Business Cyclesand Aggregate Demand

'l'he la,ttl.t, d.ear lJrulus, is not in 1,l'.s-,ll in outs ue.s.\{'il lianr Shakcspcalc

.lulius (,rn.sar

The Arnerican economv has been subjecr ro brsilresscvclcs since the earlv davs clf the Republic. Somerilrres.btrsirress conditions are healthr,, rrith rapidlv grorvingcnrplo\ ulcnt. fctories rtorking or-ertime, rnd rohustprofits. The "fabulo.ts I990s" iras such :r period forthc rrcrican econom\'. The econornv grerv rapidll';crr)plovnlent and capaci6, utilization trere exceptiotr-allv higlr. ancl unemplo,r'ment \{as low. Y-et, unlike ltecrsc in carlier long expansions, inflatiorr reruirint'dIorv tl.rroughout the 1990s.

Srrch pcliocls of pr-osperitr'

FEATURES OF THE BUSINESS CYCLE

A. WHAT ARE BUSNESSGYCLESI

Economic history shows at no economy grorts in asmooth and even pattern. A country may enjoy sev-eral years of economic expansion and prosperity, rapid increases in stock prices (as in the 1990s)or housing prices (as in e early 2000s). Then, theirrtional exuberance may flip over to irrational pes-simism as, during the 2007-2009 period, lenders stopissuing rnortgages or car loans on favorble terms,banks slow their lending to businesses, and spendingdeclines. Consequentl national output falls, unem-ployment rises, and profits and real incomes decline.

Eventually the bottom is reached and recoverybegins. The recovery may be incomplete, or it maybe so strong as to lead to a new boom. Prosperitymay mean a long, sustained period of brisk demand,plentiful jobs, and rising living standards. Or it maybe marked by a quick, inflationary flare-up in pricesand speculation, followed by anoer slump.

Upward and downward movements in output,inflation, interest rates, and employme nt form the business cvcle that characterizes all market economies.

a27

FEATURES OFTHE BUSINESS CYCLEWhat exactly do we mean by *business cycles"?

Business cycles are economywide fluctuations intotal national output, income, and employment, usu-ally lasting fbr a period of 2 to l0 years, marked bywidespread expansion or contraction in most sectorsof the economy'.

Economiss typically divide business cycles into nvomain phases: uttsion and *Prliirn Peaks and uoughsmark the turning poins of the cycle. Figure 7-1shows e successive phases of the business cycle. Thedowntum ofa business cycle is called a recession. Arecession is a recurring period ofdecne in total out-put, income, and employment, usually lasting from6 to 12 mons and marked by contractions in manysectors of the economy. A recession that is large inboth scale and duration is crlled a deprcssion.

The semiofficial judge of ttre timing of con-tractions and expansions is the National Bureauof Economic Research (NBER), a private researchorganization. The NBER defines a recession as 'asignificant decline in economic actity spread acrossthe economy, lasting more than a few months, nor-mally visible in real GDB real income, employment,

C.9:Et

oo

o'6d

FIGURE 7-1. A Busines Cyde, like e Year, tls lts SeasonsBusiness cycles are the irregular expa.nsions and contractions in economic actity. (Theseare the actual monly data on industrial production for a recent business.cycle period')

t28

indrrstrial production, and wh

ltL sl N Ess-c\'(:l,ll 'l lll.( )Rll.-s

. ,{s output falls, infladon slorr,s and the dernandfor cnrde rnaterials declines, and materials'prices tumble. llages and the prices of senicesalc unlike'ty- to fzrce a sinlilar decline, brtt thel'tcncl to risc lcss rapidlv irr economic dotlntttrns.

. Busincss plolits Iall sharplv iu lecessions. In antic-ipatiorr ol this. conrrnon-stock prices usrralll'fall asirrrcstors snill thc scctrt ofa brsiness dorvrttrrn.

Gencrall), as busincss conclitiotts dctcriorate :rtrdemplo\rncllt llls, thc l'c

t30

Eventrralll, investors her'rnre skeptical aborrt tlrefrndrmental valrre of rnarrr' of these finls. l.oss

,THE DOWN\r,\RD-S[.OPINC A(;CREGATE DEMAND (lLlRVE

clisposable income, which is personal incomelcss taxcs. Other factors affecting consrtmptionarc longcrrtcrrn trer'ds irr income, householdwealth, ard thc aggrcgatc price lcvcl. Aggregatedernand arralysis fbcrscs or thc detclrninantsof r,l c

t32

In addition, sorne elements ofrvealth rnay bc lixcclit.t nominal terrns. Exanrples hcre rvotrld be holdingsof monev arrd bonds, wl.rich usually contain promisesto pay a certain number of dollars in a given pcriod.If the price level rises, therefore, the real valtre o[wealth declines, and this would again lead to lor.r'erlevels of real consumption.

