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Business cycle is defi ned as increases and decreases in business activity of fixed amplitude that occur regularly at fixed
intervals, then there is no business cycle.

At the peak real GDP, or output, reaches a maximum and then begins to fall. (trough is the opposite)

Hypothetical Business Cycles The three-phase business cycle runs from peak to peak, beginning with a recession, which
ends at a trough, followed by a recovery.

Endogenous Theories These theories place the cause of business cycles within rather than outside the economy.
Innovation theory, Psychological theory, Inventory cycle theory Monetary theory, Underconsumption theory.

Exogenous Theories Just as endogenous theories place the causes of the business cycle within the economy, exogenous
theories place the causes of the business cycle outside the economy. The war theory.

The Ten Leading Economic Indicators

1.Average workweek of production workers in manufacturing When workers get less overtime, output may be
declining.

2. Average initial weekly claims for state unemployment insurance When first-time claims for unemployment
insurance benefi ts rise, employment maybe falling.

3. New orders for consumer goods and materials When manufacturers receive smaller orders, they may cut back on
output.

4. Vendor performance (companies receiving slower deliveries from suppliers) Better on-time delivery by suppliers
means they have a smaller backlogof orders.

5. New orders for capital goods If these orders drop, then businesses are planning less output.

6. New building permits issued This provides a good indication of how much construction activity there will be three or
four months from now.

7. Index of stock prices Declining stock prices may reflect declining prospects for corporate sales and profits.

8. Money supply If the Federal Reserve slows the growth of the money supply, interest rates will rise, and it will be
harder for businesses and individuals to borrow money.

9. Spread between rates on 10-year Treasury bonds and Federal funds Long-term interest rates are usually much higher
than short-term interest rates. Federal reserve policies designed to slow the economy raise short-term interest rates with
little effect on long-term rates. So a smaller spread between short-term and long-term interest rates implies a restrictive
monetary policy and a decline in output.

10. Index of consumer expectations As consumers grow less confi dent about the future, they plan to
make fewer major purchases.

Unemployment rate is the percentage of people in the labor force who are willing and able to work, but who are not
working.

Unemployment rate =Number of unemployed /Labor force

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Types of Unemployment

Frictional Unemployment are people who are between jobs or just entering or reentering the labor market. About 2 to 3
percent of our labor force is always frictionally unemployed.

Structural Unemployment A person who is out of work for a relatively long period of time, say, a couple of years, is
structurally unemployed. The economy does not have any use for this person. About 2 to 3 percent of our labor force is
always structurally unemployed.

The “unemployables” These people cannot read, write, or do simple numerical computations. In a workplace
that increasingly demands these minimal skills, more and more of these people are fi nding themselves virtually shut out
of the labor force.

Cyclical Unemployment If we allow for a certain amount of frictional and structural unemployment, anything above the
sum of these two would be cyclical unemployment. Fluctuations in our unemployment rate are due to cyclical
unemployment.

Seasonal Unemployment At any given time a couple of hundred thousand people may be out of work because this is
their “slow season.”

Inflation It is a broadly based rise in the price level. Generally, we consider inflation a sustained rise in the average price
level over a period of years. Inflation has hurt creditors and helped debtors.

The consumer price index is based on what it costs an average family to live.

Percent increase in CPI = (CPI in current year - CPI in previous year) x 100
CPI in previous year

Deflation is a broadly based decline in the price level, not for just a month or two but for a period of years.
Disinflation occurs when the rate of inflation declines.

Theories of the Causes of Inflation

Demand-Pull Inflation When there is excessive demand for goods and services, we have demand-pull infl ation. What is
excessive? When people are willing and able to buy more output than our economy can produce.

Cost-Push Inflation There are three variants of cost-push infl ation. Most prominent is the wage-price spiral. Because
wages constitute nearly two-thirds of the cost of doing business, whenever workers receive a signifi cant wage increase,
this increase is passed along to consumers in the form of higher prices. Higher prices raise everyone’s cost of living,
engendering further wage increases.

Demand-pull inflation is set off by an increase

in demand for goods and services without any
increase in supply.
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Cost-push inflation happens when production costs
rise. Sellers can no longer supply the same output at
cur-rent prices. This results in a decrease in supply.

