Jeffs PART

The Business Cycle, Aggregate Demand and

Aggregate Supply
Business Cycles
In this topic we explore the concept of the business cycle. A business cycle occurs due to the fluctuations
that an economy experiences over time resulting from changes in economic growth. Understanding
business cycles is the essence of a course in macroeconomics. Economists try to discern where the
economy is located and more importantly where it is heading in order to deal with possibly adverse future
economic events. When the economy is at or is heading in an undesirable direction, economists may
apply fiscal or monetary policy tools to change the course of the economy.
In general, a business cycle describes changes in the demand-side of the economy as measured by
GDP, where:
GDP = C + I + G + NX
Over time, GDP does not remain constant and will change for many reasons, economic and noneconomic. Economic reasons include changes in government policies such as taxes and interest rates.
The non-economic reasons are too many to even consider listing, but include factors such as war,
drought, natural and man-made disasters.

Using Figure 7-1 as a guide, the horizontal axis measures time, while the vertical axis yields the real GDP
growth rate. As the graph shows, we begin with an increasing growth rate of real GDP during an
economic expansion. Eventually, growth approaches and then reaches a peak. Why are peaks reached,
or why doesn't economic growth continue to increase indefinitely? The answer is prolonged periods of
economic growth (or short periods of very intensive economic growth) are eventually accompanied by
rising inflation rates (or the threat of higher inflation). The higher prices (inflation) bring forth counter
cyclical policies used to dampen inflationary pressures.

The defining part

of the business
Business Cycle Overview
cycle is a
recession. Without
a recession, the
economy doesn't
really experience a
Percentage of time that the US Average length of business cycle,
just a period of a
prolonged
Economy is in a recession
the recession
economic
expansion.
Before Between 1992 and
2000, the U.S.
40%
21 months
1945
economy did not
see a recession
17%
11 months
and set the record After - 1945
for the longest
period of economic Since 1980
expansion without
10%
a recession. There
were changes in
real GDP growth during this time period, GDP even decreased in the first quarter of 2003, but no
recession. The table above shows how the business cycle evolved in the 20th century.
Prior to 1945, periods of recession were almost as common as days when the economy was growing. As
we will discuss in Unit 9, until the Great Depression of the 1930s, economic policy makers generally did
little to counteract the forces that drove the business cycle, choosing instead to allow the economy to take
its own course. The result was long (typically almost 2 years) and frequent recessions that we usually
much more severe than modern-day recessions.
Modern economic thought is characterized by the use of both fiscal and monetary policies to counteract
and smooth out the business cycle. As the table shows, economists have had success in using these
policies to make the dealings of U.S. firms, as well as the life of Americans who work and save in financial
markets less turbulent. To better understand the use of fiscal and monetary policies, take another look at
the GDP equation:
GDP = C + I + G + NX
GDP is the sum of consumption + investment + government spending + net exports (exports - imports).
This equation can be written in further detail as:

GDP = C(Y - T) + I(r) + G + NX

Y is equal to income and T represents taxes.
(Y - T) gives us disposable income and thus consumption depends on the level of disposable income C(Y
- T).
r represents the interest rate and investment responds to changes in the interest rate.

As r increases, I will decrease.

As r decreases, I will increase.

Fiscal Policy is represented by the executive and legislative branches of government and captures
changes in taxes (T) and government spending (G). In the United States, the president and Congress
make these decisions. As we can see from the equation, a decrease in T will increase disposable income
(Y - T), increasing C and therefore increasing the growth rate of GDP. Government spending (G) directly
affects GDP growth.
If the economy is in a recession, a combination of tax cuts and increases in government spending can
stimulate economic activity. For example, the U.S. economy saw its first recession in a decade in 2001.
Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending
over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the
7% (at an annual rate) range.
Monetary Policy is conducted by the central bank of a country - in the United States this is the Federal
Reserve Board. Details will be present later in the class, but the Federal Reserve can increase and
decrease interest rates to change business investment (I) in the equation above. Changes in interest
rates will also influence consumption, but our focus in this class will be the effect on investment.
For example, in the year 2000, the federal funds interest rate was 6.5% and by the summer of 2003, the
interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest
rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid
economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal
Reserve.
Observers have concluded that economics is a somewhat imprecise field, especially when it comes to
dealing with business cycles. Economic indicators such as GDP and the inflation rate are trailing
indicators. They tell us a good deal about the economy, but importantly they tell us where the economy
is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of
economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth
in the current or following calendar quarter. Although there is often a correlation between future GDP
growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly.
Economists need to be able to identify changes in the growth trend and to spot these variations by
using leading indicatorssuch as changes in business inventories.
Knowing current economic conditions is useful information for economists, but knowing where it is going
is critical. As noted, economists use leading indicators to try to accurately predict future changes in GDP
and the inflation rate. Interpreting the signals given by the leading indicators on what direction the
economy is taking is often weakly understood by economists, sometimes the indicators give conflicting
signals and the conclusions made are often controversial.

