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Home , Aggregate demand, Aggregate supply, Business cycle

Chapter THE 15 CYCLE*

Key Concepts FIGURE 15.1 Keynesian Theory

„ Cycle Patterns, Impulses, and Mechanisms 140 The is the irregular and nonrepeating up- and-down movement of business activity. The average 130 lasts a bit more than one year, and GDP falls

6 percent from peak to . The average expansion lasts almost four years, and GDP rises 22 percent from 120 SAS trough to peak. ♦ Some cycles (e.g., tennis matches) require impulses 110 AD0 to start each cycle. ♦ Some cycles (e.g., sunrise and sunset) reflect the 100

design of the system. level (GDP deflator, 1996 = 100) AD ♦ Some cycles (e.g., rocking horses) combine im- 1 pulses and design. 7891011 and accumulation play key roles in Real GDP (trillions of 1996 dollars) the business cycle. occur when investment decreases; expansions occur when investment increases. Business cycles can be classified as aggregate ♦ The Keynesian mechanism has two aspects. First, a theories and real business cycle theory. change in investment has a effect on ag- gregate demand. Second, the short-run aggregate „ Theories curve is horizontal, so, as illustrated in Fig- of the Business Cycle ure 15.1, shifts in the AD curve have a large effect on GDP. The Keynesian theory of the business cycle regards ♦ volatile expectations as the main source of economic The response of is asymmetric; wages fluctuations. do not fall in response to decreases in aggregate demand but they do rise in response to increases in ♦ The Keynesian impulse is changes in firms’ expec- aggregate demand. Hence the can remain tations about future sales and profits. This change stuck in a recession. affects investment.

* This is Chapter 30 in Economics.

227 228 CHAPTER 15 (30)

expected aggregate demand. The recession ends FIGURE 15.2 when aggregate demand increases back to expected Monetarist and Theory aggregate demand. 140 ♦ The new classical theory asserts that only unex- pected changes in aggregate demand affect real SAS 130 rates and GDP. ♦ The new Keynesian theory asserts that labor con- tracts allow money wages to change only slowly. A 120 change in aggregate demand that was unanticipated when the labor contract was signed will affect real 110 wages and GDP even if, when the event actually AD0 occurs, it has come to be anticipated.

100 „ Real Business Cycle Theory (GDP deflator, 1996 = 100) The real business cycle theory (RBCRBCRBC) regards random AD1 fluctuations in as the main source of eco- 7891011 nomic fluctuations. Real GDP (trillions of 1996 dollars) ♦ The impulse in RBC theory is technological changes that affect the growth rate of productivity. The monetarist theory of the business cycle regards ♦ The RBC mechanism is a change in productivity fluctuations in the money stock as the main source of that affects investment demand and labor demand. economic fluctuation. During a recession, both decrease. The decrease in ♦ The impulse in the monetarist theory is changes in investment demand lowers the real rate, so the growth rate of the quantity of money. the intertemporal substitution effect decreases the ♦ The monetarist mechanism is changes in the growth supply of labor. As illustrated in Figure 15.3, the rate of the quantity of money that shift the AD LAS curve shifts leftward and de- curve. The economy moves along an upward- creases. The AD curve shifts leftward because of the sloping SAS curve, as is illustrated in Figure 15.2, decrease in investment. GDP decreases and the for a decline in the monetary growth rate. Aggre- price level falls. gate demand decreases from ),0 to ),1. ♦ Eventually, money wages respond to the change in FIGURE 15.3 the price level so that the SAS curve shifts and the Real Business Cycle Theory economy returns to potential GDP. 140 LAS1 LAS0 A rational expectation is a forecast based on all avail- able information. Rational expectations theories of 130 business cycles focus on the rationally expected money wage rate. The two rational expectations theories are the new classical theory and new Keynesian theory... 120 ♦ The impulse in the new classical theory is unantici-

pated changes in aggregate demand. 110 ♦ The major impulse in the new Keynesian theory is AD0 unanticipated changes in aggregate demand, but 100

anticipated changes also play a role. Price level (GDP deflator, 1996 = 100) ♦ The rational expectations mechanism is an unex- AD1 pected shift in the AD curve that moves the econ- omy along its SAS curve as real wage rates change. 7891011 Figure 15.2 illustrates the effect of an unexpected Real GDP (trillions of 1996 dollars) decrease in aggregate demand to ),1. ),0 is the THE BUSINESS CYCLE 229

