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AS-AD and the Business Cycle

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AS-AD and the Business Cycle Chapter AS-AD and the Business Cycle CHAPTER OUTLINE 1. Provide a technical definition of recession and describe the history of the U.S. business cycle and the global business cycle. A. Dating Business-Cycle Turning Points B. U.S. Business-Cycle History C. Recent Cycles 2. Explain the influences on aggregate supply. A. Aggregate Supply Basics 1. Why the AS Curve Slopes Upward a. Business Failure and Startup b. Temporary Shutdowns and Restarts c. Changes in Output Rate 2. Production at a Pepsi Plant B. Changes in Aggregate Supply 1. Changes in Potential GDP 2. Changes in Money Wage Rate and Other Resource Prices 3. Explain the influences on aggregate demand. A. Aggregate Demand Basics 1. The Buying Power of Money 2. The Real Interest Rate 3. The Real Prices of Exports and Imports B. Changes in Aggregate Demand 1. Expectations 2. Fiscal Policy and Monetary Policy 3. The World Economy C. The Aggregate Demand Multiplier 4. Explain how fluctuations in aggregate demand and aggregate supply create the business cycle. A. Aggregate Demand Fluctuations B. Aggregate Supply Fluctuations C. Adjustment Toward Full Employment 710 Part 10 . ECONOMIC FLUCTUATIONS CHAPTER ROADMAP What’s New in this Edition? Chapter 29 is now the first chapter in which the students en‐ counter the AS‐AD model. This chapter now uses some of the material from the second edition’s Chapter 23 introduc‐ tion to AS‐AD to explain the beginning about aggregate supply and aggregate demand. The connection between the AS‐AD model and business cycle has been rewritten and made even more straightforward for the students. Where We Are In this chapter, we provide a definition of recession and de‐ scribe the history of the U.S. business cycle over the past 150 years. In addition, we introduce and then explain the influ‐ ences on both aggregate supply and aggregate demand. Lastly, we use aggregate demand and aggregate supply to explain how fluctuations in them create the business cycle. Where We’ve Been This chapter moves away from long‐run economic growth, covered in Chapters 23 to 25, and the monetary economy, covered in Chapters 26 to 28 to focus on business cycles and the AS‐AD model. Where We’re Going The next chapter looks at aggregate expenditure to develop more insight into aggregate demand. The AS‐AD model is also used to help explain policy debates in Chapter 33. IN THE CLASSROOM Class Time Needed Although it might be possible to cover the material in this chapter in two class sessions, it is sufficiently important and challenging that spending at least two and one half class periods is a good investment. Depending on the current state of the economy, you can spend upwards of three or more class periods on it! An estimate of the time per checklist topic is: • 29.1 Business‐Cycle Definitions and Facts—20 to 25 minutes • 29.2 Aggregate Supply—30 to 40 minutes • 29.3 Aggregate Demand—30 to 40 minutes • 29.4 Understanding the Business Cycle—40 to 50 minutes Chapter 29 . AS-AD and the Business Cycle 711 CHAPTER LECTURE 29.1 Business-Cycle Definitions and Facts • The business cycle consists of a peak, recession, trough, and expansions. • A standard definition of a recession is a decrease in real GDP that lasts for at least two quarters (six months). The NBER (National Bureau of Economic Research) uses a broader definition of recession to date business‐cycle turning points. It defines a recession as “a period of significant decline in total output, income, employment, and trade, usually last‐ ing from six months to a year, and marked by widespread contractions in many sectors of the economy.” U.S. Business-Cycle History • The NBER has identified 33 complete cycles starting from a trough in December 1854. • Since 1854, the average length of an expansion is 35 months and the average length of a recession is 18 months. During the years since World War II, the average recession short‐ ened to 11 months and the average expansion lengthened to 59 months. • After a recession that ran from July 1990 to March 1991, the U.S. economy entered a re‐ cord‐breaking expansion that lasted 120 months until March 2001 when the economy en‐ tered a recession. The trough was reached in the 3rd quarter of 2001, after which the economy has been in an expansion. 29.2 Aggregate Supply Real GDP depends on labor, capital, technology, land, and entrepreneurial talent. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP. When the quantity of labor demanded equals the quantity of labor supplied, there is full employment in the labor market and real GDP equals potential GDP. Aggregate Supply Basics • The aggregate supply curve is the re‐ lationship between the quantity of real GDP supplied and the price level when all other influences on produc‐ tion plans (the money wage rate, the prices of other resources, and poten‐ tial GDP) remain constant. • As illustrated in the figure, the AS curve is upward sloping. This slope reflects that a higher price level com‐ bined with a fixed money wage rate, lowers the real wage rate, thereby in‐ creasing the quantity of labor em‐ ployed and hence increasing real GDP. 712 Part 10 . ECONOMIC FLUCTUATIONS Why the AS Curve Slopes Upward • When the price level changes, three reactions create the positive relationship between the price level and quantity of real GDP supplied: • Business Failure and Startup: Real GDP changes when the number of firms in business changes. If the price level rises relative to costs, profits increase, the number of firms in business increases, and the quantity of real GDP supplied increases. • Temporary Shutdowns and Restarts: The price level relative to costs is an influence on temporary shutdown decisions. If the price level rises relative to costs, fewer firms will decide to shut down, so more firms operate and the quantity of real GDP sup‐ plied increases. • Changes in Output Rate: When the price level rises and the money wage rate doesn’t change, the quantity of labor demanded increases and production increases. Changes in Aggregate Supply • When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the AS curve. The AS curve, however, does not shift. • When potential GDP increases, aggregate supply increases and AS curve shifts right‐ ward. The potential GDP line also shifts rightward. • Short‐run aggregate supply changes and the AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other re‐ source prices decreases short‐run aggregate supply and shifts the AS curve leftward. In this case, the potential GDP line does not shift. 29.3 Aggregate Demand The quantity of real GDP demanded is the sum of consumption expenditure (C ), investment (I ), government expenditures (G ), and net exports (X − M ), or Y = C + I + G + (X − M ). Aggregate Demand Basics • The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. • As the figure shows, the AD curve is downward sloping. Moving along the aggregate demand curve the only thing that changes is the price level. Chapter 29 . AS-AD and the Business Cycle 713 Why the AD Curve Slopes Downward • The negative relationship between the price level and the quantity of real GDP de‐ manded reflects three factors: • Buying Power of Money: When the price level rises, the buying of money decreases and so people decrease consumption expenditure. • Real Interest Rate: When the price level rises, the demand for money increases, which raises the nominal interest rate. Because the inflation rate does not immediately change, the real interest rate also rises so that people decrease their consumption ex‐ penditure and firms decrease their investment. • Real Price of Exports and Imports: When the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded. Changes in Aggregate Demand • Any factor that influences expenditure plans other than the price level changes aggregate demand and shifts the aggregate demand curve. Factors that change aggregate demand are: • Expectations: Expectations of higher future income, expectations of higher future in‐ flation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward. • Fiscal policy and monetary policy: The government influences the economy by setting and changing taxes, making transfer payments, and purchasing goods and services, which is called fiscal policy. Tax cuts, increased transfer payments, or increased gov‐ ernment purchases increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand. • The world economy: Exchange rates and foreign income affect net exports (X − M ) and, therefore, aggregate demand. A decrease in the exchange rate or a an increase in for‐ eign income increases aggregate demand. Aggregate Demand Multiplier • An initial change in expenditure is magnified by the aggregate demand multiplier so that aggregate demand changes by a multiple of the initial change. 29.4 Understanding the Business Cycle Macroeconomic Equilibrium • Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. • If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices.
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