economics. 311

2 312 CHAPTER 14 C. The Central Role of Investment and Capital 1. All theories of the business cycle agree that investment and the accumulation of capital play a crucial role. 2. Recessions begin when investment slows and recessions turn into expansions when investment increases. 3. Investment and capital are crucial parts of cycles, but are not the only important parts. D. The AS-AD Model 1. Business cycle theories can be divided into two types: aggregate demand theories and real business cycle theory. II. Aggregate Demand Theories of the Business Cycle A. Three types of aggregate demand theories have been proposed: Keynesian, monetarist, and rational expectations. B. Keynesian Theory 1. The Keynesian theory of the business cycle regards volatile expectations as the main source of business cycle fluctuations. a) Keynesian Impulse: The impulse in the Keynesian theory is expected future sales and expected future profits insofar as these affect investment. Keynes described these expectations as animal spirits, which means that because such expectations are hard to form, they may change radically in response to a small bit of new information.

3 THE BUSINESS CYCLE 313 b) Keynesian Cycle Mechanism: The mechanism of the business cycle is the initial change in investment, which affects aggregate demand, combined with a flat (or nearly so) SAS curve. c) An increase in investment has multiplier effects that shift the AD curve rightward; a decrease has similar multiplier effects that shift the AD curve leftward. d) The response of the money wage rate to changes in aggregate demand is asymmetric; the money wage rate rises quickly if aggregate demand increases but is rigid if aggregate demand decreases. i) Rightward shifts in AD lead to an initial expansion in real GDP, but the money wage rate rises and the expansion ends as GDP returns to potential GDP. ii) The asymmetry of how the money wage rate responds to changes in aggregate demand means that leftward shifts of AD lower real GDP but, without some other change, the money wage rate does not fall and so the economy remains in a below full-employment equilibrium. e) The Keynesian theory is most like the tennis match, in which cycles are the result of outside forces applied at the turning points. 2. Figure 14.1 illustrates a Keynesian recession 3. Figure 14.2 illustrates a Keynesian expansion. C. Monetarist Theory 1. The monetarist theory of the business cycle regards fluctuations in the quantity of money as the main source of economic fluctuations. a) Monetarist Impulse: The initial impulse is the growth rate of the money supply. b) Monetarist Cycle Mechanism: The mechanism is a change in the monetary growth rate that shifts the AD curve combined with an upward sloping SAS curve. i) An increase in the monetary growth rate lowers the interest rate and the foreign exchange rate, both of which have multiplier effects that shift the AD curve rightward.

4 314 CHAPTER 14 ii) A decrease in the monetary growth rate raises the interest rate and the foreign exchange rate, both of which have multiplier effects that shift the AD curve leftward. c) The money wage rate is only temporarily sticky, so an increase in aggregate demand eventually raises the money wage rate and a decrease in aggregate demand eventually lowers the money wage rate. i) An increase in aggregate demand and a rightward shifts in the AD curve lead to an initial expansion in real GDP, but the money wage rate rises and the expansion ends as GDP returns to potential GDP. ii) A decrease in aggregate demand and a leftward shifts in the AD curve lead to an initial contraction in real GDP, but the money wage rate falls and the recession ends as GDP returns to potential GDP. d) The monetarist theory is like a rocking horse, in that an initial force is required to set it in motion, but once started the cycle automatically moves to the next phase. 2. Figure 14.3 illustrates a Monetarist business cycle using the AS-AD model. D. Rational Expectations Theories 1. A rational expectation is a forecast based on all the available relevant information. There are two distinctly different rational expectations theories: a) The new classical theory of the business cycle regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations. b) The new Keynesian theory of the business cycle also regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuations, but also leaves room for anticipated fluctuations in aggregate demand to play a role. 2. Rational Expectations Impulse: Both rational expectations theories regard unanticipated fluctuations in aggregate demand as the impulse of the business cycle. However, the new Keynesian theory says that workers are locked into long-term contracts, so even though a fluctuation in aggregate demand is today anticipated, if it was unanticipated when the contract was signed, it will create a fluctuation in economic activity.