Criticisms of the RBC theory are that: ♦ Investment fell, which was the (only) source of the ♦ Money wages are sticky. decrease in aggregate demand. Both aggregate de- ♦ The intertemporal substitution effect is too weak to mand and decreased so that the account for large fluctuations in employment. price level and real GDP decreased. ♦ ♦ Technology shocks are implausible as an impulse Even though employment and aggregate hours fell, that causes a business cycle. labor productivity and the real wage rate both in- creased during 2001. The increase in labor pro- ♦ Productivity shocks, as measured, are correlated ductivity and the real wage rate were greater than is with factors that change aggregate demand. typical during a recession. Defenses of the RBC theory are that: ♦ It explains both business cycles and economic „ The growth. ♦ It seems to be consistent with microeconomic data The Great Depression of the 1930s led to a decline in concerning labor supply, labor demand, and in- real GDP of 29 percent and an increase in the unem- vestment demand. ployment rate from 3.2 percent to 25 percent. ♦ ♦ Money is correlated with productivity shocks be- The initial source of the Great Depression was un- cause changes in real GDP change the quantity of certainty and pessimism, which reduced investment money. and expenditure on durable . ♦ It suggests that efforts to smooth the business cycle disagree about why the initial recession might harm the economy. turned into the Great Depression. Two hypotheses have been advanced: ♦ Aggregate demand continued to decrease because of „ Expansion and Recession and pessimism. During the 1990s and ♦ failures and the collapse of the quantity of The longest expansion in U.S. history was from March money caused aggregate demand to decrease. 1991 through March 2001. During this expansion, The Great Depression is unlikely to occur again be- technological change, such as personal computers, cre- cause of: ated opportunities that required large amounts of ♦ Bank deposit insurance provided by the Federal investment. Deposit Insurance (FDIC). ♦ Increased investment and shifted the AD ♦ The Federal Reserve’s determination to act as the curve rightward. increased lender of last resort. potential GDP and labor productivity so the LAS ♦ curve shifted rightward. Real GDP increased sig- The larger fraction of GDP that is accounted for by nificantly and the price level rose only modestly. and spending. ♦ ♦ The U.S. expansion is similar to what the real The increased number of families that have two (or business cycle model predicts, with technological more) wage earners. change increasing investment, the demand for la- bor, and the supply of labor. In March 2001 the entered a recession. Helpful Hints At least through 2001, the recession was extremely mild. 1. THE CHALLENGE OF THE REAL BUSINESS CYCLE ♦ There were no obvious external shocks, fiscal pol- THEORY : RBC theory is based on the assumption icy changes, or changes that that the economy is always producing on its long- would have brought about the recession. The run aggregate supply curve; that is, the economy is growth rate of productivity slowed and growth in always at potential GDP. Because potential GDP is the high-tech sector slowed. So, the recession ap- also the full-employment level of GDP, the real pears similar to what the real business cycle model business cycle theory asserts that, in the labor mar- predicts. ket, wages (or other mechanisms) are sufficiently 230 CHAPTER 15 (30)

