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Chapter 08:
The Business Cycle
McGraw-Hill/Irwin
8-2
Learning Objectives
08-01. Know the major macro outcomes
and their determinants.
08-02. Know why the debate over macro
stability is important.
08-03. Know the nature of aggregate
demand (AD) and aggregate supply (AS).
08-04. Know how changes in AD and AS
affect macro outcomes.
8-4
Stable or Unstable?
Prior to the 1930s, conventional wisdom
was a market-driven economy, which
was inherently stable.
Business cycles (ups and downs in the
economy) were short-lived, and the market
seemed to correct (regulate) itself.
There was no need for government
intervention that is, the prevailing view
dictated a policy of laissez faire..
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A Self-Regulating Economy
Classical economics: the economy selfadjusts to any deviations from its longterm growth trend.
In this view, wages and prices are flexible.
If there are excess goods, the producer can
Lower prices and sell more, eliminating excess goods.
Decrease output and lay off workers. Laid-off workers
compete for jobs by asking for lower wages. At lower
wages, firms will hire more workers.
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A Self-Regulating Economy
Says Law: supply creates its own
demand.
Whatever was produced would be sold.
All workers who sought employment would
be hired.
This would occur because people have time
to adjust prices and wages downward.
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Macro Failure
The self-adjustment mechanism did not
work during the Great Depression.
John Maynard Keynes analyzed the
situation and concluded that self-adjustment
could not occur because of an insufficiency of
effective demand.
He asserted that a market-driven economy
was, in fact, inherently unstable.
Government Intervention
For an underperforming economy, Keynes
proposed that the government intervene to
By more output.
Employ more people.
Provide more income transfers.
Make more money available.
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Business Cycle
The four parts of a
modern business cycle
are
The peak, where GDP
maximizes.
Recession, where GDP
declines.
The trough, where GDP
minimizes.
Recovery, where GDP
increases.
The growth rate averages 3%, but the economy fluctuates around
that average, occasionally achieving negative GDP growth, or
decline.
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Aggregate Demand
Aggregate demand (AD): the total
quantity of output (real GDP) demanded
at alternative price levels in a given
time period, ceteris paribus.
The collective behavior of all buyers in the
marketplace.
It comprises all goods and services.
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Aggregate Supply
Aggregate supply (AS): the total
quantity of output (real GDP) producers
are willing and able to supply at
alternative price levels in a given time
period, ceteris paribus.
The collective behavior of all suppliers (sellers)
in the marketplace.
It comprises all goods and services.
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Macro Equilibrium
AS and AD summarize
the market activity of
the macro economy.
Macro equilibrium:
the combination of price
level and real output
that is compatible with
both AD and AS.
Where AD and AS
intersect.
at PE and QE.
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Macro Failures
Let QF be the goal of
full-employment
GDP.
The equilibrium
output QE is
undesirable; it does
not reach our macro
goal.
Also, AD and AS can
shift, meaning that
any equilibrium can
be unstable.
8-25
AS Shifts
AS will shift left if
Business costs rise.
Business taxes rise.
Natural disaster occurs.
On the graph, AS
shifts left away from
full-employment GDP.
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AD Shifts
AD will shift left if
Sending decreases.
Expectations get worse.
Taxes increase.
On the graph, AD
shifts left away from
full-employment GDP.
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Short-Run Instability:
Competing Theories
Classical economists believe the
economy will self-regulate and gravitate
toward full employment.
Keynes and his followers do not believe
this. They believe the economy might get
worse without government intervention.
In addition, there are controversies about
the shape of AS and AD and the potential
to shift these curves.
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Keynesian Theory
This is a demand-side theory.
A recession originates with a deficiency of
spending.
AD is too far to the left.
Policy: increase government spending to shift AD
back to the right.
Monetary Theory
This is also a demand-side theory.
Emphasizes the role of money in financing AD.
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Demand-Side Theories
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Supply-Side Theory
A shift in AS to the left causes output and
employment to decrease and inflation to
increase.
This problem cannot be corrected by shifting
AD.
Shift AD right and unemployment falls but inflation
worsens.
Shift AD left and inflation is reduced but
unemployment rises.
Supply-Side Theories
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Long-Run Self-Adjustment
Advocates argue that short-run instability
is not as important as the long-run trend in
economic growth.
Relies on the view that the economy can selfadjust.
Once it adjusts to a short-run deviation, the
economy will return to its long-run growth path.
Long-Run Self-Adjustment
The long-run AS curve is
vertical at the natural
rate of output.
The implication is that
shifts in AD will affect
prices but not output in the
long run.
If AD1 shifts to AD2, prices
rise but output stays at QN.
Why no increase in output?
As prices rise, short-run
profits grow, but so do costs,
wiping out the new profits.
This kills the incentive to
increase output.
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