5 THE BUSINESS CYCLE Rational Expectations Cycle Mechanisms: The mechanism in both theories stresses that changes in aggregate demand affect the price level. With a fixed money wage rate, the real wage rate changes, which then leads firms to alter their levels of employment and production. 4. In both theories, a recession occurs when a decrease in aggregate demand lowers the price level and so raises the real wage rate. The hike in the real wage rate leads firms to reduce employment so that unemployment rises. In both theories, eventually the money wage rate falls so that the recession ends. (An expansion occurs and ends for opposite reasons.) a) The new classical theory asserts that only unanticipated changes in aggregate demand affect the real wage rate; anticipated changes affect the money wage rate and have no effect on the real wage rate. Hence anticipated changes in aggregate demand have no effect on real GDP. b) The new Keynesian theory asserts that long-term labor contracts prevent anticipated changes from affecting the money wage rate, so even if a change is correctly anticipated today, if it was unanticipated when the labor contract was signed, it affects the real wage rate. Hence, both anticipated and unanticipated changes in aggregate demand affect real GDP. 5. Both theories are like rocking horses, in which an initial force starts the business cycle but then the fluctuation automatically proceeds to the end of the cycle. The new classical cycle is more rapid than the new Keynesian cycle. Figure 14.4 illustrates a Rational Expectations business cycle using the AS-AD model. E. AS-AD General Theory 1. All three of these types of business cycle explanation can be thought of as special cases of a general AS-AD theory of the business cycle, in which fluctuations in aggregate demand (and sometimes aggregate supply) cause the business cycle. III. Real Business Cycle Theory A. The real business cycle theory (RBC theory) regards random fluctuations in productivity as the source of the business cycle. These productivity fluctuations are assumed to result mainly

6 316 CHAPTER 14 from fluctuations in the pace of technological change, though other factors might also occasionally matter. B. The RBC Impulse 1. The impulse in RBC theory is the growth rate of productivity that results from technological change. 2. Growth accounting is used to measure the effects of technological change. 3. Figure 14.5 illustrates the RBC impulse from C. The RBC Mechanism 1. The RBC mechanism stresses that a change in productivity affects investment demand and the demand for labor. a) A decrease in productivity lowers firms profit expectations and decreases both investment demand and the demand for labor.

7 THE BUSINESS CYCLE Figure 14.6 illustrates labor and capital markets in an RBC recession. 3. The Key Decision: When to Work? a) In the labor market, the decrease in the demand for labor shifts the labor demand curve leftward. In the capital market, the decrease in the demand for investment lowers the real interest rate. b) Through the intertemporal substitution effect, the real interest rate affects the supply of labor. The lower the real interest rate, the lower the return from current work. In response, the supply of labor decreases. Because the demand for investment decreased, the real interest has, indeed, fallen, and so the labor supply curve shifts leftward, as illustrated in Figure 14.6(b). c) The leftward shift in the labor demand curve is larger than the leftward shift in the labor supply curve, so the real wage rate falls and employment decreases. 4. Real GDP and the Price Level a) The decrease in productivity shifts the LAS curve leftward (there is no SAS curve in the RBC theory) and the decrease in investment demand shifts the AD curve leftward. The price level falls and real GDP decreases. b) Figure 14.7 illustrates an RBC recession in the AS-AD framework. 5. Money plays no role in the RBC theory; the theory emphasizes that real things, not nominal or monetary things, cause business cycles.