!!'e illustrate the impact of a higher price levelgraphicallv in Figure 7-4(a) on page I34. Say thatthe economt,is in equilibrium at poir.rt B, with aprice level of 100 and a real GDP of$3000 billion.Next assume that prices rise by 50 percent, so theprice index P rises from 100 to 150. Srrppose thatat that higher price Ievel, real spending declinesbecause of lower real disposable income. Totalreal spending declines to $2000 billion, shorvnat point C. \'!'e see here how higher priccs havcreducerl real spending.

CHAPTER 7 . RUS NESS CYCI-F,S ,{N 1) A(:C;REG.{IE DEMANI)

T

I IIt.. l)( )\\ N\{rARt)-St.()PtN(; {(;(;RF.(;,\TF. t)t.\f AND (.t'RvF,

the rnacroecorl otrric poli( t^ uoiabh\ rrhich are rrnderg()verntrrent control. These rre mol)etary policv(steps by rvhich the central brnk can rffect interestlates:rrrd other ranciirl conditions) and fisc:rl pol-ic\: (taxes zrncl goverrtment expenditrrres). Table 7-lillustlatcs horv thcse go\ernrnent policies can aflectdillL'rcnt colnPoncDts of agglcgate denrancl.

'l'lrc scconcl sct includcs ?xog?tous tnrinbles, ot'rariablcs that al'c clctcrnrirrcd orrtside the A.S-,'l/)liarncwtr'k. As'Ihblc 7-l shows, sornc of thcsc vari-al;lcs (strch As l{ars or rcvolutions) alc outsiclc thcscope of rnacroeconorric arrahsis propei sontc (strchirs foreign econ

t34

(a) Movements along the Aggregate Demand Curve

1,000 2,000 3,000 4,000 5,000Heal GDP (billons)

I]I.ISI\LSS (;\'(]LES AND ACGREGATE DElI{AND

(b) Shifts of Aggregate Demand

0 1,000 2.000 3,000 4,000 5,000Real GDP (bllions)

CHAPTER 7

-

200o-9.3 1s0

100

o

fi rso'EfL

'1 00

FIGURE 7-4. Movement along rs. Shifts of the Aggregate Demand CurveIu (a), a higher price level rvith giverr rrorninal rlorrcy irrcornt.s lrwt'rs r'al rlisxrsablt.irrcorne; this lcads to lright'r' intt:rt:st rat

OTI II'I I'I)I.] II.,RVI\f D BYTOTAI- I,X PI, }IDITT ' RES

undcrstanding ol nlacloccollonl ics that tr()\{ pertnitsthe governrnellt to con(luct its rrronctar-\,atrd fiscalpolicies so as to prevelrt sltocks li onl l.r.rlrtirtB illtorecessions rnd to keep recessitrts liottt sttorvballirtgirrto depressior-rs.

f)rrlin traruquil periods, people oftert declirrctlrrt the business cvcle has been vanqrtislted. Is tlris arealistic possibilitv? While busincss ct'clcs ltalc trtotl-erated in America over the lirst quarte r-tcntttry, thcyhave arcttralll' become rnole prevalcttt in otlte r ccottr>mies. So take heed of the fbllowing propltctic rvortlsof the great macroeconotttist Artltur Okttrr. lvhicllare prrticltlarly approp ate as the w()rld cc()llollrvherds irrto recessior.r in 2007-2009:

Rr.t cssitns ale now generallr consi

r3

GDPM

Gross domestic oroduct

FIGURE 7-7. The Equilibrium l,evel of National Ouaputls Determined When Total Expenditure ( TE) EqudsOutputThe blrre CC line represens e consumprion funcdon(shorrn in Figr.rre 7-6). The /1 arrows indicare consantinrestment. Adcling 11 to CC gives the 7/1 curre ol toraldesired investment plus consunrptiorr srcnding. Akrrrgthe 45' line, expenditurcs cxactlv cqrral GDP EquilibrirrmGDP conrcs at p(,int E, rvhich is the inrersection of the 7Z'I inc and the 45' line. This is the only level of GDP at rvhichthe desired spending on ' + /exactlt equals output.

the CC linc. Recall that the consumption functionshorvs thc clesired consumption corresponding toeach levcl of income. \\'e have omtted nxes, trans-lers, and other items, so that pe rsonal income eqrralsnational income, and national income eouals GDP.

\{'c ntw develop in Figure 7-7 an importanr nen'graph shorving the total expenditure-output relation-ship. 'f his graph is sometimes called rhe "Keynesiancross," bccatrse it shows hou'otrtput equals expendi-ttre when the expendittrre cune crosses the 45'line.(If yotr are not sure about the significance of the 45"lirc, lotk back at Chapter 6's explanation.)

