Chapter 22 – Understanding Business Cycle Fluctuations
Chapter 22
Understanding Business Cycle Fluctuations
Chapter Overview
The objective of this chapter is to use the framework developed in the last chapter to
understand fluctuations in output and inflation. We will examine why output and
inflation vary from quarter to quarter and from year to year, and what determines the
extent of fluctuations. Then, in the second part of the chapter we will use the model to
see how modern central banks can use their policy tools to stabilize the economy and
consider the pitfalls they face.
Learning Objectives: Establish an understanding of:
1. Sources of fluctuations in output and inflation
2. How to use AS/AD analysis
3. Policy trade‐offs and the limits of stabilization
Important Points of the Chapter
Business cycle fluctuations are the periods of recession and expansion that an economy
experiences. They are the result of shifts in the dynamic aggregate demand curve and/or
the short-run aggregate supply curve. In order to stabilize the economy, policymakers
need to understand what is changing and decide what to do in response.
Application of Core Principles
Principle #5: Stability. The aggregate demand/aggregate supply model is useful in
understanding how monetary and fiscal policymakers seek to stabilize output and
inflation. This is called stabilization policy.
Teaching Tips/Student Stumbling Blocks
Chapter 22 completes the discussion initiated in Chapter 21, that monetary policy
is used to stabilize the economy – reflecting Core Principle 5, that stability
enhances economic welfare.
If you have not already done so, you may wish to review the algebraic
formulation of the model at the end of Chapter 21 in this manual.
The context of the discussion is the basic model of output and inflation, which
itself reflects Core Principle 4 that markets set prices (and how they change,
which is the inflation rate) and allocate resources (in this analysis, aggregate
output).
This chapter introduces the term “disinflation.” Be sure that students understand
that disinflation is not the same thing as deflation, which is a reduction in the
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Chapter 22 – Understanding Business Cycle Fluctuations
overall price level. Disinflation means prices are still going up but at a slower
rate.)
Features in this Chapter
Tools of the Trade: Defining a Recession: The NBER Reference Cycle
The definition of a recession as two successive quarters of negative GDP growth has its
drawbacks. One is that since GDP data is computed and published quarterly, a definition
based on GDP cannot indicate the specific months in which a recession started and ended.
To determine that information, we need a definition that is based on measures like
production, employment, sales, and income, all of which are available monthly. The
National Bureau of Economic Research (NBER) has a Business-Cycle Dating Committee
that has become the unofficial arbiter for the time at which the economy has reached a
peak or trough. They define a recession based on activity (not just growth); the length of
time is ambiguous; and there is an element of judgment in dating the peaks and troughs.
Your Financial World: Stabilizing Your Consumption
Borrowing allows individuals to keep their purchases of consumer goods and services—
their consumption—smooth despite fluctuations in their incomes. But credit is only a
stop-gap measure that should be used for as short a time as possible.
Your Financial World: The Problem with Measuring GDP
GDP can be measured as the sum of all the expenditures or the sum of all the income
generated. Expenditures and income should, then, be equal, but that’s not always true.
The difference, called “Statistical Discrepancy” can be more than a percentage point of
GDP and so can have a big impact on official estimates of overall economic performance.
The practical implication of the statistical discrepancy is that it makes us unsure about the
current level of real output. Uncertainty about something so crucial to interest rate
decisions adds to the difficulty of making monetary policy.
In the News: Potential Output: Risk Permanent Damage
The Great Depression and the Great Inflation are two failures of 20th century
macroeconomic policy in the US. In both cases, policy makers could not properly gauge
the economy’s potential output. The stakes are high in determining the correct potential
output because policy is determined based on that prediction. Bad policy can further
exasperate problems in an economy.
Lessons of the Article: Potential output is determined by an economy’s resources
(labor and capital) and its technology. Central bankers neither observe it directly nor
control it. But they aim to keep output close to its potential, so when potential output
changes in unpredicted ways, it can lead to large policy errors. Uncertainty about
potential output rose sharply when the post‐crisis U.S. recovery remained weak for
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Chapter 22 – Understanding Business Cycle Fluctuations
several years but inflation failed to decline sharply (see Figure 21.13). Eventually,
FOMC members judged that some of the slowdown was permanent and began to
scale back their projections for long‐run economic growth.
Additional Teaching Tools
Louis Uchitelle, in his “Economic View” column of July 11, 2004 (“Beyond a President’s
Control,” The New York Times) writes that while people hold the president responsible for
the health of the economy, the president’s influence “is inevitably less than is advertised.”
He writes, “Booms and busts, in sum, do not come and go in response to finger snapping
by presidents.” He adds that what presidents can control is the distribution of income.
In a July 1, 2010 article in Business Week, Hugo Lindgren compares the views of Paul
Krugman, who forecasts a third depression in coming months, and John Paulson who
sees the U.S. continuing to grow.
http://www.businessweek.com/magazine/content/10_28/b4186004424615.htm
Virtual Tools
Visit the National Bureau of Economic Research on the web to learn more about its work
on business cycles. Find its most recent announcement about the cycle, as well as
historical data.
http://www.nber.org/cycles/main.html
Of particular interest is the “Frequently Asked Questions” section of that same website,
which provides more detail about how the NBER economists arrive at their conclusions.
http://www.nber.org/cycles/recessions.html#faq
Learn more about the business cycle indicators developed by the Conference Board on its
web site at:
http://www.conference-board.org/publications/publicationlisting.cfm?subtopicid=200.