8 318 CHAPTER The shock that drives the business cycle in the RBC theory is the same force as generates economic growth, technological change. RBC theory concentrates on the short-run variations in technical and productivity change, whereas the trend growth in technological change is the major factor affecting long-term growth. D. Criticisms of Real Business Cycle Theory There are three main criticisms of the real business cycle theory: 1. The claim that money wages are sticky, contrary to the assumption of flexible money wages made by the RBC theory. 2. The assertion that intertemporal substitution is too weak to shift the labor supply curve by much and hence too weak to generate substantial changes in employment with small changes in the real wage rate 3. The claim that technology shocks are an implausible source of business cycle fluctuations, and also measured technology shocks are correlated with factors that change aggregate demand and so are not good measures of pure aggregate supply shocks. E. Defense of Real Business Cycle Theory RBC proponents defend the real business cycle theory with four points: 1. The claim that RBC theory works insofar as it explains both cycles and economic growth 2. The assertion that RBC theory is consistent with a wide range of microeconomic evidence about labor demand and supply, investment demand, and other data 3. They acknowledge that money and business cycles are correlated but argue that this correlation exists because fluctuations in economic activity create changes in the money supply and not vice versa 4. The fact that RBC theory raises the possibility that business cycles are efficient so that efforts to smooth the business cycle reduce economic welfare IV. Expansion and Recession During the 1990s and 2000s A. The U.S. Expansion of the 1990s 1. The expansion that started in March 1991 lasted until March 2001, a total of 120 months. The previous all-time record for an expansion was 106 months, which took place in the 1960s. Several factors caused this long and strong expansion: a) Productivity Growth in the Information Age: Massive amounts of technological change occurred during the 1990s. (For instance, computers and related technologies exploded, as did biotechnology activity.) The technological changes created profit opportunities, which increased investment demand. In turn, the higher capital stock increased aggregate supply. b) Fiscal policy and Monetary Policy were both restrained and helped the expansion continue.

9 THE BUSINESS CYCLE Figure 14.8 illustrates how aggregate demand and long-run aggregate supply both increased during the expansion. The increase in potential GDP increased short-run aggregate supply but a higher money wage rate offset this increase so that, on net, short-run aggregate supply decreased a little. Real GDP increased, from $7.1 trillion to $9.9 trillion. Because aggregate demand increased more than aggregate supply, the price level rose, from 84 to This expansion seems identical to RBC predictions: technological change increases productivity, with the result that labor demand and aggregate supply increase. B. The U.S. Recession of The 2001 recession was the mildest on record. Several factors contributed to the recession and its mildness: a) Absence of External Shocks: There was no clearly visible external shock to set off the recession. b) Fiscal Policy: There were no major fiscal shocks to trigger the recession. As the recession developed, the normal workings of automatic stabilizers moved the budget into deficit, and after September 11 increased government purchases also increased aggregate demand. c) Monetary Policy: There were no major monetary shocks prior to the start of the recession, although the Fed had raised interest rates a little in 2000 and held M2 growth steady. 2. Productivity growth slowed in early 2001 but by itself, this slowdown seems insufficient to have lead to a recession. But it was associated with a very severe reduction of business investment that was the proximate cause of the fall in aggregate demand and the start of the recession. 3. Labor productivity increased, as did the real wage rate, because employment and aggregate hours fell more than GDP and unemployment rose. The rise in the money wage rate decreased short-run aggregate supply. 4. Figure 14.9 illustrates the 2001 recession using the AS-AD model.

10 320 CHAPTER 14 V. The Great Depression A. In early 1929 unemployment was at 3.2 percent. 1. In October the stock market fell by a third in two weeks. The following four years were a terrible economic experience: the Great Depression. 2. In 1930, the price level fell by 4 percent and real GDP decreased by 9 percent. Over the next three years several adverse shocks hit aggregate demand. Real GDP and the price level both decreased by 26 percent from their 1929 levels. 3. The 1920s were a prosperous era but as they drew to a close increased uncertainty affected investment and consumption demand for durables. a) The stock market crash of 1929 also heightened uncertainty. b) The uncertainty decreased investment, which decreased aggregate demand and real GDP in Until 1930, the Great Depression was similar to an ordinary recession. 5. Figure illustrates using the Great Depression using the AS-AD model. Economists disagree over what changed the recession into the Great Depression. B. Why the Great Depression Happened 1. Some economists think that continued falls in investment and consumption were the primary factors that decreased aggregate demand and created the depression. 2. Other economists (such as Milton Friedman) assert that inept monetary policy was the primary factor that lead to the decrease in aggregate demand. 3. Banks failed in an unprecedented numbers during the Depression. The main initial reason was loans made in the 1920s that went sour. But bank failures fed on themselves. People seeing one bank fail, took their money out of other banks which resulted in the other banks failing. 4. The massive number of bank failures resulted in a huge contraction in the quantity of money that was not offset by the Federal Reserve. C. Can It Happen Again? 1. Four reasons make it unlikely that another Great Depression could recur today: 2. Bank deposit insurance. a) Deposits in banks now are insured by the Federal Deposit Insurance Corporation so that depositors need not fear that if their bank fails they will lose their deposit. As a result, depositors do not withdraw their money from their bank when they see another bank fail, so bank failures do not feed on themselves. 3. Lender of last resort. a) The Fed today realizes that in an economic collapse it should lend to banks that need reserves to keep the banking system from collapsing.