flexible so that the economy is always at full em- 16. The new Keynesian theory of the business cycle ployment. So the real business cycle theory view is stresses intertemporal substitution. that fluctuations in employment represent fluctua- Real Business Cycle Theory tions in the level of . The level of full employment changes when labor demand 17. According to the real business cycle theory, the and/or labor supply changes. For instance, a de- source of a recession is a slowdown in the growth crease in labor demand decreases the level of full- rate of the quantity of money. employment equilibrium and actual employment in 18. The real business cycle theory assumes that money the economy decreases. wages are flexible and adjust quickly. As the text indicates, the real business cycle theory 19. According to the real business cycle theory, actual of the economy is controversial. The assumptions GDP always equals potential GDP. underlying this approach seem extreme to many economists. Nonetheless, real business cycle theory Expansion and Recession During the 1990s and 2000s has had a surprising amount of success in explain- 10. Between 1991 and 2001, the United States had a ing various facts about business cycles, and a sizable sustained expansion that was the result of signifi- minority of economists believe that the real busi- cant productivity growth. ness cycle theory is a good way to analyze the busi- ness cycle. 11. In the United States, between 1991 and 2001 both potential GDP and aggregate demand increased Which group of economists is correct? At this time, and the increase in aggregate demand exceeded that it is impossible to tell because the evidence on the of potential GDP. real business cycle theory is still accumulating. But if this approach ultimately is accepted, it will repre- 12. The recession that started in 2001 was the result of sent a major change from the more conventional a decrease in government purchases and an increase aggregate demand theories. in taxes. The Great Depression Questions 13. The stock crash of 1929 was the cause of the Great Depression. 14. The existence of the Federal Deposit Insurance „ True/False and Explain Corporation reduces the likelihood that a recession Cycle Patterns, Impulses, and Mechanisms like the Great Depression could happen again. 11. Recessions start when investment slows or de- 15. One reason that a recession is unlikely to grow into creases. another Great Depression is that the government Aggregate Demand Theories of the Business Cycle sector today is much larger than it was during the 1930s. 12. Keynesian, monetarist, and rational expectations theories of business cycles assert that fluctuations in aggregate demand are the source of business cycles. „ Multiple Choice 13. The impulse in the Keynesian theory of business Cycle Patterns, Impulses, and Mechanisms cycles is a change in business’ expectations of future 11. An average recession lasts for about ____; an average sales and profits. expansion lasts for about ____. 14. In the Keynesian theory, money wages do not fall a. 1 year; 1 year in response to a decrease in aggregate demand. b. 4 years; 1 year 15. According to the new classical rational expectations c. 1 year; 4 years theory, an expected decrease in aggregate demand d. 4 years; 4 years leads to a recession. THE BUSINESS CYCLE 231

12. In an average recession, real GDP falls by about 18. Which of the following is the impulse in the new ____; in an average expansion real GDP climbs by classical business cycle theory? about ____. a. An unexpected change in aggregate demand. a. 6 percent; 6 percent b. A change by the Fed in the growth rate of the b. 22 percent; 6 percent quantity of money. c. 6 percent; 22 percent c. A change in expectations about future sales and d. 22 percent; 22 percent profits. d. A change in the growth rate of productivity. 13. Recessions begin when ____ decreases. a. consumption expenditure 19. According to the rational expectations theories, if b. investment the Federal Reserve unexpectedly reduces the quan- c. government purchases tity of money during a recession, d. exports a. nothing will happen because the recession is al- ready occurring. Aggregate Demand Theories of the Business Cycle b. the recession will tend to deepen, as aggregate 14. Which of the following is the impulse in the demand unexpectedly decreases. Keynesian business cycle theory? c. the recession will tend to end because aggregate a. An unexpected change in aggregate demand. supply unexpectedly increases. b. A change by the Fed in the growth rate of the d. the recession will tend to end because aggregate quantity of money. demand unexpectedly increases. c. A change in expectations about future sales and Real Business Cycle Theory profits. d. A change in the growth rate of productivity. 10. Which of the following is the impulse in the real business cycle theory? 15. Which theory of the business cycle has a mechanism a. An unexpected change in aggregate demand. that allows the economy to remain in a recession b. A change by the Fed in the growth rate of the indefinitely? quantity of money. a. Keynesian c. A change in expectations about future sales and b. Monetarist profits. c. New classical d. A change in the growth rate of productivity. d. New Keynesian 11. The intertemporal substitution effect refers to the 16. Which of the following is the impulse in the mone- idea that tarist business cycle theory? a. a higher real wage rate increases the quantity of a. An unexpected change in aggregate demand. labor supplied. b. A change by the Fed in the growth rate of the b. a higher real wage rate decreases the quantity of quantity of money. labor supplied. c. A change in expectations about future sales and c. a higher real increases the supply of profits. labor. d. A change in the growth rate of productivity. d. the demand for labor depends on the money wage rate, not the real wage rate although the 17. In the monetarist theory, a decrease in the growth supply of labor depends on the real wage rate. rate of the quantity of money ____ decreases GDP and ____ decreases employment. 12. By itself, an increase in aggregate demand increases a. temporarily; temporarily GDP by the least amount in the ____. b. temporarily; permanently a. Keynesian theory c. permanently; temporarily b. monetarist theory d. permanently; permanently c. new Keynesian theory d. real business cycle theory 232 CHAPTER 15 (30)

