Econ 13, Foldvary

Mankiw, Chapter 20

Aggregate Demand and Supply, and Business Cycles.

The business cycle - fluctuations in output which have a regularity of frequency.

What causes the business cycle?

There is no consensus among economists on the theory of business cycles.

Different schools of thought have different theories of cycles.

Some economists think there is no cycle, but only random fluctuations.

My analysis is that there are cycles.

The appearance is irregularity, but the underlying reality is a regularity with similar causes.

But there are different types of cycles, minor short ones and major long ones,

and also random fluctuations.

The major cycles have been historically very regular, appearing about every 18 years.

These major long cycles are closely related to the real estate cycle.


A recession means the GDP is receding or falling.

A crash is a very sudden and deep recession.

A depression is the bottom of a business cycle, during which there is relatively low output and high cyclical unemployment.

Other phases: expansion, boom, peak

Employment follows GDP with a lag.

The points of inflection: when the rate of growth or decline switches signs.

In the cycle, first derivative, rate of growth, second derivative, change in the rate of growth.

A negative second derivative ultimately causes the first derivative to turn negative.

With Y=C+I+G+X-M, what drives the business cycle?

Economists agree that it is changes in I.

Consumer spending is rather stable.

Changes in investment drives the cycle.

(Fig. 1)

Why would investment slow down?

Because investors and entrepreneurs expect lower profits.

Why lower profits?

Because of either decreasing demand or rising costs.

Usually, the first cause is rising costs.

What kinds of costs could rise?

Labor, but rising labor costs reflect greater productivity and demand, unless legislated.

Interest rates could rise artificially due to fed policy to reduce inflation.

Sometimes a rise in the price of oil has occurred before a recession, and sometimes not.

Oil price increases make a recession worse, but do not cause them by themselves.

The major cause historically has been real estate prices.

During a boom, the price of land escalates due to speculative demand.

Land becomes priced for future use, making present use too expensive.

There is an artificial boom due to excessive money creation and artificially low interest rates.

When interest rates rise, they combine with high real estate costs to choke off investment.

One third of investment is related to real estate.

The remedy for the business cycle is, according to this analysis, free banking and a shift untaxing production and instead obtaining public revenue from land rent.

Aggregate supply and demand

Graph of aggregate supply and demand on p. 432.

Vertical axis is the price level.

MV is fixed. If MV changes, the curve shifts.

aggregate demand - for all goods.

aggregate supply - of all goods.

AqD: aggregate quantity demanded.

AqS: aggregate quantity supplied.

Why does aggregate demand slope down?

Because with the same amount of money, people can buy more stuff at lower price levels.

That is called the wealth effect.

A lower price level makes money purchase more goods, so AD is greater.

Shows AD as a straight line, but really is convex.

Does a shift in consumption change AD?

Suppose you earn $48,000 per year, or $4000 per month. You were spending all your money for consumption.

Now you decide to save half your money.

You now only consume $24,000 of goods.

Does this decrease AD?

Not unless the money is kept in currency. (Hoarded.)

The savings get put into a bank account and get loaned out for investments.

That investment adds to AD, so the reduced consumption did not decrease AD.

If not enough people want to invest, the interest rate will fall until investment equals savings.

If consumption drops and it does not get invested, what does this assume?

It assumes that the rate of interest is stuck, and does not respond to changes in the supply and demand for loanable funds.

This is called a "liquidity trap."

The question is then, why are people not borrowing? Or, why do the banks refuse to lend?

It is because of some intervention, such as the threat of war or legal restrictions.

In a pure free market, a liquidity trap would be highly unlikely.

What can shift AD?

Changes in MV.

If there are idle resources such as unemployment, AD can shift out if the resources get employed. That can happen because of foreign spending or because prices are stuck.

Demand-side policy aims at increasing AD.

In the short run, an increase in the money supply may not immediately change interest rates or prices, because the increase is not expected.

There can be lags in responses.

Also in the short run, an increase in the money supply can reduce interest rates before it increases prices, so there is more investment and more output.

In the short run, an increase in G that comes from borrowing from abroad can increase AD because it takes some time for prices to rise.

But if G comes from taxes, there is no shift in AD because paying taxes reduces C and I by as much as the rise in G.

This graph has upward sloping AS.

In the long run, aggregate supply is vertical, fixed by the factor markets

and the aggregate production function.

But in the graph, AS slopes up diagonally.

In that case, a greater AD does increase output.

How does that happen?

Because of sticky-prices or sticky-wages.

The money wage is sticky.

Workers resists having their nominal wage cut.

People's perceptions are often based on nominal appearances.

Workers complain to the employer more if their nominal wage is reduced than if the real wages is reduced because of a higher price level.

It is the psychology of anchoring to recent data.

In the labor market, the real wage w/p is not an equilibrium wage.

Suppose M rises and V does not change.

AD rises. The price of goods rises, but in this case, the nominal wage does not rise.

In the short term, if wages are sticky and above equilibrium, aggregate supply can slope up.

Why? Unions might be stuck in long-term contracts.

Or, it might take a while before people realize that there has been inflation.

Nominal wages can be slow to adjust to new conditions.

If w is stuck and p rises, w/p falls.