The German inflation eventually led to a complete economic

breakdown, helped touch off a worldwide depression, and
paved the way for a new chancellor named Adolf Hitler.

“Misery index,” which was the inflation rate and the

unemployment rate combined. One thing the economy
has rarely been able to attain simultaneously is a low
unemployment rate and stable prices.

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The Classical Economic System The centerpiece of classical economics is Say’s law named for Jean Baptiste Say “Supply
creates its own demand.”

GDP = C + I GDP = C + S

If savings were greater than investment, there would be unemployment.

If savings were greater than investment, the interest rate would fall. Why? Because some savers would be willing to
lend at lower interest rates and some additional investors would be induced to borrow at lower interest rates.

Prices and wages will fall to bring about equilibrium between saving and investing.
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The aggregate demand curve shows that as the price level declines, the quantity of goods and services demanded rises.

Defined GDP as the nation’s expenditure on all the final goods and services produced during the year at market prices.
Stated mathematically, GDP = C + I +G + X n

There are three reasons why the quantity of goods and services purchased declines as the price level increases.

The Real Balance Effect When the price level goes up, your purchasing power goes down. The money you have in the
bank, your stocks and bonds, and all your other liquid assets shrink in terms of what they can buy. You feel poorer, so
you’ll tend to spend less. The real balance effect is the influence of a change in your purchasing power on
the quantity of real GDP that you are willing to buy.

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The Interest Rate Effect A rising price level pushes up interest rates, which in turn lower the consumption of certain
goods and services and also lowers investment in new plant and equipment. Let’s look more closely at this two-step
sequence. First, during times of infl ation, interest rates rise, because lenders need to protect themselves against the
declining purchasing power of the dollar. Second, certain goods and services are more sensitive to interest rate changes
than others. Clearly, then, when interest rates rise, the consumption of certain goods and services falls, and when
interest rates fall, their consumption rises.

The Foreign Purchases Effect When the price level in the United States rises relative to the price levels in other
countries, what effect does this have on U.S. imports and exports? Because American goods become more expensive
relative to foreign goods, our imports rise (foreign goods are cheaper) and our exports decline (American goods are more
expensive).
In sum, when our relative price level increases, this tends to increase our imports and lower our exports. Thus, our net
exports (exports minus imports) component of GDP declines. When our relative price level declines, the net exports
component (and GDP) rises.

Define aggregate supply as the amount of real output, or real GDP, that will be made available by sellers at various price
levels .

What happens is that we find two things: (1) the equilibrium full-employment level of real GDP and (2) the
corresponding price level, which happens to be 100.
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 What does this mean? It means that in the long run our economy will produce the level of output that will
provide jobs for everyone who wants to work (that is, the unemployment rate will be 5 percent). In other words, in the
long run our economy will produce at full-employment GDP.

The Short-Run Aggregate Supply Curve

The economy may operate below full-employment GDP in the short run.

Why does the short-run aggregate supply curve sweep upward to the right? Because business firms will supply increasing
amounts of output as prices rise. Why? Because wages, rent, and other production costs are set by contracts in the short
run and don’t increase immediately in response to rising prices.

As output continues to rise, land, labor, and capital become more expensive and less-efficient resources are pressed into
service.

As output approaches full employment, antiquated machinery and less-productive facilities must be used. And so, as the
full-employment level of GDP is approached, the short-run aggregate supply curve is becoming steeper and steeper.

You’ll also notice in Figure 8 above that output continues to rise even after we’ve exceeded full-employment GDP. Is this
possible ? Can our real GDP ever exceed our full-employment GDP? Yes, it can. But only in the short run.

Why, then, does the short-run aggregate supply curve eventually become vertical? Because there is a physical limit to the
output capacity of the economy. There is just so much land, labor, and capital that can be put to work, and when that
limit is reached, there is no way to increase production appreciably.

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What if saving and investment were not equal? For instance, if saving were greater than investment, there would be
unemployment. Not everything being produced would be purchased.

If the quantity of savings exceeded the quantity of loanable funds demanded for investment purposes, the interest rate
would simply fall. And it would keep falling until the quantity of savings and the demand for investment funds were
equal.

Three possible equilibriums existed— below full employment, at full employment, and above full employment.

