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Macroeconomics

Business Cycles and


Macroeconomic Policy

lector univ. dr. ec. av. Alexis DAJ
Phases of the Business Cycle
Business Cycle - Definition: alternating
increases and decreases in the level of
business activity of varying amplitude and
length
How do we measure increases and
decreases in business activity?
Percent change in real GDP!
Why do we say varying amplitude and
length?
Some downturns are mild and some are
severe
Some are short (a few months) and some are
long (over a year)
Do not confuse with seasonal fluctuations!


Phases of the Business Cycle
Expansion Expansion Recession
The Phases of the Business Cycle
Secular
growth
trend
Trough
Peak
0
Jan.-
Mar
T
o
t
a
l

O
u
t
p
u
t

Apr.-
June
July-
Sept.
Oct.-
Dec.
Jan.-
Mar
Apr.-
June
July-
Sept.
Oct.-
Dec.
Jan.-
Mar
Apr.-
June
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Note: Shaded areas indicate recessions.
Real GDP 1958-2007, in 2000 dollars
Note: Years is on horizontal axis and real GDP
is on vertical axis.
General trend of economic growth
Recession years are shaded blue: note downward
slope on graph indicating that GDP is decreasing.
The GDP Gap, 1945-2000
The GDP gap is the amount of production by which potential GDP
exceeds actual GDP
10-9
Actual
GDP
Actual
GDP
Potential GDP
GDP gap
Potential
GDP
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Since potential GDP has exceeded actual GDP for most years since World War II,
we have had a GDP gap. However in some periods, most recently from 1996
through 2000, actual GDP has been greater than potential GDP
U.S. real gross domestic product per person
from 1900 to 2004
Long-Run Economic Growth
Secular long-run growth, or long-run growth, is the
sustained upward trend in aggregate output per person
over several decades.
A country can achieve a permanent increase in the
standard of living of its citizens only through long-run
growth. So a central concern of macroeconomics is what
determines long-run growth.
The Conventional Three-
Phase Business Cycle
10-4
Year
Prosperity
Peak
Trough
Trough
Peak
Peak
2005 2010 2015
Recession
What is a recession?

Generally, 2 or more quarters of declining real
GDP
Implication: its not officially a called a
recession until the economy has already been
declining for 6 months!



Who decides when were in a recession?

E.g.: National Bureau of Economic Research
traditionally declares recessions
Private research organization, not a federal
agency

Recession dates from peak of business
Post-World War II Recessions*
*The February 1945October 1945 recession began before the war ended in August 1945.
Note: These recessions were of varying duration and severity.
Another Look at Expansions and Recessions
Can you find a pattern? Neither can economists!
Thats why recessions are hard to predict.
Business Cycle Theories
Endogenous theories:

Innovation theory: innovation leads to saturation.
Psychological theory: alternating optimism and
pessimism
Inventory cycle theory: inventory and demand not
in sync
Monetary theory: changes in money supply by
Federal Reserve
Underconsumption theory: or overproduction

Business Cycle Theories
Exogenous theories:

The external demand shock theory: effect of
foreign economies
War theory: war stimulates economy; peace
leads to recession
The price shock theory: fluctuations in oil
prices

Endogenous
Starts from within the model
Endo- inside, source
Genous- born

From outside of the model
Exo- outside
Genous- born, source
Exogenous
The Main Instruments of
Macroeconomic Policy
18
Objectives and Instruments of
Macroeconomic Policy

Objectives of Macroeconomic Policy
Instruments of Macroeconomic Policy
Birth and Development of
Macroeconomic Policy
19
Objectives and Instruments of
Macroeconomic Policy
Objectives of Macroeconomic Policy

Full Employment
Stable Price
Economic Growth
Balance of Payments
20
Objectives and Instruments of
Macroeconomic Policy
Instruments of Macroeconomic Policy

Demand Management
Supply Management
International Economic Policy
21
Objectives and Instruments of
Macroeconomic Policy
Birth and Development of Macroeconomic Policy

Since 1930s, three phases:
Phase 1: 1930s-World war, New Policy
Phase 2: After World war , fiscal policy and
monetary policy.
Phase 3: 1970s, Stagflation appeared. Western
countries strengthen the adjustment of market
mechanism.
The Main Instruments of Macroeconomic Policy
Fiscal Policy
Government expenditure
Taxation
Influence on AD / AS
Monetary Policy
Interest rates
Money supply
Exchange rates
Supply side policies

What is fiscal policy
Fiscal policy looks at how government spend their money and how
they control their taxes.
There are 2 types of fiscal policy:
Contractionary fiscal policy: Where the government reduce
spending and / or when they make taxes higher.
Expansionary fiscal policy: Where the government cut taxes or
increase government spending. They will increase the amount the
government borrows to fund the expenditure.

Observation: Neutral fiscal policy is usually undertaken when an
economy is in equilibrium. Government spending is fully funded by
tax revenue and overall the budget outcome has a neutral effect on
the level of economic activity.
Government Expenditure
Government expenditure covers all spending by the public
sector
The government spends money on many things including:
Education
Defence
Welfare benefits
Healthcare
Infrastructure
Police
Government Borrowing
As well as gaining revenue through taxation the
government can also finance their spending through
borrowing
The public sector net cash requirement (PSNCR)
measures the annual borrowing requirement of the
government in an economy
The budget deficit has been renamed to the public
sector net cash requirement (PSNCR) to avoid
confusion with net borrowing.
Government Borrowing
Public sector borrowing requirement (PSBR) is the
old name for the budget deficit in the United
Kingdom.
PSBR occurs when expenditures for the
government activities in the public sector of the
economy exceed the income. The resulting deficit is
then financed by borrowing funds from the public,
usually by the means of government bonds.

