Chapter 12 – Economic Fluctuations

“Economic depression cannot be cured by legislative action or executive pronouncement. Economic wounds must be healed by the action of the cells of the economic body - the producers and consumers themselves”. Herbert Hoover

Business Cycle

The Gaps of recessionary and inflationary does not just happen randomly.

They occur in a sequence based on changes in output and spending.

In principle, a sustained boost in real output is referred to as expansion, but is continue by an extension of falling output, which is referred to as a contraction.

When rises & falls in real output constitute one of these two pattern expansion and contraction, this is known as business cycle.

All these changes occurred from the patterns can be shown through a trend line that indicates a Long-run growth potential.

Business Cycle Graph

Contraction

When an economy has reached to its peak, the economy is said to be “a boom”, this occurs when real GDP is at the top highest value/ maximum width in the business cycle.

Causes of Contraction

A contraction occurs when economic contractions originates with events that rises make the situation to be experiencing “a boom”.

Expenditures and spending will drive up the demand for production inputs, (ie. Labour raw materials).

The Role of Expectations

The adjustments of lowering aggregate demand can be expended by the reactions of both households and businesses to start reductions in output and fluctuations.

Both households and businesses depend their needs future expectations and demand.

As economy experiences reductions in spending, they are likely to consider 3 types of spending; this includes consumption, investment, and exports.

If the expectations in businesses and households continuously to increase, then everything will go down to the drain. As a result, it will decline in real output level as well as further downfall in spending and in output.

Effects of Contraction

The effect of aggregate demand declines from D0 and D1 because of periods of contraction.

Because of this decline, this cannot meet the equilibrium output and the initial inflationary gap will eventually turn into a recessionary gap.

Periods of expansions, on the other hand, reverse the change, and cause the curve to shift its place from AD1 to AD0, and rises equilibrium output

Expansion and Contraction

Recessions and Depression

Generally, the wider of the length the period decline its real output, the more effectives for its reaction.

Recession is a type of decline in real output that hold back its decline for at lasts 6 months. A depression happens if the reduction in real output in rather long, as happened during the early 1930s (The Great Depression).

Expansion

A recession and depression may damage the economy for its effects, but however, once the economy get back on the roll it reaches a trough where at this point recession gap will be at the max, and more over, unemployment level will reach its highest level.

After this point, this will suppress the economy for expectations by other factors, but the economy enters a phase of expansion.

Causes of an Expansion

The recovery for its lost can be change by the previous stages of contraction.

The lower levels of spending & production are connected through trough reductions that reduce the demand for production inputs.

Effects of an Expansion

Since the aggregate demand curve shifts to the right (AD1 to AD0). The recessionary gap is turned into an inflationary gap. Which will causes the unemployment level to change from rise to fall.

Neoclassical Theory

based on two major assumptionsFlexible Labour markets Say’s Law

Flexible Labour Markets

Its when the real wage is a certain amount, the quantity supplied of labour exceeds the quantity demanded; it results in an amount of workers involuntarily unemployed. Therefore the forces of demand and supply push the wage to equilibrium level to eliminate surplus.

2 types of unemployment : voluntary and involuntary voluntary unemployment exists when ever workers

decide that real wages are not high enough to make work worthwhile

involuntary unemployment is when someone wants to work at the current real wage rate but cannot find a job

Flexible Labour Market

Say’s Law

using a circular flow of money in the economy. Supply automatically creates its own demand. (produce goods and services in order to purchase others)

eg: A tailor makes clothes, in order to have funds to buy other products. The production of goods and services generates enough funds to purchase them.

Keynesian Theory

explains how involuntary unemployment and under spending had become a chronic problem during depression

Challenge to Flexible Labour Markets

Keynes believes that workers were influenced by money illusions – workers would respond to changes in nominal wages, rather than real wages and purchasing power.

If price drops by 10%, workers would not mind if nominal wages are cut by 10% as well – wages and purchasing power are no affected

According to Keynes, workers do mind. They see a decrease in nominal income as a drop in living standards. Trade unions tend to reject nominal wage cuts. Nominal wage does not move down.

Inflexible Labour Market

Challenge to Say’s Law

Output levels not interest rates – adjust to bring about a balance between total injections and withdrawals.

When injections are less than withdrawals, output falls until a new equilibrium level is reached.

It is only at this equilibrium output that Say’s Law is true, with injections and withdrawals the same.

Statistical Models

models that are composed of equations that summarize macroeconomics behavior in numerical terms

Composite Index

index calculated monthly weighted average of 10 leading indicators leading indicators show movement that precedes

changes in the GDP (eg: The Stock Market) future GDP movements are also directly related to

current employment trends the unemployment rate lags behind GDP, because

there is usually a delay between changes in business revenue and new hiring or layoffs

must move in the same direction for three consecutive months before it is said to forecast changes in GDP

Composite Index con’t

Index can give false predictions 5 indicators that are included in the composite index are furniture

and appliance sales, retail sales of other durable goods, new orders for durable goods, a shipment to inventory ratio of finished goods, and a house spending index.

the change in any of these indicators point to corresponding future changes in the GDP

Toronto Stock Exchange 300 ( TSE 300 ) represents the composite index’s financial and money markets.

measure of money supply is called M1 movements in share prices reflect expected changes in corporate

profits, alterations in the money supply are directly tied to future spending plans

composite index can forecast turning points in the business cycle