ECONOMIC FLUCTUATIONS: THE BUSINESS CYCLE

Business Cycle 3/19/2014

A central concern of macroeconomics is the upswings and downswings in the level of real output or economic fluctuations called the business cycle.

There are expansions and contractions

Aggregate economic activity declines in a contraction or recession until it reaches a trough Then activity increases in an expansion or boom until it reaches a peak

A particularly severe recession is called a depression

The sequence from one peak to the next, or from one trough to the next, is a business cycle Peaks and troughs are turning points

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A Complete Business Cycle consists of an expansion and a contraction

Peak
2.00 1.50 1.00 0.50 0.00 -0.50 -1.00 -1.50 -2.00 2000-I

recession

2002-I

2004-I

Trough

Expansion

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The business cycle is recurrent, but not periodic Recurrent means the pattern of contraction-trough-expansion-peak occurs again and again Not being periodic means that it doesn't occur at regular, predictable intervals

Business cycle
Business cycle is the fluctuation in the level of economic activity alternating between periods of depression and boom conditions. It is the economic condition alternating between periods of economic growth and contraction. Business cycles are innate to market economies.

Key indicator of cycles is the rise and fall in real GDP, which mirrors changes in employment and the price levels.

Four Phases of Business Cycle

Peak or boom Recession Trough Recovery

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peak- a phase where business activities are in their temporary maximum. the economy at this phase is at full employment and the level of output is at its full capacity recession- a phase in business cycle that is characterized by a decline in total output , income and employment. trough/depression- it is the turning point of recession or when economic activity is at its lowest. (unemployment is so severe) recovery- in this phase, there is a recovery in the economy wherein income, output, interest rate, wage and employment are rising.

FISCAL POLICY

Fiscal policy is the use of government spending and taxes to influence the nations spending, employment and price level. (Tucker 2008 p.527) It is the manipulation of the national government budget to attain price stability, relatively full employment, and a satisfactory rate of economic growth (Slavin 2005 p. 275)

Fiscal policy is reflected through the governments spending, taxation, and borrowing policies. It is one of the major tools that government utilizes in order to help promote the goals of full employment, price stability, and rapid economic growth.

When the supply of money is constant, government expenditures must be financed with either: (1) taxes and other revenues derived from the sale of services (i.e fees and charges) or assets (such as privatization of government owned and controlled corporations and selling of government assets) or (2)) borrowings (either domestic or foreign)

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When government revenue from taxes is equal to government expenditure, the government has achieved a balanced budget. budget deficit- total government spending exceeds total government revenue budget surplus- government revenue's exceed its total expenditure

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Changes in the size of the deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand. Changes in the size of the budget deficit or surplus may arise from either: 1. A change in the state of the economy, or, 2. A change in discretionary fiscal policy. The natinal budget is the primary tool of fiscal policy. Discretionary changes in fiscal policy: deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

Keynesian view to fiscal policy

Government budget should be used to promote a level of aggregate demand consistent with full employment rate of output

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When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by: increasing the governments purchases of goods & services, and/or, cutting taxes. expansionary policies Government policy actions that lead to increases in aggregate demand.

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When inflation is a potential problem, Keynesian analysis suggests a shift toward a more contractionary fiscal policy by: reducing government spending, and/or, raising taxes.

contractionary policies Government policy actions that lead to decreases in aggregate demand.

MONETARY POLICY

Monetary policy is a macroeconomic policy which involves the regulation of the money supply, credit and interest rates in order to control the level of spending in the economy. It is the measure or action undertaken by central banks to influence the general price level and the level of liquidity in the economy.

During the 1950s and 1960s, most Keynesian argued that monetary policy could be used to control inflation, but that was often ineffective as a means of stimulating aggregate demand. It was popular to draw an analogy between monetary policy and the workings of a string. Like a string, monetary policy could be used to pull ( hold back) price increases and thereby control. However, just as one cannot push with a string, according to this popular view, monetary policy could not be used to push (stimulate) aggregate demand.

Money supply increases

Interest rate falls

Expansionary Monetary Policy Problem: Recession and Unemployment Measures: 1.Central bank buys securities through open market operations 2.CB lowers bank rate.

Investment increases

Aggregate demand increases

Aggregate output increases by the increase in investment

Price level rises

Expansionary monetary policy

Refers to a monetary policy setting that intends to increase the level of which could also result in a relatively higher inflation path for the economy.

Contractionary monetary policy

Is a monetary policy setting that intends to decrease the level of liquidity/money supply in the economy and which could also result in a relatively lower inflation path for the economy.

Money supply decreases

Interest rate rises

Restrictive or Tight Monetary Policy Problem: Inflation

Investment decreases

Aggregate demand declines

Aggregate output decrease by the decrease in investment

Measures: 1.Central bank sells securities through open market operations 2.It rises bank rate.

Price level fallss

What is Money Supply (Ms)?

Economists define money supply (Ms) as anything that is generally accepted as payment for goods or services or in the repayment of debts (Mishkin, 2003)

The term money is also being used to describe income It may also refer to generally accepted in payment for goods and services or in repayment of debts and distinct from income and wealth.

Functions of Money
1.As a medium of exchange 2.As a unit of account 3.As a store of value

Measuring Money Supply (Ms)

1. M1 or Narrow Money- consists of currency in

circulation (or currency outside depository corporations) and peso demand deposits. 2. M2 or Broad Money- consists of M1 plus peso savings and time deposits. 3. M3 or Broad Money Liabilities- consists of M2 plus peso deposit substitutes, such as promissory notes and commercial papers 4. M4- consists of M3 plus transferrable and other deposits in foreign currency.

Factors Which Increases the Demand for Money

1. A reduction in the interest rate. 2. A rise in the demand for consumer spending. 3. A rise in uncertainty about the future and future opportunities. 4. A rise in transaction costs to buy and sell stocks and bonds. 5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.

6. A rise in the demand for a countrys good abroad. 7. A rise in the demand fro domestic investment by foreigners. 8. 8. A rise in the belief of the future value of the currency. 9. A rise in the demand for a currency by central banks (both domestic and foreign).