BUSINESS FLUCTUATIONS

BUSINESS FLUCTUATIONS

 Economic history shows that the economy

never grows in a smooth and even
pattern.

 Expansion/ prosperity  recession or

financial crisis or depression

 Bottom is reached  recovery begins

BUSINESS FLUCTUATIONS

 Upward & downward movements in

output, inflation, interest rates &
employment form the business cycle that
characterizes all market economies.
FEATURES OF THE BUSINESS CYCLE

 What do we mean by “business cycle”?

 Economy wide fluctuations in total
national output, income and
employment, usually lasting for a
period of 2 to 10 years.
 Divided into two main phases:
 Recession
 Expansion
 Figure 1: Business Cycle

Peaks & troughs mark the turning points of the cycles. This diagram shows the
successive phases of the business cycle.
Recession

 The downturn of a business cycle is called

recession.

 Recurring period of decline in total output, income

and employment, usually lasting from 6
months to a year and marked by widespread
contractions in many sectors of the economy

 Depression is a recession that is major in both

scale and duration
 Although we call short-term fluctuations
“cycles”, the actual pattern is irregular.

 No two business cycles are quite the same.

 No exact formula can be used to predict

the duration and timing of business cycles.

 Because of their irregularities, they resemble

the fluctuations of the weather.
Figure 2: Business Cycle in the
Philippines

Source: The Business Cycle in the Philippines. Sandra M. Leitner

Customary Characteristics of
a Recession
1. Consumer purchases decline sharply,
while business inventories of
automobiles and other durable goods
increase unexpectedly.

2. The demand for labor falls – first seen in

a drop in the average workweek, followed y
layoffs and higher unemployment
3. As output falls, inflation slows. Wages and prices
of services are unlikely to decline, but they tend to rise
less rapidly in economic downturns.

4. Business profits fall sharply. In anticipation of this,

common-stock prices usually fall as investors
sniff the scent of a business downturn. But because
demand for credit falls, interest rates generally also
fall.

Expansions are the mirror image of

recessions, with each of the above factors
operating in the Opposite direction.
BUSINESS CYCLE THEORIES
A. EXOGENOUS VS. INTERNAL CYCLES
It is useful to classify the different sources of
business cycle into two categories:
1. Exogenous Theory – find the sources
of the business cycle in the fluctuations of
factors outside the economic system
-- in wars, revolutions and elections; in oil
prices, gold discoveries, and migrations; in
discoveries of new lands and resources; in
scientific breakthroughs and technological
innovations; even in the sunspots, climate
change or the weather.
Example:

 Discovery of New World

 When explorers began to return to Europe with
their treasures, this led to an increase in the
amount of monetary silver and gold, increasing
prices and leading to economic expansion.

 The exogenous event – discovery of

America – producing an economic expansion.
2. Internal Theory– look for mechanism
within the economic system itself that
give rise to self-generating business cycle.

In this every expansion

approach,
breeds recession and contraction,
and every contraction breeds revival and
expansion – in quasi-regular, repeating chain.

One important case is the multiplier-

accelerator theory.
Multiplier-Accelerator Theory
 Rapid growth stimulates investment.

 High investment in turn stimulates more

output growth and the process continues until the
capacity of the economy is reached, at which point the
economic growth rate slows.

 Slower growth reduces investment

spending and inventory accumulation, which tends to
send the economy into a recession.

 The process then works in reverse until the trough is

reached, and the economy than stabilizes and turns up
again.
BUSINESS CYCLE THEORIES
B. DEMAND-INDUCED CYCLES
One important sources of business fluctuations
Is shocks to aggregate demand.
Figure 3: A Decline in Aggregate Demand Leads to an Economic Downturn

Qp AS
AD
AD’
Price Level

B
P
P’ C

Potential Output

Q’ Q
Real Output
 B

 Figure 3 shows how a decline in AD lowers output. Say

that the economy begins in short-run equilibrium at pt. B.
 Then, because of a decline in defense spending or
tight money, the AD curve shifts leftward to AD’. If there is no
change in AS, the economy will reach a new equilibrium at pt. C.
 Note that output declines from Q to Q’. In addition, pricesare
lower than they were at the previous equilibrium and the rate
of inflation falls.
 The case of boom is, naturally, just the opposite.