11 THE BUSINESS CYCLE Taxes and government spending. a) The government accounts for a larger share of aggregate expenditures. This spending is not reduced when a downturn strikes, so aggregate demand today does not decrease as much in a recession. b) Additionally, taxes and transfer payments operate as automatic stabilizers that moderate the fall in disposable income during a recession. 5. Multi-income families. a) A much larger proportion of families today have two people working. So, when one worker loses a job the household s income does not fall to zero, so the household s consumption demand is more stable. Reading Between the Lines The news article discusses the expansion of The points are made that the economy had its best quarterly growth rate in nearly twenty years in the third quarter of 2003; consumer spending, exports, residential construction, and business investment all grew rapidly; but high productivity growth means that economic growth has not immediately translated into more jobs. New in the Seventh Edition Data and figures have been all updated. Reading Between the Lines is new and focuses on the jobless recovery following the 2001 recession. Teaching Suggestions Two Big Upfront Suggestions You can use this chapter as a serious application chapter that uses a lot of background material on AS-AD and the deeper models that lie behind LAS, SAS, and AD. But it is not advisable to attempt to teach this chapter in its entirety unless you ve laid the groundwork described in Where we have been. You can also use this chapter as a source of material on the U.S. economy during the 1990s and 2000s and the Great Depression. You can use most of what is in these parts of the chapter (parts 1, 4, and 5) any time after Chapter Cycle Patterns, Impulses, and Mechanisms The advent of graphing calculators has meant that students are much more familiar with the notion of a cycle than they used to be. It is important to make sure that students understand that the business cycle is only a cycle in the sense that real GDP fluctuates around a trend, and it in no way resemble a sine curve. It is useful to look at data to get across the point that in the business cycle, both the amplitude and the frequency of the cycle are highly irregular, and that the movement of the graph is not always smooth. It is impressive to students to show them how the depth of recessions has tended to become less over time, and the length of expansions more. The contrast between pre and post 1940 is fairly striking; one way to explain it is to talk about the size of government and the extent of automatic stabilizers. Very few students will be able to guess correctly what proportion of wage earners paid income or payroll taxes in 1935; ask them, and then tell them the answer (less than 5 percent). The ideas of impulse and propagation mechanism are fairly intuitive, and the discussion