13. According to the ____ theory of business cycles, a The Great Depression change in the monetary growth rate has no effect on 19. The Great Depression was the result of a ____ shift real GDP. of the aggregate ____ curve. a. Keynesian a. leftward; supply b. monetarist b. rightward; supply c. new Keynesian c. rightward; demand d. real business cycle d. leftward; demand

14. Which of the following is NOT a criticism of the 20. According to monetarists such as , real business cycle theory? the Great Depression was the result of a. The impulse assumed for the real business cycle a. the crash of 1929. theory is implausible. b. a massive contraction of the quantity of money, b. The long-run aggregate supply curve is vertical. leading to large decreases in aggregate demand. c. Money wages are sticky. c. an expansion of the quantity of money, leading d. The changes in productivity ascribed to technol- to higher . ogy actually are caused by aggregate demand. d. loss of business and .

Expansion and Recession During the 1990s and 2000s 21. In which episode was there a wave of bank failures? 15. The length of the 1991–2001 expansion in the a. The Great Depression of the 1930s. United States was b. The Minor Recession of the 1970s. a. somewhat shorter than the average expansion. c. The recession of 2001. b. somewhat longer than the average expansion. d. Both the Great Depression of the 1930s and the c. equal to the length of the average expansion. recession of 2001. d. longer than any other expansion in U.S. eco- nomic history. 22. The Federal Deposit Insurance Corporation (FDIC) a. keeps reserve requirements high so that 16. The expansion in the United States during the can meet large withdrawals. 1990s most closely resembles the type of expansion b. loans reserves to banks. predicted by the ____ theory. c. insures deposits, thereby reducing the incentive a. Keynesian for depositors to make large withdrawals from b. monetarist banks expected to fail. c. new Keynesian d. insures banks against bad loans. d. real business cycle 23. During the Great Depression, the Federal Reserve 17. The U.S. recession that started in 2001 was the re- ____ the discount rate and allowed the quantity of sult of money to ____. a. . a. lowered; expand b. monetary policy. b. lowered; contract c. an adverse external . c. raised; expand d. a slowdown in productivity growth that lead to a d. raised; contract decrease in investment. 24. Multi-income families reduce the probability of 18. During the U.S. recession that started in 2001, the another Great Depression by aggregate shifted ____ and the aggre- a. reducing the probability of everyone in the fam- gate supply curve shifted ____. ily being simultaneously unemployed. a. rightward; rightward b. investing more in the economy. b. rightward; leftward c. paying more taxes. c. leftward; rightward d. increasing fluctuations in consumption expen- d. leftward; leftward diture. THE BUSINESS CYCLE 233

„ Short Answer Problems TABLE 15.1 FIGURE 15.4 Theories and Impulses Short Answer Problem 1 Theory Impulse 140 SAS1 SAS2 Keynesian