 Here, the AD curve shifts to the right, output

approaches potential GDP or even overshoots it, and prices and
inflation rise.

 Business-cycle fluctuations in output, employment

and prices are often caused by shifts in AD.
 These occurconsumers, businesses or
as
governments change total spending relative to
the economy’s productive capacity.
 When these shifts in AD lead to sharp business downturns, the
economy suffers recessions or even depressions.
A sharp upturn in economic activity can lead to inflation.
Thinking about Business Cycles

 Economist have observed business cycles for

almost 2 centuries. Here are some of the
different approaches that have been
proposed:
1. Monetary theories – attributes business
fluctuations to the expansion and contraction
of money and credit
Example:
Federal reserve raised nominal interest rates to
18% to fight inflation  recession in 1981-1982
2. Multiplier-accelerator model – proposes that
exogenous shocks are propagated by the
multiplier mechanism (to be discussed next
meeting) along with a theory of investment
called accelerator principle.

The theory shows how the interaction of

multiplier & accelerator can lead to regular
cycles in AD.
3. Political Theories – attributes fluctuations to
politicians who manipulate economic
policies in order to be re-elected.
Example:
Presidential elections

4. Equilibrium-business cycle – claims that

misperceptions about price & wage
movements lead people to supply too much
or too little labor, which leads to fluctuations
of output and employment.
5. Real-business cycle – holds that innovations
or productivity shocks in one sector can
spread to the rest of the economy and cause
recessions and booms. Cycles are caused
by shocks in AS and not by changes
in AD.

Example:
Russia – transition from central planning to
the market in 1990s  decline in output due
to disruptions and confusions.
6. Supply shock – when business fluctuations
are caused by shifts in aggregate
supply.

Example:
Oil crisis of 1970s – when sharp increases in
oil prices contracted aggregate supply,
increased inflation and lowered output and
employment.
Which best explains the
facts of business cycles?
 Each of the competing theories contains
elements of truth, but none is
universally valid.

 A wise macroeconomist knows not

only the different theories but also when
and where to apply them.
FORECASTING BUSINESS CYCLE

 Economist have developed forecasting

tools to help them foresee changes in
economy.

ECONOMETRIC MODELING & FORECASTING

 For a more detailed look into the future,
economist turn to computerized
econometric forecasting.
ECONOMIC MODEL– set of equations,
representing behavior of the economy that has
been estimated using historical data.

Pioneers: Jan Tinbergen of Netherlands &

Lawrence Klein of the University of
Pennsylvania.

Today there is an entire industry of

econometricians estimating macroeconomic
models and forecasting the future of the
economy.
How are computer models of
the economy constructed?
 Models start with an analytical framework
containing equations representing both AD &
AS.
 Using the techniques of modern econometrics,
each equation is “fitted” to the historical data to
obtain parameter estimates (like the MPC or
slope of the investment demand function).
 At each stage, modelers use their experience and
judgement to assess whether the results are
reasonable.
 Finally, the whole model is put
together and run as a system of equations.

 Under ordinary circumstances, the

forecasts do a fairly good job of
illuminating the road ahead.

 At other times, particularly when there are

major policy changes forecasting is a
hazardous profession.
THE THEORY OF
AGGREGATE DEMAND
AGGREGATE DEMAND

 The total or aggregate quantity of

output that is willingly bought at a
given level of prices, other things held
constant.