12 322 CHAPTER 14 in the text should get them across well; what students may need some help understanding is that there are alternative theories of what the impulses and mechanisms are, and that we will be looking at several alternatives. 2. Aggregate Demand Theories of the Business Cycle It is worth quickly reviewing the AS-AD model, because this becomes the organizing principle for distinguishing between the alternative theories: all can be cast into the AS-AD framework, with the differences between them being what moves, how, and why. The Keynesian model is relatively straightforward and easy for students to grasp, being based on business sentiment shifts changing investment. Similarly, Monetarist theory is based on changes in the growth rate of money. An obvious question students will think of is why would the Fed change monetary policy in ways that produce a cycle? Point out that this may not be deliberate, but may be caused by miscalculations of what is going on in the economy, or changes in the relationship between monetary policy and aggregate demand arising from financial innovation or events elsewhere in the world. Rational expectations theories to a large extent broaden the Keynesian explanation by seeing the impulse as arising from unpredictable errors in forecasting aggregate demand, rather than fluctuations in investment alone. 3. Real Business Cycle Theory The RBC approach distinguishes itself from the other theories by positing that fluctuations have their origins in real phenomena, not money, business sentiments, or rational expectations not being fulfilled. Intuitively, it is appealing to students: they are all aware of technical progress, and it is intuitively a very small step to acceptance that the pace of technological change varies, and so does the pace of productivity change, and that will produce fluctuations in the demand for capital and labor. The only difficulty with this is that it is much easier to grasp intuitively in terms of fluctuations in the rate at which these things change than in the absolute shifts in curves that we translate it into when we simplify to talking in terms of levels and a fixed potential GDP rather than fluctuations about trend growth. It may be helpful for students to first expound on the ideas intuitively in terms of trend growth rates and fluctuations about them, and then remind students that in order to simplify, we take out the trend growth and talk about the business cycle as though it was fluctuations about a fixed potential GDP in a static economy. There is a potential for confusion here, but it applies to all discussions about the business cycle, which in reality is fluctuations about trend growth, but which in order to be able to use the AS-AD framework we have simplified to a static situation. 4. Expansion and Recession During the 1990s and 2000s There are two issues that may well generate a lot of student interest. The first is whether there is a new economy, or whether the economy s behavior in the 1990s was fundamentally the same as in earlier expansions. Looking at the trends in productivity data in class may well generate some useful discussion, although the instructor should be armed with a good understanding of both the ambiguities in the measures and the tendency for productivity measures to be revised fairly drastically. The second issue is why the 2001 recession was so shallow and short, and what caused it. The proximate cause was clearly the collapse of business investment, but the interesting question is why that happened. 5. The Great Depression Take a few moments in class to describe various facts about the Great Depression and its impact. Strive to reinforce your students understanding of the importance of this watershed event. The fact that real GDP fell by about 30 percent from 1929 to 1933 is impressive, but in an abstract fashion. Emphasize the unemployment rate, because it is easy for students to identify with unemployment. Point out that the unemployment rate peaked at between 20 to 25 percent for several years and averaged over 10 percent for the decade of the 1930s. To really bolster what these unemployment

13 THE BUSINESS CYCLE 323 rates mean, remind the students that an unemployment rate of 25 percent means that one out of every four workers is unemployed. Ask them to imagine what it must have been like to be unemployed at that time, especially because this was an era with no major transfer programs such as unemployment compensation. Indeed, discuss with the students that at the time there were sincere doubts whether the capitalist system would continue; many people looked to other forms of economic organization socialism, communism, or fascism as answers to the Great Depression. Continue by describing how the Great Depression still affects our economy today. In particular, such institutions as Social Security, federal insurance for bank deposits, and unemployment compensation were initiated during the 1930s. Perhaps more importantly, the idea that the federal government should take an active role in the nation s economy matured during this decade. These features are so common that it is hard to envision their absence. But in a real way, we owe their presence whether for good or bad to the Great Depression! Many economists, even younger ones, and especially older ones, were initially attracted to macroeconomics because at one point in their lives, they were personally touched by the plight of welfare recipients. They thought that the best way to lessen their burden was to reduce the unemployment rate, so they became economists. If you are one of these economists, share your motivation with your students. This sort of interest can become contagious and enhance students enthusiasm for learning the material. This chapter and the next (which deals with macroeconomic policy) is an excellent opportunity to point out the importance of macroeconomics. People s lives are adversely affected by recessions and slow economic growth. There are lots of examples you can give: some people are forced on welfare; some college students can t find jobs for long periods after graduating; indeed, some families are unable to send their children to college at all; and some older workers are forced to retire well before they would like while others are forced to keep working longer than they had planned. All these costs could be avoided if the nation could eliminate recessions and slow growth. Ask the students if this state of affairs is possible. And do not be afraid to offer your opinion. Students will often think that another Great Depression is very unlikely to happen. Get some data from, e.g., the World Bank s Web site, and show them what happened to real GDP in parts of the former Soviet Union in the early 1990s, and in some of the South East Asian economies in If you want to take the time, you can have an interesting discussion on the topic of how, for example, Indonesia s real GDP can fall 25 percent but reported unemployment hardly change (without unemployment compensation, people cannot afford to be unemployed; the two million or so who did lose jobs became either self-employed or unpaid family workers). The business cycle has very real impacts on people s lives, and although not as dramatic, the impacts in the United States are just as real. Asking students if they know anyone who lost a job or had their hours reduced during the recession is always a worthwhile exercise just after one. Most principles of economics textbooks have a chapter that is similar to this one. However, many of them contain an extended discussion to the effect that, This school of thought thinks this, but this other school of thought disagrees, and, by the way, here s a third school of thought that thinks the first school is partially correct but partially wrong.... This material is (appropriately enough!) found to be exceptionally tedious by the students. Fortunately, Parkin s chapter is not at all like these other weak attempts. Parkin shows the students how the schools relate to each other, discusses the different impulses and mechanisms stressed by each school, and presents an incredibly exciting chapter. You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated

14 324 CHAPTER 14 about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it hard-line monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students strong interest when you discuss this topic. You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics. The Big Picture Where we have been Chapter 14 extensively uses almost all the previously studied material in macroeconomics. It is a serious chapter. If you want to scratch the surface of the business cycle, you will cover the measurement issues in Chapter 5and the AS-AD overview in Chapter 7. If you want to teach a deeper appreciation of the business cycle, you will use Chapter 16. The chapter draws extensively on the AS- AD model developed in Chapter 7 and it uses the analysis of the labor market and the capital market of Chapter 8, and parts of the growth accounting material in Chapter 9. Where we are going Chapter 14 sets the stage for the policy chapters of the macroeconomic section, Chapters 15 and 16, which deal with fiscal and monetary policy. Chapter 14 gives essential background and motivational material necessary for the students to thoroughly grasp the material in Chapters 15 and 16. Moreover, a familiarity with the Great Depression truly reinforces their grasp of why stabilization and other policies is important. Overhead Transparencies Transparency Text figure Transparency title 88 Figure 14.1 A Keynesian Recession 89 Figure 14.2 A Keynesian Expansion 90 Figure 14.3 A Monetarist Business Cycle 91 Figure 14.4 A Rational Expectations Business Cycle 92 Figure 14.6 Capital and Labor Markets in a Real Business Cycle 93 Figure 14.7 AS-AD in a Real Business Cycle 94 Figure 14.8 The 1990s Expansion 95 Figure 14.9 The 2001 Recession

15 THE BUSINESS CYCLE 325 Electronic Supplements MyEconLab MyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book. PowerPoint Lecture Notes PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter. PowerPoint Electronic Lecture Notes for students are available in MyEconLab. Instructor CD-ROM with Computerized Test Banks This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software. Additional Discussion Questions 11. What phase of the business cycle is the United States currently in? If a recession, when do you think an expansion will occur? If an expansion, when do you think a recession will occur? Why? 12. Which theory emphasizes animal spirits? What role do these animal spirits play in business cycles? 13. What is the intertemporal substitution effect? In what theory is it important and why? 14. Does an increase in the price level necessarily signal an impending recession? An impending expansion? 15. Carefully explain why fluctuations in investment are an important factor in each business cycle theory. 16. It is immediate that recessions boost the unemployment rate and lower real GDP. Most people view both these effects as harmful. Do recessions have any good effects? If so, what are they and why are they good? 17. How do you think recessions influence elections? 18. Which theory or theories does the U.S. economic experience of the 1990s most strongly support? Explain your answer. 19. In which school of thought would you place yourself: Keynesian, monetarist, new classical, new Keynesian, or real business cycle? Why? 10. Do you think the United States will suffer an economic episode similar to the Great Depression in the near future? Why or why not? 11. Which theory or theories best explains the 2001 U.S. recession? Justify your answer. 12. In the United States, the impact of a recession is heavily concentrated on those who suffer from cyclical unemployment. Consider an economy in which the bulk of the labor force does not work for wages, but is employed in family farms or enterprises (this still characterizes many African and Asian economies). How would the impact of a recession differ?

16 326 CHAPTER Describe how the typical business cycle seems to have changed during the period since To what would you attribute these changes?