130 Monetarist New classical 120 SAS3 New Keynesian Real business cycle 110 4. Complete Table 15.1 by listing the impulse that AD0 100 each theory stresses as the primary cause of eco- Price level (GDP deflator, 1996 = 100) nomic fluctuations. 5. What is the basic controversy among economists about the behavior of the labor market during a re- 8 9 10 11 12 Real GDP (trillions of 1996 dollars) cession? What is each theory’s position in this con- troversy? Why is the controversy important in terms of designing an appropriate antirecessionary 1. Figure 15.4 shows the initial aggregate demand ? curve, ),0, and three aggregate supply curves. 6. What caused the recession that became the Great a. Which aggregate supply curve is consistent with Depression? What changed the recession into the Keynesian theory? Great Depression? b. Which aggregate supply curve is consistent with 7. List four important features of the U.S. economy monetarist theory? that make severe depression less likely today. Ex- c. Which aggregate supply curve is consistent with plain how each factor helps stabilize the economy. real business cycle theory? 8. How do government transfer payments help reduce 2. Suppose that the aggregate demand curve in Figure the severity of a recession that are the result of an 15.4 shifts leftward by $2 trillion. unexpected decrease in aggregate demand? a. Draw this shift in Figure 15.4. b. Along which aggregate supply curve is the de- „ You’re the Teacher crease in GDP the largest? The least? c. Relate your answers to part (b) to your answers 1. “Even before I read this chapter, I thought that to problem 1. For a decrease in aggregate de- business cycles were important. But one thing that I mand, which theory predicts the largest decrease just can’t understand is why economists can’t figure in GDP? The smallest decrease in GDP? The out which theory of business cycles is correct. largest change in the price level? The smallest? That’s so important, I’d have thought they would 3. Suppose that the economy is in a recession. Further know which theory is right! Are economists stupid suppose that people now come to expect the Fed to or what?” Your friend has a rather jaundiced view respond by increasing the quantity of money. of economists’ intelligence. You would certainly like to set your friend straight about how bright a. According to the new classical theory, what is economists are by explaining why the cause(s) of the effect on real GDP and employment of the business cycles aren’t totally known. increase in the quantity of money? b. According to the new Keynesian theory, what is the effect on real GDP and employment of the increase in the quantity of money? 234 CHAPTER 15 (30)

Answers The Great Depression 13. F The might have increased uncertainty and helped spur the initial recession „ True/False Answers in 1929. However, it was not the sole cause of Cycle Patterns, Impulses, and Mechanisms the Great Depression. 11. T The data show that recessions start when 14. T By insuring deposits in banks, the FDIC relieves investment slows and expansions begin when people of the worry that if their banks fail they investment accelerates. might lose their funds. 15. T The government sector tends to stabilize the Aggregate Demand Theories of the Business Cycle economy because government purchases do not 12. T The sole exception to the focus on aggregate decline in a recession. demand is the real business cycle theory, which stresses fluctuations in aggregate supply as the „ Multiple Choice Answers source of business cycles. 13. T Because ’ expectations about future Cycle Patterns, Impulses, and Mechanisms profits can change so rapidly, Keynes called 11. c Recessions are shorter than expansions. them “animal spirits.” 12. c Generally, after each recession GDP climbs 14. T Because money wages do not fall, the economy during the next expansion to new heights. remains stuck in a recession until aggregate de- 13. b A slowing of investment “kicks off” almost all mand increases. recessions. 15. F A decrease in aggregate demand leads to a reces- sion only if it is unexpected. Aggregate Demand Theories of the Business Cycle 16. F The real business cycle theory stresses intertem- 14. c The Keynesian theory emphasizes expectations poral substitution. of future sales and profits. 15. a Because money wages are assumed not to re- Real Business Cycle Theory spond to decreases in aggregate demand, after a 17. F Monetarists assign importance to a slowdown in decrease in aggregate demand the economy re- the growth rate of the quantity of money. Real mains mired in a recession until some other fac- business cycle economists assert that changes in tor causes an increase in aggregate demand. the quantity of money do not create business cy- 16. b Monetarists assert that the major impulse in cle fluctuations. creating business cycles is changes in the growth 18. T With rapidly and efficiently adjusting money rate of the quantity of money. wages, the real business cycle theory asserts that 17. a The decline in the growth rate of the quantity of the economy is always at full employment. money causes a recession, but then, as money 19. T According to real business cycle theory, techno- wages adjust to the lower price level, the reces- logical change affects potential GDP, and it is sion ends and the economy returns to full em- fluctuations in potential GDP that result in ployment. business cycles. 18. a The new classical theory point to unexpected changes in aggregate demand as the impulse that Expansion and Recession During the 1990s and 2000s causes business cycles. 10. T The expansion between 1991 and 2001 was the 19. b According to the rational expectations theories, longest expansion in U.S. history. unexpected decreases in aggregate demand de- 11. T Both aggregate demand and potential GDP in- crease GDP. creased. The increase in aggregate demand ex- ceeded that in potential GDP, so the price level Real Business Cycle Theory rose. 10. d The real business cycle theory asserts that the 12. F The recession was the result of a slowdown in impulse leading to business cycles is changes in the growth rate of productivity. the growth rate of productivity. THE BUSINESS CYCLE 235