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 Demand-pull infl ation, which was described as
“too much money chasing too few goods.”
Demand-pull inflation occurs in the
intermediate range of the aggregate supply
curve in the fi gure in the box, “The Ranges of
the Aggregate Supply Curve.”

The equilibrium level of GDP was determined

primarily by the volume of expenditures
planned by consumers, business firms,
governments, and foreigners.

Aggregate demand, said Keynes, is our economy’s prime mover. Aggregate demand determines the level of output and
employment. In other words, business firms produce only the quantity of goods and services they believe consumers,
investors, governments, and foreigners plan to buy.

The Keynesian Aggregate Expenditure Model

The Consumption and Saving Functions Here’s the consumption function: As income rises, consumption rises, but not
as quickly . It is a “fundamental psychological law,” said Keynes “that men are disposed, as a rule and on the average, to
increase their consumption as their income increases, but not by as much as the increase in their income.”
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As incomes rise, is spend some of this additional income and save the rest—which brings us to the saving function: As
income rises, saving rises, but not as quickly.

The Investment Sector Investment is unstable. We learned in Chapter 6 that investment is the loose cannon on our
economic deck. Keynes was well aware of this. What causes recessions in the Keynesian model? A decline in profit
expectations causes recessions, or as Keynes puts it, the marginal efficiency of capital.

Disequilibrium and Equilibrium

When aggregate demand exceeds aggregate supply, a chain reaction is set off and continues until the economy is back
in equilibrium. The fi rst thing that happens is that inventories start declining. What do business fi rms do? They order
more inventory. Consequently, orders to manufacturers rise, and, of course, production rises. Manufacturers will hire
more labor, and eventually, as plant utilization approaches capacity, more plant and equipment are ordered.

When aggregate supply is greater than aggregate demand, the economy is in disequilibrium. Aggregate supply must fall.
Because aggregate supply is greater than aggregate demand, production exceeds sales, and inventories are rising. When
retailers realize this, what do they do? They cut back on orders to manufacturers. After all, if you found you were
accumulating more and more stock on your shelves, wouldn’t you cut back on your orders? Remember, not only does it
cost money to carry large inventories—shelf space as well as money is tied up—but also there is always the risk that you
may not be able to sell your stock. When manufacturers receive fewer orders, they reduce output and consequently lay
off some workers, further depressing aggregate demand as these workers cut back on their consumption. Retail fi rms,
facing declining sales as well as growing inventories, may reduce prices, although during recent recessions price
reductions have been relatively uncommon. Eventually, inventories are sufficiently depleted. In the meantime,
aggregate supply has fallen back into equilibrium with aggregate demand.

When the economy is in disequilibrium, it automatically moves back into equilibrium. It is always aggregate supply that
adjusts. When aggregate demand is greater than aggregate supply, the latter rises, and when aggregate supply exceeds
aggregate demand, aggregate supply declines. Please keep in mind that aggregate demand (C 1 I) must equal the level of
production (aggregate supply) for the economy to be in equilibrium. When the two are not equal, aggregate supply must
adjust to bring the economy back into equilibrium.

Keynesian Policy Prescriptions

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Recessions are temporary because the economy is self-correcting. Declining investment will be pushed up again by
falling interest rates, while, if consumption falls, it will be raised by falling prices and wages. And because recessions are
self-correcting, the role of government is to stand back and do nothing.

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Fiscal policy is the manipulation of the federal budget to attain price stability, relatively full employment, and a
satisfactory rate of economic growth .

The Recessionary Gap and the Infl ationary Gap

Equilibrium GDP is the level of output at which aggregate demand equals aggregate supply.
Aggregate demand is the sum of all expenditures for goods and services (that is, C + I + G + X n)
Aggregate supply is the nation’s total output of final goods and services.
Full-employment GDP . Full employment means nearly all our resources are being use. It is also the level of spending
necessary to provide full employment of our resources .

A recessionary gap occurs when equilibrium GDP is less than full-employment GDP. Equilibrium GDP is the level of
spending that the economy is at or is tending toward. Full-employment GDP is the level of spending needed to provide
enough jobs to reduce the unemployment rate to 5 percent.

How do we close this gap? We need to raise spending—consumption (C) or investment (I) or government expenditures
(G)—or perhaps some combination of these. John Maynard Keynes tells us to raise G. Or we may want to lower taxes.
Lowering business taxes might raise I; lowering personal income taxes would increase C.