The goal of this topic is to discover how economic policy makers interpret and react to business cycles.
The two most important macroeconomic variables are the real growth rate of GDP and inflation (the
unemployment rate is also crucial, but is closely tied to GDP growth). The goals of economic
policymakers are simple:

To maintain real GDP growth at a relatively constant, positive level. For example,
economists may desire 3.0% annual growth in GDP (1).

Compatible with the growth in real GDP, keep the unemployment rate at a level
consistent with the full-employment level of unemployment. Remember, fullemployment is not zero unemployment, but a level where all those in the labor force
seeking work, can find a job fairly quickly.

Minimize the level of inflation and keep it there. Optimally, the economy will have a
sustained low inflation rate, 3% or below for example.

Taking the perspective of the Federal Reserve, ranking the above goals in order of importance yields:

Most important - minimize the inflation rate. The Federal Reserve will force economic
growth to slow down or even fall into a recession if it sees inflation as too high. Evidence
is given by the 1982 recession when the Federal Reserve raised interest rates until the
economy tumbled and inflation was taken down. Economists recognize that once high
rates of inflation are established, they are very difficult to reduce and should be avoided
in the first place.

Once the inflation rate is tamed, the Federal Reserve will try to lower the unemployment
rate to a level consistent with full employment - currently about 4% in the United States.

And once the economy is at full employment, the Federal Reserve will attempt to
maintain real GDP growth at a rate equal to the economy's supply side growth rate.

Manas PART
(1) Once the unemployment rate is minimized, the Federal Reserve targets a the non-inflationary growth
rate of real GDP. This rate is based on supply-side factors of the growth in the labor supply and worker
productivity. For example, if the U.S. labor force increases by about 1.0% annually and the yearly
increase in worker productivity or output per worker at private nonfarm businesses is estimated to
average about 2% each year then the target growth rate equals 3%.
It is critical to note that monetary and fiscal policies have no effect on the supply-side growth rate. The
policies are used to change demand-side (GDP) growth.

No problem we say. It goes without saying that accomplishing these three simple goals simultaneously is
equivalent to having a job as the circus lion tamer. The hungry lions in this case are leaping inflation,
plunging GDP, snapping politicians and a roaring public. The economic policymaker/lion tamer must not
lose his vigilance or these lions may take a large bite out of his rump.

Before we go into the details of the business cycle, here is a summary of some important points to
remember.

The policymakers desire to smooth out the business cycle by minimizing the
magnitude of variations in economic growth over the course of the business cycle.

It is crucial to understand where the economy is going in the future. If the path is not
desired, then changes in economic policy can be made today to prevent that path from
being realized. For example, assume that real GDP is growing at a desired 3% annual
rate. If the Federal Reserve determines that GDP growth will soon slow down to a
significantly lower growth rate, it can reduce interest rates today to stimulate future
economic growth and try to maintain real GDP growth at 3% in the future.

Leading economic indicators are the crystal ball for economic policymakers, and
are used to predict the economy's future. Unlike your neighborhood fortune-teller, the
economic crystal ball is usually cloudy. As a result, errors in judgment and public policy
are possible. Economic policy errors include:
o

GDP growth is too rapid and inflation rates increase to uncomfortable levels,

GDP growth slows down too much, leading to an increase in the unemployment
rate and possibly a recession.

In an attempt to reduce inflationary pressures, economic policymakers will attempt to slow economic
growth. The reduction in the growth rate of real GDP corresponds to an economic downturn, where GDP
growth has fallen from its peak level.
Are economic policymakers stupid? Historically, economic downturns are eventually followed by
a recession when real GDP growth actually becomes negative. Recessions are often synonymous with
rising rates of unemployment. Rising unemployment rates certainly get the attention of economic policy
makers who furiously enact expansionary policies (the durations of recessions tend to be much shorter
than positive growth periods). The closest that economic policymakers come to nirvana is during the
expansionary phase. The worst is over, economic growth is increasing (often very quickly), jobs are being
created, and inflation remains muted. Everyone deserves their day in the sun, but after a brief interlude of
happiness, rising inflation causes a storm of tears for even the most optimistic economists.
Leading Economic Indicators
As noted earlier, economic policymakers try to predict where the economy is heading in
the near future based on leading economic indicators. The Fed follows many economic
indicators which can give signs regarding changes in future economic growth and
inflation. For example, as these economic indicators reach the danger zone, there is
increasing likelihood that the economy is overheating and increasing the danger of rising
inflation in the near future. Important leading economic variables that the Fed closely
monitors include:
1) The unemployment rate: in relation to full-employment. On average, labor comprises
roughly 2/3 of total production costs for businesses. When the unemployment rate
reaches and then falls below full-employment, labor shortages build. As producers trying
to expand production find new workers becoming increasingly scarce, they are forced to
add costly overtime and offer higher wages to entice non-labor force members to work.
The result is upward wage pressures. Wage increases translate into higher production
costs, higher prices for goods and services and an increase in the inflation rate.