11. c Basically, the higher boosts the is significantly more stable than otherwise. As a return from , so, in order to earn more result, the family’s consumption expenditures are and thus save more, people increase their supply more stable. of labor when the real interest rate rises. 12. d In the real business cycle theory, a change in „ Answers to Short Answer Problems aggregate demand by itself has no effect on real 5)5 GDP; instead, it affects only the price level. 1. a. Aggregate supply curve 3 is consistent with the Keynesian view of a horizontal aggregate 13. d Real business cycle theory asserts that only real factors can affect real GDP. supply curve. 5)5 14 b The long-run aggregate supply is vertical in all b. Aggregate supply curve 2 is a monetarist, theories because it reflects potential real GDP. upward-sloping aggregate supply curve. c. Real business cycle theory assets that the econ- Expansion and Recession During the 1990s and 2000s omy is always on its vertical long-run aggregate 15. d The expansion between 1991 and 2001 was the supply, so the real business cycle aggregate sup- longest in U.S. , exceeding the ply curve is 5)51. second longest expansion, during the 1960s, by more than a year. FIGURE 15.5 16. d The expansion was created by increased produc- Short Answer Problem 2 tivity that has been the result of technological SAS1 change, factors emphasized by the real business 140

cycle theory. SAS2 17. d Neither fiscal policy nor monetary policy was the 130 source of the 2001 recession; the most likely a SAS source was the slowdown in U.S. productivity 120 3 growth that lead to a decrease in investment. 18. d Both aggregate demand and aggregate supply 110 b decreased. AD0

The Great Depression 100 c 19. d Though which factors shifted the aggregate de- Price level (GDP deflator, 1996 = 100)

mand curve is controversial, the Great Depres- AD1 sion reflected massive leftward shifts in the 7891011 aggregate demand curve. Real GDP (trillions of 1996 dollars) 20. b Monetarists point to the Great Depression as evidence that changes in monetary growth are a 2. a. Figure 15.5 shows the $2 trillion decrease in major cause of business cycles. aggregate demand. 21. a During the Great Depression the wave of bank 5)5 failures dwarfed previous experience. Since the b. Along aggregate supply curve 3 the new Great Depression, federal deposit insurance has equilibrium is at point a. The price level has eliminated bank failures as a major feature of re- stayed constant (at 120), but GDP has declined cessions. by $2 trillion. The smallest change in GDP oc- curs with aggregate supply curve 5)51. Along 22. c By insuring deposits, the FDIC helps reduce the this aggregate supply curve, the new equilibrium extent of bank failures. is at point c, so the price level falls the most 23. d Economists generally agree that the Fed’s policy (from 120 to 100), but GDP does not change. It during the Great Depression was the opposite of remains at $10 trillion. what it should have been. c. Figure 15.5 shows that for a decrease in aggre- 24. a Because not everyone in the family is likely to be gate demand, the Keynesian theory (with its new unemployed simultaneously, the family’s income equilibrium at point a) predicts the largest 236 CHAPTER 15 (30)