 AD is the desired spending in all

product sectors: consumption, private
domestic investment, government purchases
of goods and services, and net exports.
FOUR COMPONENTS

 Consumption - consumers' expenditure on

goods and services: This includes demand for
durables & non-durable goods.
 Determined by disposable income; focuses on real
consumption
 Investment - Gross Domestic Fixed Capital
Formation - i.e. investment spending by
companies on capital goods. Investment also
includes spending on working capital such as
stocks of finished goods and work in progress.
 Government Purchases – Government
spending on publicly provided goods and
services including public and merit goods.
Transfer payments in the form of social
security benefits (pensions, job-seekers
allowance etc.) are not included as they
are not a payment to a factor of production
for output produced. A substantial increase in
government spending would be classified as
an expansionary fiscal policy.
 determined by government spending decisions.
 Net exports
Exports of goods and services - sold overseas are an inflow
of demand into the circular flow of income in the economy
and add to the demand for locally produced output. When
export sales from it are healthy, production in exporting
industries will increase, adding both to national output and
also the incomes of those people who work in these
industries.

Imports of goods and services- Imports are a withdrawal

(leakage) from the circular flow of income and spending in
the economy. Goods and services come into the economy -
but there is a flow of money out of the economic system.

Therefore spending on imports is subtracted from

the aggregate demand equation. Note that X-M is the
current account of the balance of payments.
Four components of AD
 Figure 1: Components of Aggregate Demand

Price Level C I G X
P
AD

Q
Real GDP
 The figure shows AD curve & its four components. At P,
we can read the levels of C, I, G and Net exports, which
sum to GDP or Q. The sum of the four spending streams
at this price level is aggregate spending or AD, at that
price level.
THE DOWNWARD SLOPING OF AD CURVE
 Holding other things constant, the level of
spending declines as the overall price
level in the economy rises.

 What is the reason for the downward slope?

 There are some elements of income or wealth
that do not rise when the price level rises.

 When price level goes up, real

disposable income falls, leading to a
decline in real consumption expenditures.

 Some elements of wealth maybe fixed

nominal terms.
 Example:
 Holding of money & bonds, which usually contain
promises to pay a certain number of money in a
given period.
 One important route by which prices affects
spending is through money supply.
 The central bank keeps money supply fixed in
dollar terms, so when prices rise, the real
money supply will fall.

Example:
Suppose the nation’s money supply is
constant at $600B. If CPI doubles, the real
money supply falls from $600B to $300B.
 As the real money supply contracts, money
becomes scarce or “tight”. Interest rates &
mortgages payment rise and credit becomes
harder to obtain.
 Tight money causes a decline in
investment and consumption.
 In short, a rise in prices with a fixed money
supply, holding other things constant, leads to
tight money & produces a decline in total
real spending.
 As a result of all these effects of higher prices,
the economy would move up and to the left
along the downward sloping AD curve.
Shifts in AD

 What are the key variables that lead to shifts

in AD?
 We can separate the determinants of AD into
two categories:
 Macroeconomic policy variables
under government control
 Exogenous variables (those that are
determined outside AS-AD framework).
Variable Impact on Aggregate Demand
Policy Variables
Monetary Policy Increase in money supply lowers interest rates and relaxed
credit conditions including higher levels of investment &
consumption of durable goods. In an open economy,
monetary policy affects the exchange rate and net exports.

Fiscal Policy Increases in government purchases of goods and services

directly increase spending: tax reductions or increases in
transfers raises disposable income and induce higher
consumption. Tax incentives like an investment tax credit
can induce higher spending in a particular sector.
Foreign
Foreign Output Output growth abroad leads to an increase in net export.

Asset Values Rise in stock market increases household wealth & increases
consumption; leads to lower cost of capital & increases
business investment.

Advances in Technology Technological advances can open up new opportunities for

business investment. Important examples have been the
railroad, the railroad, the automobile and computers.

Other Political events, free-trade agreements, and the end of the

cold war promotes business and consumer confidence and
increase spending on investment and consumer durables.
Is the Business Cycle
Avoidable?
 Better understanding of
macroeconomics permits the
government to conduct monetary and fiscal
policies to prevent shock from turning
into recessions and to keep recessions
from snowballing into depressions.
“Recessions are now generally considered
to be fundamentally preventable, like
airplane crashes and unlike hurricanes. But
we have not banished air crashes from the
land, and it is not clear that we have the
wisdom or the ability to eliminate
recessions. The danger has not
disappeared. The forces that produce
recurrent recessions are still in the wings
merely waiting for the cue.”
– Arthur Okun
END.