Another important indicator related to employment is new jobless claims.

Released every Thursday, new jobless claims give the number of people
who are making an initial claim for unemployment benefits. If the number
of new jobless claims is rising over time, the indication is that firms are
increasingly laying off workers who then are filing for unemployment. A
persistent increase in claims indicates that demand for goods and
services is falling and unemployment rates will be rising. On the other
hand, if new jobless claims remain constant or are falling, then labor
markets are in good shape. Currently, economists consider 400,000 new
weekly jobless claims to be the dividing line between a labor market to is
adding jobs (on a net basis) and one that is experiencing net job losses.
Even in the best of times, workers lose jobs and a number of 300,000, for
example, signifies that the economy and labor market are doing very
well. The lower the number of new jobless claims, the better for the labor
market and people seeking employment.
2) The Labor Cost Index: measures what the title indicates the cost in terms of wages,
salaries and benefits paid by firms to their employees. This is a very important indicator
since even in the high technology US economy, labor still comprises about 2/3 of the total
production costs to a firm. If the index is rising at a fairly rapid pace, and consumer
demand is strong, firms are likely to pass on their higher production costs to the
consumer by raising prices. In contrast, if the index remains steady, then strong
consumer demand may not lead to higher prices and inflation.
3) The utilization of productive capacity: capacity utilization refers to the amount of
physical capital available to firms that is in use. At any time, firms have a given stock of
capital equipment such as machinery, office space, factories, computers and
telecommunications infrastructure available to assist workers in the production of goods
and services. In the short run, a firm's, industry's or economy's capital stock is considered
fixed, as it often takes awhile to invest in additional capital equipment, especially when
new office or factory space is required to increase output to meet growing demand.
The Fed regularly surveys different producers to estimate how much of
the capital stock in place is actually being used. As various producers
within an industry reach full-capacity (100% use of the capital available)
due to high demand for their product, firms are likely to begin charging
customers higher prices to satisfy additional demand. This is the result of
higher production costs resulting from additional shifts, overtime and
other costs relating to increased use of the available capital.
For the economy as a whole, the Fed becomes cautious as the
capacity utilization rate approaches 84%. The Fed considers this to be
the threshold at which inflationary pressures will build in some parts of
the manufacturing sector. Although 84% is well below 100%, at this point
the Fed judges that some important industries will be approaching 100%
capacity utilization. Industries that are likely to reach full capacity before
the economy as a whole include manufacturers of basic commodities
such as steel, aluminum and paperboard used in shipping final goods.
As an example, consider the auto industry. When demand for autos is
growing due to robust economic growth, auto manufacturers increase
their output and the use of their capacity. Excess capital equipment and
factory space, which had previously been idled, is put into production.
Steel is an important input in automobile production and as auto
manufacturers increase their output they order more steel used in

production. At first, steel producers may also have some spare capacity
(also known as slack) or unused capital equipment. However, as orders
from the auto producers continue to grow, soon all available capital used
in steel production is put into use. Adding extra capital would take several
years, so the only way steel firms can boost production to meet
additional demands is to add overtime and extra shifts - using the capital
more intensively. In most cases, workers are paid higher wages for
working overtime or extra shifts, and these higher production costs are
passed on to the auto manufacturers. As auto producers pay higher
prices for their steel inputs, they pass on the higher cost to the consumer
by raising the prices of their final goods.
4) Commodity prices: as noted above, higher raw material and commodity prices (e.g.,
steel, copper, aluminum, paperboard) are often passed on to the final product.
5) Changes in business inventories: rapid growth in demand for goods and services
will deplete business inventories. As businesses increase production to meet additional
demand and to rebuild inventories to desired levels, inflationary pressures may build. Of
course, falling inventories can also be a sign of weak consumer demand. The trend has
to be placed in the context of overall economic conditions.
6) Worker productivity gains: worker productivity refers to output per worker, or how
much of a good or service a worker produces during a given time period (e.g. per hour or
day). As workers gain job experience, knowledge and skills, they become better at their
jobs and their productivity improves. Increases in worker productivity helps to dampen
inflationary pressures by decreasing production costs. Rates of change in worker
productivity vary only slightly from year-to-year and significant changes are due to longrun economic dynamics. Presently, U.S. worker productivity improves by about 2.0%
annually.
The above leading indicators: the unemployment rate, capacity utilization, commodity
prices, changes in business inventories and gains in worker productivity all help to give
economists a picture of where the economy is going. Consider the U.S. economy in the
beginning of 1994. The unemployment rate had fallen into a range consistent with what
the Federal Reserve considers to be full employment (a shade below 6%). Capacity
utilization had run up past 84%, commodity prices were beginning to show upward spikes
and business inventories continued to fall. Combined with other economic indicators
followed by the Fed, these conditions signaled an increase in the inflation rate in the near
future. Consequently, by raising interest rates, the Fed took action to slow economic
growth before inflation rates actually increased.

