Chapter THE BUSINESS 15 CYCLE* Key Concepts FIGURE 15.1 Keynesian Theory Cycle Patterns, Impulses, and Mechanisms 140 The business cycle is the irregular and nonrepeating up- and-down movement of business activity. The average 130 recession lasts a bit more than one year, and GDP falls 6 percent from peak to trough. 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. Price level (GDP deflator, 1996 = 100) AD ♦ Some cycles (e.g., rocking horses) combine im- 1 pulses and design. 7891011 Investment and capital accumulation play key roles in Real GDP (trillions of 1996 dollars) the business cycle. Recessions occur when investment decreases; expansions occur when investment increases. Business cycles can be classified as aggregate demand ♦ The Keynesian mechanism has two aspects. First, a theories and real business cycle theory. change in investment has a multiplier effect on ag- gregate demand. Second, the short-run aggregate Aggregate Demand Theories supply 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 money wages 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 economy 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 Rational Expectations Theory aggregate demand. 140 ♦ The new classical theory asserts that only unex- pected changes in aggregate demand affect real SAS 130 wage 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 Price level (GDP deflator, 1996 = 100) The real business cycle theory (RBCRBCRBC) regards random AD1 fluctuations in productivity 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 interest 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 employment 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 aggregate supply 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 Great Depression 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 consumption expenditure on durable goods. ♦ It suggests that efforts to smooth the business cycle Economists 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 uncertainty and pessimism. During the 1990s and 2000s ♦ Bank 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 profit opportunities that required large amounts of ♦ Bank deposit insurance provided by the Federal investment. Deposit Insurance Corporation (FDIC). ♦ Increased investment and exports shifted the AD ♦ The Federal Reserve’s determination to act as the curve rightward. Capital accumulation 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. taxes and government 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 United States 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 monetary policy 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 full employment. 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.