When there is an infl ationary gap, equilibrium GDP is to the right of full-employment GDP. It is to the left when there’s a
recessionary gap. Equilibrium GDP is greater than full-employment GDP when there’s an inflationary gap. When there’s a
recessionary gap, full-employment GDP is greater than equilibrium GDP.

Recessionary gap: Equilibrium GDP is too small.

Infl ationary gap: Equilibrium GDP is too large.

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The Multiplier and Its Applications

Multiplier =1/1-Marginal propensity to consume

The multiplier is used to calculate the effects of changes in C, I, and G on GDP.

The automatic stabilizers protect us from the extremes of the business cycle.
 During inflations, tax receipts rise.
 During recessions, saving declines.
 During prosperity, saving rises.
 Credit availability helps get us through recessions.
 During recessions, more people collect unemployment benefits.
 During recessions, corporations pay much less corporate income taxes.
 A safety net for the poor

Fiscal policy is the manipulation of the federal budget to attain price stability, relatively full employment, and a
satisfactory rate of economic growth.

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The main fiscal policy to end the Depression was public works.

Discretionary fiscal policy dictates that we increase government spending and cut taxes to mitigate business downturns,
and that we lower government spending and raise taxes to damp down inflation. In brief, we fight recessions with budget
deficits and inflation with budget surpluses.

Defining the Lags

The effectiveness of fiscal policy depends greatly on timing. Unfortunately, it is subject to three lags: the recognition,
decision, and impact lags.

Recognition lag is the time it takes for policy makers to realize that a business cycle’s turning point has been passed, or
that either infl ation or unemployment has become a particular problem.

Decision lag is the time it takes for policy makers to decide what to do and to take action.

Impact lag is the time it takes for the policy action to have a substantial effect.

The Deficit Dilemma

Deficit is created when the government is paying out more than it’s taking in.
When the budget is in a surplus position, tax revenue is greater than government spending.
Finally, we have a balanced budget when government expenditures are equal to tax revenue.
The Public Debt

The public, or national, debt is the amount of currently outstanding federal securities that the Treasury has issued.

National debt it is the cumulative total of all the federal budget deficits less any surpluses.

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Money is any asset that can be used to make a purchase.

The three jobs of money are: (1) medium of exchange, (2) standard of value, (3) store of value.

M1 (money supply) = currency, demand deposits, traveler’s checks, and other checkable deposits
M1 + savings, small- denomination time deposits, and money market funds = M2 (measure of money)
M2 + large-denomination time deposits + money market mutual funds held by institutions. = M3

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The Keynesian Motives for Holding Money
Transactions motive, Precautionary motive, Speculative motive

Four Influences on the Demand for Money The amount of money we hold is influenced by four factors: (1) inflation (2)
income, (3) interest rates, and (4) credit availability.

Branch Banking versus Unit Banking Banking is legally defined as accepting deposits. Branch banking, therefore, would
be the acceptance of deposits at more than one location.

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Monetary policy is the manipulation of the money supply.

Required reserves is the minimum amount of vault cash and deposits at the Federal Reserve District Bank that must be
held by the financial institution.
Actual reserves is what the bank is holding. If a bank is holding more than required, it has excess reserves.
Therefore, actual reserves + required reserves = excess reserves.

Primary reserves are its vault cash and its deposits at the Federal Reserve District Bank. These reserves pay no interest;
therefore the banks try to hold no more than the Federal Reserve requires. Ideally, then, they hold zero excess reserves.

Treasury bills, notes, certifi cates, and bonds (that will mature in less than a year) are generally considered a bank’s
secondary reserves.

The Creation and Destruction of Money

Banks create money by making loans.

Money is destroyed when a loan is repaid to the bank.
Deposit expansion multiplier = 1/ Reserve ratio

The Tools of Monetary Policy

Open-market operations are the buying and selling of U.S. Treasury bills, notes, and bonds.

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Fed wants to increase the money supply, it goes into the open market and buys U.S. government securities.

Interest rate = Interest paid / Price of bond

Excess reserves = Monetary multiplier x Potential expansion of the money supply

Recognition lag is usually shorter for monetary than for fiscal policy.

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