ch. 14. the business cycle. –different theories of the business cycle keynesian monetarist real...
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Ch. 14. The Business Cycle.
–Different theories of the business cycle•Keynesian•Monetarist•Real Business Cycle
–Origins of and the mechanisms at work during the Great Depression
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• Business Cycle Patterns– The business cycle is an irregular and
nonrepeating up-and-down movement of business activity that takes place around a generally rising trend.
– http://www.nber.org/cycles.html– Recessions are getting shorter.– Expansions are getting longer.
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The Role of Investment
• All theories of the business cycle agree that investment and the accumulation of capital play a crucial role.– Recessions begin when investment slows and
recessions turn into expansions when investment increases.
– Investment and capital are crucial parts of cycles, but are not the only important parts.
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Cycle Patterns, Impulses, and Mechanisms
• The AS-AD Model– All business cycle theories can be described
in terms of the AS-AD model.– Two business cycle theories
• Aggregate demand theories• Real business cycle theory
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Aggregate Demand Theories of the Business Cycle
– Three types of AD theories• Keynesian• Monetarist• Rational expectations
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AD Theories of Business Cycle
• Keynesian Theory– Volatile expectations are the main source of
business cycle fluctuations.– Nominal wages are rigid downward, but not
upward.
• Keynesian Impulse– “Animal spirits” change radically in response
to a small bit of new information.– Expected future sales and expected future
profits, which changes investment.
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AD Theories of Business Cycle
• Keynesian Cycle Mechanism– Changes in “animal spirits” lead to change in
investment– AD shifts– a flat (or nearly so) SAS curve.– Changes in I have multiplier effects
• e.g. as income rises, consumption rises, causing AD to shift further to the right, etc.
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AD Theories of Business Cycle
– A Keynesian recession.
– Real wages and productivity should rise during a recession.
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AD Theories of Business Cycle
– A Keynesian expansion.
– Real wages and productivity should fall during an expansion.
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AD Theories of Business Cycle
• Monetarist Theory– fluctuations in the quantity of money are the
main source of business cycle fluctuations in economic activity.
• Monetarist Impulse– The initial impulse is the growth rate of the
money supply.
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AD Theories of Business Cycle
• Monetarist Cycle Mechanism– A change in the monetary growth rate that
shifts the AD curve combined with an upward sloping SAS curve.
– An increase in the growth rate • lowers interest rates and the value of the dollar,
shifting AD rightward • multiplier effects amplify the effect.
– A decrease in the monetary growth rate has opposite effects.
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AD Theories of Business Cycle
• Recession phase of Monetarist business cycle.
• Real wages and productivity should rise during a recession.
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Aggregate Demand Theories of the Business Cycle
• Expansion phase of monetarist business cycle.
• Real wages and productivity should fall during an expansion.
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AD Theories of Business Cycle
• Rational Expectations Theories– New classical theory
• Unanticipated fluctuations in AD are the main source of economic fluctuations.
– New Keynesian theory • Unanticipated fluctuations in AD are the main
source of economic fluctuations but also leaves room for anticipated fluctuations in AD to play a role.
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AD Theories of Business Cycle
– A rational expectations business cycle recession.
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AD Theories of Business Cycle
– Rational expectations expansion.
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Real Business Cycle Theory
– technological change creating random fluctuations in productivity is the source of the business cycle.
• The RBC Impulse– The impulse in RBC theory is the growth rate
of productivity that results from technological change.
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Real Business Cycle Theory
• The RBC Mechanism– Two immediate effects follow from a change in
productivity• Investment demand changes• The demand for labor changes
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Real Business Cycle Theory
– The capital and labor markets in a real business cycle recession.
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Real Business Cycle Theory– A decrease in productivity lowers firms’ profit
expectations and decreases both investment and labor demand
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Real Business Cycle Theory
– The interest rate falls.
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Real Business Cycle Theory– The lower real interest rate lowers the return from
current work so the supply of labor decreases.
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Real Business Cycle Theory• Employment falls by a large amount and the real wage rate
falls by a small amount. Labor productivity decreases.
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Real Business Cycle Theory
• Money in RBC– plays no role in the RBC theory; – RBC theory emphasizes that real things, not nominal
or monetary things, cause business cycles.
• Cycles and Growth– The shock that drives the cycle in RBC is the same
force that generates economic growth.– RBC concentrates on its SR consequences: growth
theory concentrates on its long-term consequences.
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The Great Depression
• In early 1929 unemployment was at 3.2 percent. • In October the stock market fell by a third in two weeks.• In 1930, the price level fell by about three percent and
real GDP declined by about nine percent.• Over the next three years
– real GDP declined 29%– price level fell 24%– Unemployment peaked at 25%– Major transfer programs nonexistent.
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The Great Depression
• The 1920s were a prosperous era but as they drew to a close increased uncertainty affected investment and consumption demand for durables.
• The stock market crash of 1929 heightened uncertainty.• The uncertainty caused investment to fall, which
decreased AD and real GDP in 1930. • Until 1930, the Great Depression was similar to an
ordinary recession.
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The Great Depression
• Why the Great Depression Happened– Some economists think that the decrease in
investment was the primary cause that decreased aggregate demand and created the depression.
– Other economists (notably Milton Friedman & monetarists) assert that inept monetary policy was the primary cause of the decrease in aggregate demand.
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The Great Depression
– Unprecedented number of bank failures – Bank failures led to bank panics and more
failures. – Huge contraction in the money supply that
was not offset by the Federal Reserve.– Difficult to borrow money.
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The Great Depression
• Can It Happen Again?– Four reasons make it less likely that another
Great Depression will occur• Bank deposit insurance • Fed as lender of last resort. • Taxes and government spending • Multi-income families