change in GDP and the smallest change in the mand. Monetarists also believe that the money wage price level. The real business cycle theory (with rate is sticky, but not as sticky as Keynesian and new its new equilibrium at point c) predicts the larg- Keynesian economists think. In particular, the est change in the price level and the smallest money wage rate will adjust to changes in the price change in GDP. Finally, the monetarist theory level, but not immediately, in the monetarist view. (with its new equilibrium at point b) is midway New classical economists also acknowledge some between the two extremes. stickiness in the money wage rate but less than 3. a. In the new classical theory only unexpected monetarists. However, real business cycle econo- changes in aggregate demand affect real GDP mists think that the money wage rate is flexible and and employment. If people expect the Federal quickly adjusts to changes in the price level. As a re- Reserve to increase the quantity of money, they sult, the labor market always is in equilibrium and will expect the resulting increase in aggregate changes in employment reflect changes in full em- demand. Therefore the expected change in ag- ployment. gregate demand has no effect on GDP nor on This issue has a significant implication for the de- employment. sign of an appropriate policy to respond to reces- b. According to the new Keynesian theory, even sion. If the Keynesians and new Keynesians are though the increase in quantity of money is ex- correct, expansionary monetary or fiscal policies pected, it becomes expected only after some wage might be useful in counteracting recessions because contracts have been signed. The increase in the the decrease in employment is a sign that the money quantity of money was unexpected when the wage rate is failing to adjust. However, if the real contracts were signed. Hence the expected policy business cycle position is correct (so that the decline will still increase real GDP and employment. in employment during the recession is a sign that the level of full employment has fallen), expansion- TABLE 15.2 ary monetary or fiscal policy will simply increase the Theories and Impulses rate of inflation and have no effect on real GDP or . Theory Impulse 6. The major cause of the Great Depression was a de- Keynesian Changes in expectations about crease in aggregate demand, which was the conse- future sales and profits quence of reduced investment and consumer Monetarist Changes in the monetary expenditure (especially on durable goods), owing to growth rate uncertainty and pessimism. However, these changes New classical Unexpected changes in created only a “typical” recession, not the Great aggregate demand Depression. The reason(s) for the recession’s wors- New Keynesian Changes in aggregate demand ening are controversial. Some economists contend that were unexpected when that further decreases in aggregate demand caused labor contracts were signed by uncertainty led to the Great Depression. Other Real business cycle Changes in productivity growth economists assert that the Federal Reserve failed to act in a timely and proper manner. In particular, 4. Table 15.2 shows the impulse that each theory these economists point to the massive contraction in stresses as the primary source of economic fluctua- the quantity of money and the waves of bank fail- tions. ures as the factors that converted a recession into the 5. Economists disagree about the speed with which the Great Depression. money (and hence also the real) wage rate adjusts in 7. Four important features of the U.S. economy that the labor market. make severe depression less likely today are that: Some economists (Keynesians and new Keynesians) 1. bank deposits are insured; believe that the money wage rate is sticky and ad- 2. the Federal Reserve is better prepared to be the justs only slowly to price level changes; indeed, “lender of last resort”; Keynesian economists think that the money wage 3. taxes and are a larger frac- rate does not adjust to decreases in aggregate de- tion of GDP; and THE BUSINESS CYCLE 237