17 THE BUSINESS CYCLE 327 Answers to the Review Quizzes Page 344 Page 349 (page 716 in Economics) 1. Keynesian theory says that the business cycle is caused by volatile expectations about future sales and profits (animal spirits), a multiplier effect, and sticky money wages. Focus on the Keynesian explanation of a recession. Animal spirits reflect the impulse of the business cycle: a rapid and extensive downward revision of the expected future profitability and sales will lead to a large decrease in investment demand. The Keynesian mechanism emphasizes that the decrease in investment demand has a large effect on aggregate demand because of the multiplier effect. Finally, sticky money wages mean that the short-run aggregate supply curve is horizontal. Hence the (large) decrease in aggregate demand leads to a (large) decrease in real GDP and, with sticky money wages, the economy remains mired in the ensuing recession indefinitely. 2. Monetarist theory says that the business cycle is caused by the Fed speeding up and slowing the growth rate of money, which then changes spending plans. Focus on the monetarist explanation of a recession. A slowdown in the growth rate of money is the impulse of the cycle. The mechanism argues that the slowdown increases interest rates, which decreases investment and consumption demand, thereby decreasing aggregate demand. The short-run aggregate supply curve is upward sloping, so the decrease in aggregate demand leads to a decrease in real GDP and price level. Money wages, however, ultimately adjust to the lower price level so that the economy (eventually) returns to potential GDP. As this explanation makes clear, the role of the Fed and the money supply is that of the impulse: The Fed starts the business cycle by changing the growth rate of money. 3. New classical and new Keynesian theories (rational expectations theories) say that the business cycle is caused by unanticipated fluctuations in aggregate demand. These theories assert that unexpected changes in aggregate demand are the cycle impulse. Thus, an unexpected decrease in aggregate demand creates a recession. The mechanism focuses on real wages. An unexpected decrease in aggregate demand means that the price level is lower than expected. As a result, real wages are higher than expected, so that firms reduce their work force. Real GDP decreases, unemployment increases, and a recession occurs. Eventually money wages adjust to the lower the price level so that real wages return to the full employment level. At this time the economy returns to potential GDP and the recession is over. The roles of rational expectations and unanticipated fluctuations in aggregate demand are key. People use rational expectations (forecasts based on all available relevant information) to forecast changes in aggregate demand. Changes that cannot be forecast unanticipated fluctuations then are the impulse that creates business cycles. 4. In the new classical theory, the money wage rate responds to any and all changes in price level expectations. In the new Keynesian theory, the money wage rate is set by long-term contracts and so can respond to only changes in price level expectations that occurred before the long-term contract was set. (page 721 in Economics) 1. Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate. Fluctuations in the rate of technological change are the impulse that creates the business cycle. 2. According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor. The decrease in investment demand lowers the real interest and, via the intertemporal substitution effect, the lower real interest rate decreases labor supply. Because both the demand for labor and the supply of labor decrease, the real wage rate and employment fall because the decrease in labor demand exceeds the decrease in labor supply.

18 328 CHAPTER According to real business cycle theory, a fall in productivity growth decreases both the long-run aggregate supply and aggregate demand. Real GDP definitely decreases and, because the decrease in aggregate demand exceeds the decrease in long-run aggregate supply, the price level falls. Page 351 page 723 in Economics) 1. The main factor that contributed to the long and strong U.S. expansion in the 1990s was increased productivity growth. Productivity grew because of large technological changes. As a result of the higher productivity growth, investment increased, which, in turn, resulted in a rapid increase in the capital stock. Monetary and fiscal policies played minor roles. Monetary policy generally kept the growth rate of money low, which led to low inflation rates. Fiscal policy was generally restrained. Government purchases remained constant as a fraction of GDP and, while tax revenues increased, most of the increase was due to rapid economic growth. 2. The proximate cause of the 2001 recession was the reduction of business investment, which was the only component of aggregate demand that fell. The growth rate of productivity slowed between 2000 and early 2001, pointing to an RBC explanation for the recession. Labor productivity and real wages both rose in the 2001 recession more than is usual in a recession, contributing to the fairly large reduction in both employment and aggregate hours. There were no major fiscal or monetary shocks associated with the 2001 recession.