Daniels PART
Bottlenecks and Inflation
The correlation of wages and inflation is fairly evident: higher wages paid to workers (an input in
production) are often passed on to consumers in the form of higher prices for final goods and services. In
1994 this item was of little concern to the Fed, as wage gains remained very low. In fact, the U.S.
Department of Labor reported that inflation-adjusted (real) wages fell 2.7% from March 1994 through
March 1995. However, by late 1994, the unemployment rate had fallen to a level considered by the Fed to
be consistent with full employment.

In contrast to the calm wage picture, uncertainty in labor markets, combined with events taking place in
the area of productive capacity during 1993, gave the Fed serious alarm. In the area of capacity
utilization, we need to consider two key points:
a.

The growth in productive capacity: which refers to the number and skills of workers,
the size and quality of the capital stock, and changes in technology.

b.

Changes in the degree to which the capacity is used.

Growth rates in productive capacity tend to remain fairly constant over long intervals and respond
positively to increases in the labor force and additions to the capital used in production. The current
growth rate of productive capacity is about 3% annually for the U.S. economy. Another way of expressing
growth in a nation's productive capacity is as an expansion of the production possibilities frontier. An
economy's capability to produce goods and services grows over time at relatively constant annual rates
as the population and capital stock increase and technology improves.
A contrast to the steady, long-run growth in productive capacity is the fluctuation in the use of the
productive capacity (capacity utilization) that occurs during the course of a business cycle. Consider the
relation of a typical business cycle to changes in capacity utilization. We can identify three stages:
A. Recession: Workers are laid off and the unemployment rate climbs. Factories and
machinery are idled and capacity utilization falls significantly. A good deal ofslack is
created as capacity utilization falls.
B. Noninflationary growth: As the economy emerges from a recession, unemployed
resources (workers, factories, machinery, and other capital goods) are put back to work.
Economic growth is characterized by a falling unemployment rate and the absorption of
excess capacity. Growth is robust, and the combination of excess capacity and the
steady growth in productive capacity keep a lid on price pressures.
The situation is one where there is a large gap between actual output and potential
output. If output is well below its potential (maximum), there is plenty of excess capacity
(or slack) in the economy and producers can easily expand output with the existing
productive capacity available. Since there is a surplus of unemployed labor, wage
demands remain muted and the utilization of mothballed equipment is cheaper than
buying new capital. Importantly, higher supplies easily satisfy the increased demand for goods
and services..
In a typical business cycle, the period of noninflationary growth correlates to a time of significant job
growth in the economy. For the U.S. economy, we can expect over 200,000 new jobs to be created each
month on a net basis. For example, during the long economic expansion during the Clinton administration
(eight years without a recession, there were almost 22 million new jobs added to the economy with
average job growth of 225,000 per month.
A. Inflationary pressures: As the economy continues growing, the excess capacity present
begins to shrink. Finally, the economy begins to reach potential output or full capacity.
The resulting bottlenecks most often occur in critical areas such as raw materials and
commodities (e.g., steel, copper, aluminum).

Figure 7-2 shows the case where the steel industry has reached full capacity. Capacity limits are shown
by a nearly vertical portion of the supply curve, indicating that increases in demand bring forth little
additional output. All firms can do to increase output is to add overtime, since all capital used in
production is utilized. The main impact is an increase in prices when supply bottlenecks are present and
demand increases. Consequentially, the growth in demand outraces the long-term growth in supply,
forcing up steel prices.
For critical commodities like steel, that is an intermediate good used in many final consumer goods (such
as automobiles, washing machines, household gutters). Higher prices are often passed along. As
automobile manufacturers pay higher prices for their steel inputs, they will raise the price to the consumer
to recoup the added cost.
Returning to the recent business cycle in the United States, the recession of the early 1990s created a
good deal of excess capacity. As economic growth resumed in 1992, accelerating through 1993 and into
1994, the excess capacity was rapidly absorbed and the economy approached potential output. The
warning number the Fed uses is roughly an 84% capacity utilization rate, and this was reached in early
1994. Although an economy with a 84% capacity utilization rate is well below 100%, this number is for the
general economy. Specific industries may be reaching a capacity of 100% (such as steel and aluminum).
Those industries reaching full capacity will soon experience bottlenecks, creating increased inflationary
pressures on the overall economy. Thus, in 1994 the Fed attempted to slow U.S. economic growth by
raising interest rates.
In the next section we will investigate the topic of business cycles using the tools of aggregate demand
and aggregate supply.
Macroeconomic Equilibrium
We have studied the demand and supply curves for individual markets. Now we take all the markets in a
domestic economy and combine them into an aggregate. The aggregate demand curve accounts for the
purchases of all consumers, businesses, the government, and foreign trade in an entire domestic
economy. The aggregate supply curve looks at the total production in an economy. Studying the concepts
of aggregate demand and supply is fundamental to understanding macroeconomics. We will begin by
looking at each in isolation and then combine the two. As you will see, the topic is very similar to the
analysis of demand and supply for a specific good.
Aggregate Demand and Supply