For More Discussion
How well do the forecasters do? Consider the second article described above where an
assessment is made about the economy’s position in the business cycle. Have students go
back and find similar stories for other turning points. Were the forecasters on target?
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Chapter 22 – Understanding Business Cycle Fluctuations
Chapter Outline
I. Sources of Fluctuations in Output and Inflation
A. Sources of Fluctuations in Output and Inflation
1. A shift in the short-run aggregate supply curve or the dynamic aggregate
demand curve will move the economy away from its long-run equilibrium.
2. This means that understanding short-run fluctuations in output and inflation
requires that we study shifts in dynamic aggregate demand and short-run
aggregate supply.
3. The term “shocks” is used by economist to mean something that is
unexpected.
4. Shocks cause shifts in the dynamic aggregate demand or short-run aggregate
supply curve.
5. An increase in the price of oil, for example, affects the cost of production and
is a supply shock; a change in consumer confidence which affects
consumption expenditure is a demand shock.
B. Shifts in the Dynamic Aggregate Demand Curve
1. A shift in the dynamic aggregate demand curve can be caused by either a shift
in the monetary policy reaction curve or a change in components of aggregate
demand that are not sensitive to the interest rate (like government purchases)
that shifts the aggregate expenditure curve.
2. To study this further we will consider a decline in the central bank’s inflation
target (shift of the monetary policy reaction curve) and a fiscal policy easing
(shift in aggregate expenditure curve).
3. A Decline in the Central Bank’s Inflation Target
a. A decrease in the central bank’s inflation target shifts the monetary policy
reaction curve to the left, raising the real interest rate policymakers set at
each level of inflation.
b. Since this means a higher real interest rate at every level of inflation, the
dynamic aggregate demand curve also shifts to the left (the economy is on
a new dynamic aggregate demand curve).
c. The economy moves to a new short-run equilibrium where inflation and
current output are both lower than they were prior to the monetary policy
tightening.
d. But potential output has not changed, so there is a recessionary gap, which
puts downward pressure on production costs.
e. As a result, the short-run aggregate supply curve shifts to the right and the
economy moves along the new dynamic aggregate demand curve to a new
long-run equilibrium.
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Chapter 22 – Understanding Business Cycle Fluctuations
f. At the new long-run equilibrium output is once more equal to potential
output but the inflation rate is now lower and equal to the central bank’s
new target.
4. An Increase in Government Purchases
a. Expansionary fiscal policy consists of decreases in taxes, increases in
government spending, or (as was the case in 2001) both.
b. Increases in government purchases or cuts in taxes shift the dynamic
aggregate demand curve to the right.
c. As a result, the economy moves to a new short-run equilibrium where
inflation and current output are both higher than they were prior to the
fiscal policy easing.
d. But potential output has not changed, so there is an expansionary gap,
which puts upward pressure on wages and product prices.
e. As a result, the short-run aggregate supply curve shifts to the left, driving
inflation even higher.
f. As inflation rises, monetary policymakers raise the real interest rate,
moving the economy along the new dynamic aggregate demand curve, and
causing output to fall back to its long-run equilibrium level (potential
output).
g. The economy moves to a new long-run equilibrium where output is again
at the level of potential output but inflation is higher than it was before the
fiscal policy change.
h. The key point to note is that, unless monetary policy changes somehow,
when the dynamic aggregate demand curve shifts to the right, inflation
will rise.
i. It seems unlikely that central bankers will allow the change in fiscal policy
to drive up their inflation target; therefore they will need to act to bring the
inflation rate back down to the target rate.
j. Monetary policy makers therefore tighten, shifting the monetary policy
reaction curve to the left and consequently shifting the dynamic aggregate
demand curve to the left.
k. This brings the economy back to long-run equilibrium where output equals
potential output and inflation equals the central bank’s target.
l. A decline in aggregate expenditure, caused by a fall in consumer or
business confidence, would have the opposite impact of an increase in
government expenditures, but the logic of the adjustments would be
parallel.
m. This discussion implies that whenever we see a permanent increase in
inflation it must be the result of monetary policy. Central bankers must
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Chapter 22 – Understanding Business Cycle Fluctuations
have changed their inflation target, whether or not they acknowledge the
change explicitly.
C. Shifts in the Short-Run Aggregate Supply Curve
1. Changes in production costs shift the short-run aggregate supply curve.
2. An increase in expected inflation or in the costs of production shift the
short-run aggregate supply curve to the left, reducing the amount supplied at
every level of inflation. That is why economists refer to such a change as a
negative supply shock.
3. The bad consequences of a negative supply shock, higher inflation and lower
growth, creates a situation called “stagflation” (economic STAGnation
coupled with increased inFLATION).
4. The decline in output causes a recessionary gap, which puts downward
pressure on production costs and inflation.
5. The short-run aggregate supply curve begins to shift to the right, driving
inflation down and output up, and the economy returns to long-run
equilibrium.
6. Therefore a negative supply shock moves output and inflation temporarily
away from potential output and the inflation target, but as always, the
economy returns to the point where output equals potential output and
inflation equals the central bank’s target.
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