4. multi-income families are more economically „ You’re the Teacher secure. 1. “Look, economists really are smart. They’re working The first two reasons make a collapse of the quan- on something that is incredibly complex. Let me give tity of money and the banking system much less you an example: Economists would like to know likely today. With deposit insurance, bank failures how much a change in the quantity of money affects do not feed on each other; that is, if a bank fails to- real GDP. Think of all the different possibilities. day, its depositors are not afraid that they will lose Man! Keynesians and monetarists say that changes all the deposits that have entrusted to the bank. in the quantity of money can have large effects. Ra- Hence bank failures do not feed on each other. The tional expectations economists think that only un- fact that the Federal Reserve is more determined to expected changes can affect real GDP. And the real play an active “lender of last resort” role means that, business cycle theory says that changes in the quan- when banks need emergency funds, the Fed will tity of money have no effect. Just like you said, this loan them the funds rather than allow the bank to range of answers sure covers all the bases! fail. Consequently, for both reasons, a massive wave of bank failures and contraction of the quantity of “But, think about what we’d have to do to deter- money, as occurred during the Great Depression, is mine which answer is correct: Basically, we’d have unlikely. to change the quantity of money and nothing else. That is, government spending couldn’t change, the The larger size of the government sector helps stabi- price of oil couldn’t change, technology couldn’t lize aggregate demand. Government purchases do change — nothing could change. If any of these not (automatically) decline during recessions, so ag- other things varied, real GDP might change because gregate demand might decrease less. As income falls of that factor, not because of the change in the during a recession, so too do income taxes, which quantity of money. If we could conduct this type of helps moderate the drop in disposable income and ‘controlled’ experiment, we could figure out exactly thus stabilizes consumption expenditure. how changes in the quantity of money affected real Finally, the increased number of multi-income GDP. Do you think anyone will get to conduct this families also helps stabilize the economy. In a multi- experiment? Of course not! So economists have to income family, when one worker becomes unem- try to disentangle all the different things that affect ployed during a recession, the family still has in- real GDP and unemployment. All these things — come from its other wage earner(s). So this family’s taxes, government spending, technology, oil , consumption expenditures do not decrease as much interest rates, and the quantity of money — change during a recession and overall consumption expen- every day, and each might have an impact on GDP. diture — and hence aggregate demand — becomes Isolating the effect of any one of them is nearly im- more stable. possible. 8. When a recession arises, unemployment increases “Economists do the best they can because they and disposable income declines. Less disposable in- know the importance of figuring out which theory is come leads to a reduction in consumption expen- right. And, you know, I think that working on this diture, which has a further multiplier effect issue might actually be a real kick; I’m thinking (negatively) on aggregate demand. Transfer pay- about switching majors to economics! Becoming an ments reduce the secondary effects of a recession by can give me to chance to really help make reducing the amount by which disposable income a bunch of people’s lives a lot better off. So, if I falls. As incomes fall and unemployment increases, switch majors, you know that economists have to be government transfer payments increase in the form really smart!” of higher or other welfare payments. As a result, the decline in both disposable income and consumption are reduced. 238 CHAPTER 15 (30)

Chapter Quiz 16. In real business cycle models, business cycles exist because of a. repeated shocks to technology. 11. At the onset of a recession, ____ typically decreases. b. policy errors by the Federal Reserve. a. consumption expenditure c. repeated changes by Congress in rates. b. investment d. frequent changes in labor supply. c. government purchases d. net exports 17. In the 1990s, the U.S. economy experienced a the longest expansion in U.S. history. 12. Which theory assumes that money wages rates will b. one of the most severe recessions in U.S. history. not fall in a recession? c. several complete business cycles. a. The Keynesian theory. d. None of the above answers is correct. b. The monetarist theory. c. The new classical theory. 18. The Great Depression occurred in d. The real business cycle theory. a. the 1930s. b. the 1940s. 13. Which theory assumes that the major cause of a c. the 1970s. business cycle expansion is an increase in the mone- d. the 1980s. tary growth rate? a. The Keynesian theory. 19. During the Great Depression, GDP fell by b. The monetarist theory. approximately c. The real business cycle theory. a. 2 percent. d. None of the above. b. 11 percent. c. 19 percent. 14. Which theory focuses on shifts in aggregate supply d. 29 percent. as the source of economic fluctuations? a. The Keynesian theory. 10. Which of the following makes another Great b. The monetarist theory. Depression less likely? c. The new classical theory. a. The fact that the MPC is lower in recent years. d. The real business cycle theory. b. The fact that the MPC is higher in recent years. c. The existence of FDIC insurance for bank de- 15. In which theory can a factor that was expected when posits. a labor contract was signed have no effect on GDP? d. The fact that disposable income is higher in re- a. The Keynesian theory. cent years. b. The monetarist theory. c. The new Keynesian theory. d. None of the above.

The answers for this Chapter Quiz are on page 310