Figure 7-3 illustrates the aggregate demand curve for an economy. Note the labels on the axes. The
horizontal axis measures total economic output or GDP. The vertical axis uses the overall price level for
the economy as a measure of prices. The aggregate demand curve shows the relationship between the
price level and output. As the curve shows, there is an inverse relationship between prices and output.

Figure 7-4 illustrates the aggregate supply curve for an economy that has the same measures as
aggregate demand on the horizontal and vertical axis. The aggregate supply curve shows the total output
by producers of all goods and services in our economy. Note that the aggregate supply curve has a
relatively flat region that rapidly becomes vertical.
The flat section of aggregate supply is characterized by an economy with a good deal of excess capacity
or slack. The vertical section of the aggregate supply curve indicates that our economy has reached full
capacity, or potential output. Potential output is noted on the graph as Y f, or full-employment. Full
employment is consistent with an unemployment rate where all those who desire to work can find
employment. Individuals who are unemployed, are considered voluntarily unemployed.

DIONs PART

Potential output is not a static concept but changes over time as our economic capability to produce
goods and services expands. This concept is analogous to an outward shift in the production possibilities
frontier (PPF). As you may recall, the PPF shifts outward with growth in the labor supply, improvements in
technology, and the addition of new productive resources such as capital.
Figure 7-5 shows the rightward shift in aggregate supply as potential output increases along with the
economy's productive capacity. We see that the vertical portion of the aggregate supply that corresponds
to potential output has expanded. The expansion of aggregate supply is consistent with growth in the
labor force and the creation of new jobs. As a result, the level of output consistent with full-employment
moves from Yf 0 to Yf 1.
Changes in productive capacity move gradually as the factors that influence it tend to move in long-term
cycles. For example, changes in the labor supply are predominantly reflected in birth rates, which take
generations to show any substantial change. The research and development that allow for technological
change also take years to mature and be effectively implemented. Technological advancement tends to
be self-reinforcing, leading to moderate increases and decreases in the pace of change over time.

Finally, our macroeconomic equilibrium is determined by the intersection of aggregate demand and
supply. As Figure 7-6 shows, Po is the price level at equilibrium. In a macroeconomic context, the price

level can be used to indicate relative rates of inflation. Yo is the level of output (GDP) our economy
achieves at equilibrium.
Although not shown here explicitly, output growth can be used as an indicator for the unemployment rate.
In general, output expansion should lead to lower levels of unemployment. A reduction in output will
usually cause unemployment rates to rise.
As we noted above, changes in aggregate supply are relatively constant and reflect the steady expansion
of the economy's productive capacity. For the United States, we can expect an outward shift in aggregate
supply to correspond to a 3.0% annual rate of growth in potential output or productive capacity.
Given the steady growth in aggregate supply that can be expected to be relatively constant for sustained
intervals, we will focus most of our attention on economic policies that affect aggregate demand. As you
can see from the above graph, changes in aggregate demand will impact prices (inflation rates) and
unless we are at potential output, output (GDP and unemployment rates) will also change. The two most
important macroeconomic policies studied in this course are:

fiscal policy, and

monetary policy.

Changes in either fiscal or monetary policy can be expected to have little impact on the rate of change of
aggregate supply in the short run. Consequently, the focus of macroeconomics is understanding the
impact of macroeconomic policies on aggregate demand, where changes in aggregate demand affect the
economy's inflation and unemployment rates.
What about the long run you ask? Politicians, and thus economic policymakers, tend to be very myopic
or shortsighted. The health of the economy has a critical influence on the incumbent in an election. How
many politicians would be successful running on the following platform:
"I know the economy stinks, and you haven't worked since I was elected, but try to be reasonable.
Because of my foresight, legislation has been passed that should create strong economic growth by next
year, and many years thereafter; I promise."
Throughout this course, we will study the long-run consequences of economic policy. However, keep in
mind that much of the economic policy discussed here will focus on the short-run impacts on aggregate
demand, economic growth, inflation, and unemployment. In the next section we will develop the
relationship between macroeconomic policies and changes in aggregate demand during the business
cycle.
Once More to the U.S. Business Cycle
Using our graphical presentation of aggregate demand and supply, let us revisit the topic of the U.S.
business cycle of the early 1990s discussed in previously. We can begin in 1991, with the U.S. economy
mired in a recession. The unemployment rate had risen by roughly 3% since 1989, reaching 7.7% at its
maximum level. His fiscal hands tied by large deficits and facing an election in the fall of 1992, President
George Bush exhorted the Federal Reserve Board (Fed) to take counter cyclical action. Fed Chairman
Greenspan complied, lowering short-term interest rates with the intention of stimulating economic growth.
But as 1992 began, U.S. economic growth remained catatonic, barely stirring in response to falling shortterm interest rates. The problem belonged with long-term interest rates, which remained stubbornly high
due to the deficit hangover the economy was dealing with.
The Reagan-Bush budget deficits caused financial markets to add an inflationary premium to long-term
interest rates, an issue we will discuss in greater detail later on. Consequently, while the Fed was effective