\!e begin by drau'ing the consumption fuucrion,(.(i. \4t thcn add rotal investment to consumDrion.Nr.rmallr,, investment depencls on irrlerest rot"*. to*policr', and business confidence. To sintplifu things,ue treat investment as an cxogcnou,r vrriable, onewhose lcvel is determined outside the nodel. Sav rhat

CHAPTER 7 . Bt.iSINESS CYCI,ES ANT) AGGRL,C;ATE DI,\,f.{){I)

investlnent opporttrnities are such that investmentworrld bc exactly $200 bitlion per year regardless ofthc lcvcl of GDP. The investment schedule is stackedon top o[ thc cousurnption schedule in Figure 7-7.Note that thc C * ,f cune is higher than the Ccun'ebv cxactlv drc constant amount

OI'TPL'T DI-TT]RNTINED I}\'TOTAI, !]XPI]NDI I L'RT.-S

Applvirrg thc cqtrilibriunr corrccpt to Figrre 7-7,we see that point /i is an cqr.rili blitt nr. At poir.rt /i,anrl onl;- at point lt, docs duirul spendiug tn C * Iequal nclual oulpul. Al ant

r38 CHAPTER 7 BLISINESS (]Y(]LES ,,{ND ,\CGRF,GATE D[V-\NI)

GDP Determinaton VYhere Output Equals Planned Spending(billionr of dollars)

Onlv rvhcn the level of actual ()rrtput in colrnll(5) cxactlv cqrrals planncd expenrlitrrre (7I;) illcolrrr.lrn (fj) rvill the econ()ll\ be irr equiliblirrrrr. lneqrrilibr-iurn, arrd orrlv in eqtrilibr-irrrn. brrsiness sal 4,000 |> 3,800 J= 3,600< 3,400 t< 3,200 |< 3.000 |

(7',

Resulfingtendency of

ouqtut

Contraction(lontractionF4uilibriunF.xpansionExpansionExpansion

exfenditun.s. Th is indicates that we are taking certaincotnponenLs of sper-rding as given ouside the model.Itr the case in hand, tlrc exogcrrous cornponent isinvestent. Later, we rnll sce that thc same approachcan be usecl to determinc thc cflcct of changes ingovernmen t expendittrrcs, cxpot'ts, ard

THT: \,I L'I TIPI,I[-R

'I'lrus arr endless chrin ol' srrondary ronsunplionslterultngis sct in m()tion b1'rn1 rirrarl investnrellt of$1000. Brrt. althorrgh :rn endless chairr, it is an evet'-dirrrirrishing onc. Eventrr:rlly it adcls ttp to ir finiteatllount.

Llsing straightfbnvard arithlletic. rve crlr find thetotnl irrcrcasc irr spcnding in the following mantter:

$looo.o0+

666.67

144.14+

296.30+

197.53

i$3000.(x)

This sh

(a) Multpler Model

t40

0QopReal GDP

CHAPTER 7 . I]LISINESS (]Y(]LES AND ACCRECATE DE}ANT)

f iscal prograrns are instrumental in deciding how thenatior)'s otrtput should be divided benr'een collecriveancl private consumption and how the burden of par.IrcDt fbr collective goods should be divided amongthc poprrlation.

Onl,v rvith the development of modern macro.ccononric theory har a surprising fact been uncor.clcd: (k.vcr-rrrrrent fiscal powers also have a majormarrueron.m.it itnpact trpon the short-run movemenlsol outpuL, ernployment, and prices. The knorvledgethat liscal policy has powerftrl effects upon economicactivity lcd Lo Lhe KEnesan approach to mtcroeconomicpolitl, wlticb is the active use o government actionto rnodelate btrsiness cycles. This approach wasclcst lilr

I I0\1' (;OvI.:RN Nf F.NT FISCAI. I'()I,I(:IT:S AFFF,( :T OUTPUT

4,000

3,500

t4r

FIGURE 7-9, Taxes Reduce DisposableIncome ard Shift CC Schedule to e Rightand DownEach dollar of taxes paid shifis the (,'oschedule t() the right bv thc amount ofthe tax. A rightward (.1(,'shifi also rneans athrrvrrwalrl (l(l slrifi, llrl thc

t42 CHAPTER 7 ll( SlNl.SS (:\'(:l-l.ls ANI) A(;GRLGATE DEITIAND

FIGURE 7- 10. Government PurchasesAdd OnJust like Inrestnent toDetermine \uilibrium GDPWe non'add govr:trtntt'rtI lu clras('s orr t()pof corrsrr rrr ltiorr and investment spend-ing. This giles us the nerv tourl plannede xpenditrf re schedule. 'l E : O+ I+ O.At li, whcle th< 7Ji scht.rlrlr. int('r\(.( t\tlc 4l-r" linc, wc firrrl tlrt'cqrrilil>riunt lcvelrt (lDP

s

o

=50)l!o().o

4,000

3,500

3,000

C+l+G=TE

C+l

Govornmentpurchases

Inveslmenl

Consumption

3,000 3.500

4,000 OP

Gross domestic product (billons of dollars)

prlrchases of goods and sen'ices), on top of the cor-sunrption fttnction and the fixed rmorrnt of itrvest-rnent. The vertical distance between the l.' -f / lineand the new 77i : C + I + (; line is.just rhe quanrirv()l (;.