Direct & indirect taxes
Direct taxes are taxes of income and expenditure
e.g. income tax, corporation tax (levied on company
profits).
Indirect taxes are taxes such as VAT (value added
tax), changes in this type of tax has a rapid effect
on the level of economic activity. E.g. an increase in
VAT will cut consumption

Fiscal Policy and AD
Taxation influences the AD curve because:
An increase in taxation will decrease the level of consumption in
the economy
An increase in taxation will increase the level of government
spending in the economy
A decrease in taxation will increase the level of consumption in
the economy
A decrease in taxation can decrease the level of government
expenditure in the economy
The impact of a change in government expenditure
depends on the size of the multiplier
Fiscal Policy and AD
Governments can utilise fiscal policy to control the
level of AD in the economy
There can be problems with this due to:
Time lags
The size of the multiplier
Fiscal crowding out
Peoples reaction to cuts / rises in taxation
Fiscal Policy and AS
Fiscal policy can be used to increase the productive
capacity of the economy
This is because government expenditure can be
used to:
Increase the skill levels of workers
Provide economic incentives to firms
Increase factor mobility
Monetary Policy
Monetary policy is the use of interest rates, money
supply and exchange rates to influence economic
growth and inflation
Interest rates are the cost of borrowing money
Exchange rates the value of one currency in
terms of another
Money supply the amount of money in circulation
in an economy
Interest Rates
The Central Banks are responsible for setting interest rates
in a national economy
The Bank sets the rate after analysing macroeconomic
trends and risks associated with inflation
E.g.: Since 1997 the UK government has used interest rates
to control the level of inflation in the economy (at a level of
1.5-3.5% - target = 2.5%)
If the Bank believes the level of AD is rising too quickly
(potentially causing demand pull inflation), they will decide
to raise interest rates
Interest Rates and The Economy
Changes to interest rates influence many things in
the economy:
Housing prices and housing market if interest rates
rise the cost of mortgages increases therefore reducing
demand for housing in theory
Disposable income of house owners if interest rates
rise the real disposable income of home owners falls as
they have larger mortgage payments (variable rate only)
Interest Rates and The Economy
Credit demand if interest rates rise the amount of
credit sales should decrease as it becomes more
expensive
Investment if interest rates rise they lead to a
decrease in the level of investment
Exchange rates E.g.: An increase in interest rates
may lead to an appreciation of UK currency making
exports less attractive


Interest rates and Inflation
Interest rates are used to control inflation as when
interest rates are increased consumption decreases
as peoples real incomes are eroded by mortgage
payments and credit payments and the opportunity
cost of spending has increased
By controlling interest rates the government aims to
keep inflation at a low level
Interest and Exchange Rates
E.g., changes in the UKs interest rates will lead to changes
in the exchange value of the pound.
If interest rates rise the value of the pound will rise so the
pound will now buy more US dollars, Japanese Yen, Euros
etc.
If interest rates fall the value of the pound will fall so the
pound will now buy less US dollars, Japanese Yen, Euros
etc
Exchange rates
A fall in the exchange rate reduces the price of
exports and increases the price of imports
Domestic demand will be stimulated and more
people will buy exports as they are cheaper
This will create a deficit on the current account of
the balance of payments
As consumption will increase it will increase AD
which will increase the level of output in the
economy and more it towards full employment

Supply Side Policies
Supply side policies are policies that improve the
supply-side of the economy increasing its efficiency
and thereby resulting in economic growth
Supply side policies can act in the product and
labour markets
Supply side policies
Trade union reforms
Increased expenditure on training and education
Changes in taxation
Changes to welfare system
Privatisation
Deregulation
Free trade
Incentives for small businesses
Supply side policies
Supply side policies cause economic growth as they
cause the LRAS to shift outwards increasing the
potential output of the economy
If the economy is operating near full potential
increases in aggregate demand can cause cost
push inflation, by the LRAS curve shifting outwards
this inflationary pressure is reduced

Supply side policies
As supply side policies can cause the LRAS to shift
outwards they can lead to a fall in unemployment
levels
Many supply side policies concentrate on the labour
market and increase skills for workers which help
reduce structural unemployment in the economy
Supply Side Policies
As the LRAS shifts outwards businesses will have
lower average costs as productivity has increased
Lower costs mean that businesses are able to
compete more internationally therefore making the
balance of payments more healthy
Summary
Fiscal Policy is the use of government expenditure and taxation to
influence the level of inflation / economic growth
Government expenditure covers all things the public sector spends
money on
Taxation earns revenue for the government either directly through
income taxes or indirectly through VAT
Monetary Policy is the control of the economy through interest rates,
money supply and exchange rates
The central bank sets the rate of interest in a national economy
The government uses interest rates to control the rate of inflation
around its target of 2.5%
Supply side policies aim to increase productivity in the economy
therefore stimulating economic growth