in reducing short-term interest rates, long-term interest rates remained nearly unmoved. Critically, for
economic growth to respond to interest rate changes, long-term rates must decline. As the 1992 election
neared, reluctant long-term interest rates perpetuated stagnant economic growth, and President Bush
paid for the budget excesses of the previous decade.
Aggregate Demand and Supply

Figure 7-7 shows the relationship of aggregate demand to aggregate supply in early 1992. You may recall
the flat portion of the aggregate supply curve corresponds to theslack of excess capacity that an economy
builds during a recession and times of weak economic growth. The equilibrium level of output is labeled
as Y*. Note that Y* is well to the left of Yf. We use Yf to indicate full employment, which is consistent with
an unemployment rate where those who desire to work have jobs. Full employment is an indicator that an
economy is reaching full capacity utilization, or potential output.
After taking office in January 1993, President Clinton passed a budget that significantly reduced the fiscal
budget deficit. Responding to indications that budget deficits were under control, financial markets gave
President Clinton a windfall, as long-term interest rates rapidly declined by nearly 2% in early 1993.
The Fed gives a rough estimate that for every 0.10% decrease in long-term interest rates, economic
activity increases by $10 billion. Because the economy is much more responsive to changes in long-term
rates than it is to short-term rates, the decline in long-term interest rates during 1993 gave the U.S.
economy a $200 billion boost to GDP.
In 2001, the Fed went through a series of rate cuts that lowered the key interest rate that it controls from
6.5% to 1.75% by early 2002. Never before had the Fed decreased a key interest rate so quickly.

Figure 7-8 shows the stimulus that falling long-term interest rates gave to economic growth in 1993. The
growth rate of the U.S. economy picked up substantially, resulting in a significant rightward shift in
aggregate demand from ADo to AD1.
In addition to the shift in aggregate demand, aggregate supply also moved outward from AS o to AS1 due
to the continuous expansion in the productive capacity of the economy. As the graph shows, the
expansion in aggregate demand exceeded the growth in aggregate supply. Output increased from Y o to
Y1 and prices remained constant. In reality, the rate of increase in prices remains constant. This implies
that the inflation rate also did not change. If we look at prices on the vertical axis as representing changes
in the inflation rate, then the increase in aggregate demand has no impact on the rate of inflation.
It is important to distinguish the reasons for the shift in aggregate demand in contrast to changes in
aggregate supply. The general rule to follow for this course is the key influence on the business cycle is
changes in aggregate demand. Increases in aggregate demand raise economic output, GDP, and growth,
and lower unemployment. Contractions of aggregate demand have the opposite effect. Aggregate
demand is effective in changing economic growth only when aggregate demand is shifting along the
relatively flat part of aggregate supply. When aggregate demand shifts along the vertical range of
aggregate supply, changes in prices (inflation rates) are the only economic consequences.
For the most part, changes in aggregate supply are independent of the business cycle. We can assume
that the increase in aggregate supply is relatively constant over time, reflecting changes in our economy's
productive capacity and potential output.
The growth of potential output is reflected in the outward expansion of the production possibilities frontier.
As you may recall, important factors causing growth in the production possibilities frontier are increases in
resources (e.g., the labor supply) and changes in technology. It is evident that changes in the labor force
are pretty much independent of the business cycle. How many parents, when considering the conception
process, discuss the likelihood of a recession in twenty-two or so years just when the unknown child
graduates from college and enters the labor force? Certainly during recessions, some people will stay in
school or return to school, but for the most part the pool of labor struggles with diminished opportunities.
Changes in technology take time to research, develop, and implement, and progress is pretty much
independent of the business cycle.
The rate of technological progress does vary. It is possible that the annual increase in worker productivity
is rising due to the computer revolution that you, many businesses, and governments are participating in.