\\fhv tlo rre simply add G on the t

H()\r (;OVt.R\II[-]-T l-ls(:.\1. l'()l I(llllS ,\FFU(11 ()L l Pt l

As slrorr,rr rrr Fignrle 7-9. this ler'

144

F ISCAL.POLICY MULTI PLI ERSThe multiplier anal,vsis shows that governrrrent fiscalpolic;- is high-powered spcnding rnuch likc irvest-nrcnt. The parallel suggests that fiscal policv shouldalso havc multiplier elfects r"rpon output. And this iscxactly t'ight.

The government expenditure multiplier is theincrease in GDP rcsulting frc.m an increase of $l ingo!'ernme nt purchases of goods ard senices. An ini-Lial govcrrrment purchase of a g

FIS(:AI--POI,I(]Y MUT.TIPT,IERS t4s

Economlc Stimulus fiom Defense Spending

lVar

World War IWorld War II

Before Pearl HarborAII years

Korcan WarViemam WarPersian Gulf Warhaq War

Peiod ofwar orbuildup

l9I6-1918

t939-19411939-19,14

1950:3-1951:31965:&-1967:llfX)0:3-1991:l2003:l-2003:2

Increase in defensespending as

pertent of GDP

10.2

9.741.48.01.90.30.1

Real GDP growthover buildupperiod (%)

13.0

26.769.110.59.7

_ 1.30.5

TABLE 7-4. Fronomic Booms Accompany Large Increases in Military Spending'I'his table shons tlr

146

\{'e are in for a srrrprise. Ti offset the $200 billionincrcasc in (i ll'e need to increase nx collections byrnorc than $200 billion. In otr ntmeric:rl example, wecan fincl thc cxact sizc of tlre tax, or 'il increase from Fig-ru-c 7-$. 'flrat figrrre shows that a $300 billion incresein 7'r-cduccs rlisposable income by.just enough to prc>cltcc a constunptinn decline of $2ff) billion rvhen thel]\)isr/t. Put differcntl1', a tax increase of $30O billion

rvill shili tlc (ll, cun'e doran by $200 billion. Ilence,whilc a $ I billiorr increse in defense spending shifsup tlrc (,' + I + G line b1' $l billion, a $l billion trxincrc:rsc shif s tlorvn thc (l + 1+ C line bv only $% bil-lion (when the .&lP(.'is 7r). I'hus olTsctting an increasein go\rnment purcltues tc

SU ItI I'A RY

The Muttipler Model in PerspectiveWe havc conrpletetl r.rrr introdrct

t48

6, Aggregate demand curves differ from demand cuwesruscd in nricroecononric irnalysis. I he Al) cunes relateovcmll srt:nding orr all conrrrnerrLs ol otrtput to theovcrall rrirc lcv

QL'ESTIONS FOR DtS(:t SSl0N

multiplier

=t+MPC+(,!l/{j)r+..._l_l

I -

IIIP(: ML'S

Government Purchases andTaratonfiscal rolicy:

G efl'ect on e quilibritrnr CIDP7'cffect on (;C and on GDP

multiplicr cffccts of governmentpurchases (C) ancl taxes (7')(,'* 1* (i curve

449

FURTHER READING AND INTERNET WEBSITESFurther ReadingTlrc trrotaf iorr lirnl ()kun is Arthur M. Okur, 'l hc Politicalfionom of Pro4mit (Nortorr, Ncw Vr'k, lf)7{)), pp. 33 ll.This is a fascinating book on lllc cc()Ir()tr)i( ltistory of tlrt'1960s rritten by one of America's great macrcecontntisls.Thc classic stu LThc nrrrltiplier nrodel was developed b.v.John MaynardKt'vrrcs in 7-h (hntrtl'l'lmnl oJ I',nlt,!Tu'nl, In"r?sl en.l Mone,t(Harcourt, Ncw Y

t50

When .l drops from $200 billion ro $100 billion, howmuch must GDP drop-

7. Give (n) the cornmor sense, () rhe ar-ithrnetic, and(.) tlrc gconretrT ol th