With a lower real wage, employment rises.

Therefore, output rises.

Therefore, an increase in M made AS increase.

Also, the interest rate could be stuck.

Then a decrease in the demand for loans would not decrease the interest rate and increase investment.

If AS slopes up diagonally, something, someplace, is stuck.

Regulations and taxes create stickiness. They make economies more rigid.

In a pure free market, the AS would almost always be vertical.

Prices and wages would be flexible, and there would be little or no unexpected inflation.

But interventions can make the AS upwards sloping.

Interventions include restrictions that decrease the flexibility of wages and interest rates,

and unexpected variations in the money supply.

The aggregate supply curve, AS

Long run, vertical.

The long-run AS can shift because of:

Shifts in labor: immigration, greater supply, lower real wage, greater AS.

Population growth increases employment and therefore output.

Higher minimum wage, less employment, smaller AS.

More and better capital goods, better technology.

Aggregate production function shifts up, greater AS.

Discoveries of more oil and other natural resources, reduced cost, greater production and AS.

A blizzard destroys the grain harvest. lowers AS.

Lower trade barriers, lower costs of production, greater AS.

Taxes and regulations bring down the aggregate production function and reduce AS.

Supply-side policy aims at moving up an upward-sloping AS to a greater AqS by reducing taxes and regulations..

Over time AS shifts out and as M increases, AD shifts out, and the effect on the price level depends on which shift is greater.

Often, the stickiness in wages or prices is not due to market imperfections, but to government interventions that make it more costly or impossible to adjust.

For example, an electricity provider has to apply for permission before raissing prices.

The US postal service needs permission from a board before changing postal rates.

Unions with monopoly power may may it impossible to reduce nominal wages.

Misperception: entrepreneurs, landlords, and workers can confuse a change in the price of their goods with a change in microeconomic supply or demand rather than a change in the macroeconomic price level.

Sticky-price theory: some price are slow to adjust; menu costs.

With misperceptions, sticky wages, sticky interest rates, sticky rents, and sticky prices, AS is afffected by tghe actual price level minus the expected price level.

The exectations about the future price level can change, and shift short-run AS.

But such misperceptions are temporary.

In the long run, prices become unstuck.

Suppose the economy is hit by a wave of pessimism. For example, there could be rumors of an impending terrorist attack.

Nobody wants to invest. The demand for loanable funds drops to zero. Interest rates drop almost to zero.

They would not drop totally to zero. Why?

Because the price of assets are capitalized up as interest rates fall, and the price of bonds will not become infinite, because people expect that sometime in the future, interest rates will rise again.

The evaporation of investment would not shift AD to consumption, because people expect the crisis to go away eventually, and they want to keep their retirement savings.

So AD falls.

In the short run, output falls as prices are stuck.

Less investment leads to less output. The economy is in recession.

But in the long run, prices rise, and production shifts to consumer goods, and output rises back where it was before.

So AD and AS shocks can temporarily lead to changes in output, but later output returns to the normal level.

An increase in output in the short run, greater than the increase in the labor force, implies there were idle resources that have become employed.

It is also possible for there to be short-run increases in employment beyond normal, such as overtime and less vacation.

Business cycles.

Changes in expecations along with sticky wages or prices can explain minor short-run fluctuations, but do not explain the large swings and regularity of business cycles.

There have been two types of cycles, major and minor ones.

Minor cycles have occurred because of government actions.

1970: after rising inflation, the Fed

increases interest rates, causing a recession.

1980: after high inflation during the 1970s, high prices and interest rates lead to a downturn.

There was "stagflation" - both stagnation (no increase in GDP) and inflation.

The major cycles have had a period of about 20 years, since the early 1800s.

The major cycles have coincided with real estate cycles, in the price of land and in construction.

The Austrian theory of the business cycle.

Start with an injection of money by the Fed and the banking system.

It acts like an increase in savings. There is more borrowing, especially for investment in higher-order capital goods.

Real-estate construction is an example.

But then prices rise, and the nominal interest rate rises.

Construction and other costs rise.

The expected profit falls.

Investment slows down.

This decreases the demand for goods generally.

A recession follows.

Remedy: free banking and privae money.

The Georgist theory of the business cycle, by Henry George.

As the economy recovers, the demand for real estate rises.

Land values and rent rise.

Speculators add to the demand, making land prices rise even more.

This raises the cost of investment, and investment slows.

Remedy: shift taxes to rent.

So the Austrian and Georgist theories are complementary, and we can join them in a geo-Austrian theory of the business cycle.

This is consistent with the history of major business cycles world-wide.

The Great Depression of the 1930s.

Was world-wide.

From 1920 to 1933, the money supply fell by 28%. The Fed failed to expand the money supply to make up for a contraction of loans.

Also, Congress passed the highest tariffs in history, and other countries retaliated with high tariffs, and international trade broke down.

This reduced agricultural exports.

Farmers were impoverished.

That reduced demand for other goods.

Does a fall in the price of shares of stock cause a recession?

Some stock owners might reduce their consumption.

But if their income has not change, their savings will increase.

Interest rates will drop, and investment will increase.

So unless something is stuck, this will not lead to a fall in output.