This is certainly an issue worth considering for the long-run expansion of a nation's potential output.
Improvements in the pace of worker productivity will increase the growth rate of aggregate supply, but
gradually, independent of the business cycle. For our purposes, we will assume that the rate of aggregate
supply growth remains constant over time (at the present time for the U.S. economy it is estimated to be
between 3% annually in real terms).

BESAS PART
The Fed Takes Away the Punch Bowl

With the catalyst created by falling long-term interest rates, economic growth accelerated throughout
1993 and into 1994, reaching a frothy 6% annual rate by the fourth quarter of 1993. Figure 7-9 shows the
situation as the U.S. economy entered 1994.
The growth rate of aggregate demand (from AD 1 to AD2) was much faster than the
intrinsic rate of growth of aggregate supply (AS1 to AS2), which was roughly 2.5%
annually in the mid-1990s. As the economy expanded, the slack present in 1992 and
1993 was absorbed and capacity utilization was rapidly approaching the Fed's warning
track of about 84%. Aggregate demand was reaching the vertical portion of the aggregate
supply curve. As our economy reached potential output, warning signals were triggered. If
aggregate demand continued to grow faster than aggregate supply, the inflation rate
would soon accelerate upward.
Figure 7-9 above shows the rate of growth in aggregate demand exceeding the growth
rate of aggregate supply. As aggregate demand shifts outward along the flat part of
aggregate supply, excess capacity is soaked up, idled machinery is put back into use and
unemployed workers are hired. The growth rate of aggregate demand exceeds the rate at
which productive capacity is added to the economy. Inflationary thoughts send chills
down the hardy spines of economic policymakers.
In the graph, prices increase by a modest amount from P1 to P2. Since the actual rate of
inflation remained constant during this time, we can consider the price increase shown in
the graph a representation of inflationary pressures that were building at the time due to
the elimination of economic slack. Whether it represents actual or anticipated inflation,

the price increase leads (will lead) to higher inflation unless the growth rate of aggregate
demand is reduced.
As 1994 began, the economic party was in full swing for businesses and investors. Labor
enjoyed lower unemployment rates, yet wage gains were stifled for many. Fortunately,
inflation was increasing at an annual rate below 3%, so despite almost stagnant incomes,
workers were not losing the purchasing power that high inflation often erodes. The Fed
feared than if aggregate demand continued to grow at the pace of late 1993 and early
1994, inflation would soon result as economic bottlenecks increased. Thus the Fed
initiated a series of interest rate hikes to slow the growth rate of aggregate demand.
The Goldilocks Economy
This section begins with the story of Goldilocks and the three bears, a book most of us pick up on a regular
basis. As you may recall, momma bear liked her porridge on the cool side, papa bear wanted his porridge
piping hot. Baby bear liked it, not too hot nor too cool, but just right.
We can think of the conduct of economic policy by the Federal Reserve in the same way. If the economy
gets too hot, higher inflation is the result. Too cool, and jobs are lost, perhaps even a recession. Just right
implies that the economy is at full employment and inflation is not a problem. This is the characterization
of the US economy during the second half of the 1990s. In this case, the growth rate or speed limit of the
economy is determined by the annual supply side growth rate (e.g. 3%) and aggregate demand growth is
adjusted by the Federal Reserve to keep pace.
Assuming that the economy is at full employment, if aggregate demand growth starts to exceed the growth
rate of aggregate supply, inflationary pressures start to build (inflation rates may even have already picked
up), the economy is too hot and the Fed puts the brakes on by rising interested rates to slow down the
pace of aggregate demand growth. In contrast, if aggregate demand growth starts to lag behind the growth
rate of aggregate supply, the economy is cooling off and the Fed want to pick up the pace by reducing
interest rates. Things are just right when the annual growth rate of aggregate demand is about equal to the
annual supply side growth rate (assuming full employment and low inflation).
The key point to remember is that the determinant of long run growth is the annual
expansion of aggregate supply (shown earlier in the course by the production possibilities
frontier). Once full employment is reached, aggregate demand (GDP) cannot grow
appreciably faster than aggregate supply without causing higher inflation rates.
If the annual pace of aggregate supply picks up, for example from 3% to 4% annually, then
this also allows for non-inflationary growth of aggregate demand to increase from 3% to 4%
per year.
If the annual pace of aggregate supply drops, for example from 3% to 2% annually, then
aggregate demand must decrease from 3% to 2% per year or inflation will be the
consequence.

Figure 7-10 shows the mythical soft landing that the Fed was trying to achieve in the mid-1990s. The goal
was to have the growth rates of aggregate demand and aggregate supply in harmony, a situation known
as noninflationary growth. Once aggregate demand reaches the area of potential output (the steep part
of the aggregate supply curve), the Fed will fine-tune the growth rate of aggregate demand to equal the
growth rate of potential output or aggregate supply. Graphically, the shift from AD 2 to AD3 will match the
shift from AS2 to AS3.

