Business Cycle Theory Changes in Business Activity Economics, Unit: 06 Lesson: 01
Objectives 1.Describe phases of business cycle 2.Identify and explain the factors that cause business cycles 3.Analyze how economists use business cycle theory to predict what is going to happen 4.Analyze how the government uses predictions to make public policy
Business Cycle Theory A free market economy does not grow at a constant rate. It goes through a series of expansions and contractions. These fluctuations are called business cycles. Business cycles reflect patterns to the general level of economic activity or the level of production of goods and services (GDP). Since this is a pattern it keeps repeating itself.you can see the business cycle activity from 1914 to 1992 below in the graph.
Business Cycle Theory Four Phases of business cycle are: Expansion Peak Contraction recession Trough
Contraction or Recession For a contraction to be a true recession, you must see 2 consecutive quarters or six months of declining real GDP.
Business Cycle Theory Stages Peak Expansion Recession Trough
Expansion Phase 1. GDP 2. Durable goods 3. Factory orders 4. Raw materials orders 5. Unemployment 6. Consumer confidence 7. problem: inflation
Contraction or Recession 1. Demand 2. GDP 3. Durable goods 4. Factory orders 5. Unemployment 6.Consumer confidence 7. problem: unemployment.
Causes There are several things that may lead to fluctuations in the economy. Some are within the economy and we call them internal factors. Some are outside the economy and we call them external factors.
Internal factors (within the economic system) 1. Business Investment In an expanding economy firms invest in new capital goods. This investment spending creates new jobs and growth. If firms decide to halt investment, this slows the economy down and can cause unemployment.
2. Interest Rates and Credit When interest rates go up, consumers will not make big ticket purchases. Lower demand slows down economy. When interest rates go down we see more purchases being made causing growth.
3. Consumer Expectations Fears of the economy slowing down can cause consumers to stop spending. This will then actually slow down the economy. If consumers feel confident about the economy, they spend more. Spending more can cause growth.
External factors (outside the economic system) External Shocks These are factors outside the economic system, but they can cause fluctuations in business activities. Examples include: wars natural disasters foreign economies 9/11
Business Cycle Forecasting Must anticipate changes in real GDP Economic Indicators-
Stock prices Manufacturing orders Housing starts Consumer confidence Leading Indicators
Lagging Indicators Interest rates Unemployment Credit/Income ratio
Inflation Prices Prices
Objectives Define inflation Explain and graph the 2 types of inflation Identify the causes and effects of inflation Define stagflation Explain wage-price spiral
Price Instability 2 types of Price Instability
1. Inflation - a rise in the general level of prices 2.Deflation - a decline in the general level of prices
Core Inflation Rate Core inflation rate rate of inflation excluding the effects of food and energy prices
Major Types of Inflation and Their Causes
1.Demand-pull inflation: too many dollars chasing too few goods demand > supply AS1 PL1 AD1 GDP Q1
1.Demand-pull inflation: too many dollars chasing too few goods demand > aggregate supply aggregate AS1 PL2 PL1 AD2 AD1 GDP Q1 Q2
1. Demand-pull inflation: all sectors of the economy contribute to demand-pull inflation. Aggregate demand is C+I+G so the household sector, the business sector and the government sector contribute to too much aggregate demand. PL2 AS1 PL1 AD2 AD1 GDP Q1 Q2
2. Cost-push inflation: cost of producing goods rises (ex. cost of inputs increases) AS1 PL1 AD1 GDP Q1
2. Cost-push inflation: cost of producing goods rises (ex. cost of inputs increases). This is more harmful because not only does the PL go AS2 up, output or GDP declines. PL2 AS1 PL1 AD1 GDP Q2 Q1
Causes of Inflation There are several factors that can cause or lead to one of the major types of inflation.
1. Wage-price spiral... prices rise workers want raises to pay higher prices prices go up b/c workers paid more money workers want raises to pay higher prices prices rise higher wages ETC... Related to cost-push inflation
2. Government deficit or deficit spending crowding-out effect related to demand-pull inflation
3. Quantity Theory Quantity theory of inflation- Milton Friedman and University of Chicago economists (Monetarists) stated that too much money in the economy causes inflation. The money supply is growing; leave it alone -- Fed should not increase or decrease.
Effects of Inflation
1. The dollar buys less purchasing power decreases
2. Spending habits change, interest rates rise (won t get loans for big ticket purchases)
3. Distribution of income is altered lenders hurt (money paid back worth less) borrowers helped (used $ when worth more)
4. Reduces real wages of workers.
5. Decreases value of savings - dollar is worth less
Ways to Measure Inflation 1. CPI 2. PPI
Cost Of Living Adjustments COLA s automatic adjustments to wages each year that takes into account the rate of inflation
Stagflation This refers to a time of high unemployment (stagnant growth) plus high rates of inflation