19 THE BUSINESS CYCLE 329 Answers to the Problems 1. a. Possible combinations are A or D, E or G, and I or K. A Keynesian recession results from a decrease in investment caused by a decrease in expected profit. In an extreme case, no prices change, so the move is to A, E, and I. But a more general possibility is that the money wage rate doesn t change but the price level falls, real wage rate rises, and the interest rate falls. In this case, the move is to D, G, and K. b. D, G, and L. A monetarist recession results from a decrease in the quantity of money. The interest rate rises, and investment decreases. Aggregate demand decreases, but the money wage rate doesn t change. Real GDP and the price level decrease, the real wage rate rises, and employment decreases. The move is to D, G, and L. c. D, G, and I, K, or L. d. D, G, and I, K, or L. Either type of rational expectations recession results from an unanticipated decrease in aggregate demand. Any of several factors could initiate the decrease in aggregate demand, and the interest rate could rise, fall, or remain constant. Aggregate demand decreases, but the money wage rate either doesn t change or doesn t change by enough to maintain full employment. So real GDP and the price level decrease, the real wage rate rises, and employment decreases. e. C, and E, G, or H, and K. In a real business cycle recession, a decrease in productivity decreases the demand for labor and capital. The interest rate and the real wage rate fall and investment and employment decrease. Aggregate demand and aggregate supply decrease, so real GDP decreases but the price level might fall, rise, or remain unchanged. 2. a. Possible combinations are B or C, F or H, and J or L. A Keynesian expansion results from an increase in investment caused by an increase in expected profit and sales (animal spirits). In an extreme case, no prices change, so the move is to B, F, and J. But a more general possibility is that the money wage rate doesn t change (because of sticky money wages) but the price level rises, real wage rate falls, and the interest rate rises. In this case, the move is to C, H, and J. b. C, H, and K. A monetarist expansion results from an increase in the quantity of money. The interest rate falls, and, as a result, investment increases. Aggregate demand increases, but the money wage rate doesn t change. Real GDP and the price level increase, the real wage rate falls, and employment increases. The move is to C, H, and K. c. C, H, and I, K, or L. d. C, H, and I, K, or L. Either type of rational expectations expansion results from an unanticipated increase in aggregate demand. Any of several factors could initiate the increase in aggregate demand, and the interest rate could rise, fall, or remain constant (and thus move to point I, K, or L). Aggregate demand increases, but the money wage rate either doesn t change or doesn t change by enough to maintain full employment. So real GDP and the price level increase, the real wage rate falls, and employment increases. e. D, and E, G, or H, and L. In a real business cycle expansion, an increase in productivity increases the demand for labor and capital. The interest rate and the real wage rate rise and investment and employment increase. Aggregate demand and aggregate supply increase, so real GDP increases but the price level might fall, rise, or remain unchanged.

20 330 CHAPTER This recession is consistent with Keynesian or rational expectations theories (see the solutions 1a, 1c, and 1d). 4. This expansion is consistent with real business cycle theory (see solution 2e). 5. This recession is consistent with real business cycle theory (see the solution 1e). 6. This expansion is consistent with Keynesian, new classical, and new Keynesian theories (see the solutions 2a, 2c, 2d). 7. This recession is not consistent with any of the theories and is an unlikely combination of events. The price level does not usually rise when the real wage rate rises. 8. This expansion is consistent with real business cycle theory (see solution 2e). 9. This recession is consistent the real business cycle theory (see the solution 1e). 10. This expansion is not consistent with any of the theories and is an unlikely combination of events. The price level does not usually fall when the real wage rate falls. 11. This recession is consistent with monetarist theory (see the solution 1b). 12. This expansion is consistent with monetarist theory (see the solution 2b). 13. This recession is not consistent with any of the theories and is an unlikely combination of events. The real wage rate does not usually fall when the price level falls. 14. This expansion is not consistent with any of the theories and is an unlikely combination of events. The price level does not usually rise when the real wage rate rises.