Figure 7-11 above shows the business cycle that the U.S. economy experienced in the early 1990s. We
begin with the mild recession of 1991. This prompted Federal Reserve interest rate cuts, but the large
budget deficit resulted in an anemic recovery during 1992. It was only after a significant reduction in the
budget deficit in 1993 that long-term interest rates fell noticeably and economy growth accelerated. Rapid
growth triggered new inflationary fears as the economy neared full capacity utilization and fullemployment, prompting the Fed to raise interest rates throughout 1994. As desired, economic growth
tapered off during 1995 and into 1996. Rather than repeating the usual boom-bust cycle of growth
followed by a recession, the Fed achieved a soft landing in 1996.
As noted earlier, economic policymakers have three goals:

to minimize the inflation rate (but not negative),

to minimize the unemployment rate to a level consistent with full employment,

and to maintain a steady, non-inflationary growth rate of GDP.

In other words, the goal is to obtain and then maintain the Goldilocks economy. In this case, the Federal
Reserve will both increase and decrease interest rates in an attempt to fine-tune aggregate demand
growth so that it is just equal to the growth rate of aggregate supply from one year to the next.
For example, if aggregate supply is growing at 3% per year (equal to 1% growth in the labor force plus
2% growth in worker productivity), then the Federal Reserve would like to maintain aggregate demand
growth at an equivalent rate. Figure 7-12 illustrates this point.
Just because a recession ends and the recovery begins, there is no
guarantee that the unemployment rate will start to decrease it may even
continue to rise as it did during the recession.
To understand this concept, remember that a countrys supply side growth
rate increases independent of the business cycle. For example, in the
United States annual supply side growth is about 3% a year, boom or bust.
Regardless of economic conditions on the demand side, people graduate
from high school or college and enter the labor force. Not many Americans
can or want to postpone their high school or college graduation just
because the job market is poor. Additional, the pace of technology is not
going to be very sensitive to the business cycle. Most technological
improvements are the result of years of research and work.
As with the United States in 2002, assume that the economy is
experiencing a relatively weak recovery. If aggregate demand (GDP)
growth is positive, but only about 1% or 2% for the year, the recession will
have ended, but the pace of aggregate demand growth will be lagging
behind the economys supply side growth rate (aggregate supply). In this
case, the unemployment rate is likely to rise during the weak recovery. The
pace of job creation is not keeping up with increases in the labor force and
gains in worker productivity. If workers are more productive, fewer workers
are needed to produce the same amount of output.
For the unemployment rate to decline during a recovery, the annual rate of
aggregate demand must exceed the growth rate of aggregate supply. Only
then will new jobs be created leading to a decrease in the unemployment
rate.
A Change Takes Place: The 2001 Recession
To summarize, this unit has covered what is a typical business cycle. As the economy continues to grow,
inflationary pressures build and if left unchecked, eventually the inflation rate will start to rise. In response
to the higher inflation rate, the Federal Reserve puts the brakes on growth by rising interest rates.
Historically, the result is a recession that eliminates the problem of inflation, but leads to an increase in
the unemployment rate. The Federal Reserve cuts interest rates and economic growth perks up.
In a typical business cycle, the downturn into a recession starts with higher inflation.

The inflation is a result of strong demand for goods and services or a supply side
shock that increases production costs for firms.
Beginning in the 1990s, the Federal Reserve improved its ability to fine-tune the economy and the
Goldilocks economy developed. From 1993 until 2001, the U.S. economy experienced a recond-setting
period of uninterrupted economic growth without a hint of a recession. When recession returned to the
U.S. economy in 2001, the primary catalyst was not higher inflation but excess capacity in industry. For
the first time since the early part of the 20th Century, the U.S. economy experienced anInvestment-led
recession. As the U.S. economy dropped into the 2001 recession, inflation remained at a low level and the
Federal Reserve was rapidly lowering interest rates. However, due to excess industrial capacity, firms did
not increase investment as rates fell, instead, they continued to reduce investment in new capital.
For an example of excess capacity, consider an hypotetical auto firm and assume that the firm has four
factories that are fully stocked with capital equipment (assembly-line robots, computers, etc.). Due to
slowing demand for cars, the firm only has to use three of the factories to satisfy consumer demand and
idles the fourth factory. Capacity utilization for the firm is 75%. Lower interest rates will have minimal
effect on business investment as firms already have all of the capital that they need to meet consumer
demand.
As the Federal Reserve lowered interest rates in 2001, there was little stimulus provided due to the
widespread capital overcapacity of U.S. firms. As consumer demand weakened, firms continued to reduce
their new capital orders and dropping invesment led the U.S. economy into the 2001 recession. With
monetary policy ineffective, it was up to the use of fiscal policy to help restore positive economic growth.