Ebook Macroeconomics (6th edition): Part 2

(BQ) Part 2 book Macroeconomics hass contents: Business cycles; classical business cycle analysis - market clearing macroeconomics; keynesianism - the macroeconomics of wage and price rigidity; unemployment and inflation; monetary policy and the federal reserve system,...and other contents.

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by a resumption of economic growth

This repeated sequence of economic expansion giving way to temporary decline followed by recovery, is known as the business cycle The business cycle is a central concern in macroeconomics because business cycle fluctuations the ups and downs in overall economic activity are felt throughout the economy When the economy is growing strongly, prosperity is shared by most of the nation's industries and their workers and owners of capital When the economy weakens, many sectors of the economy experience declining sales and production, and workers are laid off or forced to work only part-time Because the effects of busi­ness cycles are so widespread, and because economic downturns can cause great hardship, economists have tried to find the causes of these episodes and to deter­mine what, if anything, can be done to counteract them The two basic questions of (1) what causes business cycles and (2) how policymakers should respond to cyclical fluctuations are the main concern of Part 3 of this book

The answers to these two questions remain highly controversial Much of this controversy involves the proponents of the classical and Keynesian approaches to macroeconomics, introduced in Chapter 1 In brief, classical economists view busi­ness cycles as generally representing the economy's best response to disturbances

in production or spending Thus classical economists do not see much, if any, need for government action to counteract these fluctuations In contrast, Keynesian econ­omists argue that, because wages and prices adjust slowly, disturbances in pro­duction or spending may drive the economy away from its most desirable level of output and employment for long periods of time According to the Keynesian view, government should intervene to smooth business cycle fluctuations

We explore the debate between classicals and Keynesians, and the implications

of that debate for economic analysis and macroeconomic policy, in Chapters 9-11 In this chapter we provide essential background for that discussion by presenting the basic features of the business cycle We begin with a definition and a brief history of

8.1 What Is a Business Cycle? 283

the business cycle in the United States We then turn to a more detailed discussion of business cycle characteristics, or "business cycle facts." We conclude the chapter with a brief preview of the alternative approaches to the analysis of business cycles

8.1 What Is a B usiness Cycle?

Countries have experienced ups and downs in overall economic activity since they began to industrialize Economists have measured and studied these fluctuations for more than a century Marx and Engels referred to "commercial crises," an early term for business cycles, in their Communist Manifesto in 1848 In the United States, the National Bureau of Economic Research (NBER), a private nonprofit organization of economists founded in 1920, pioneered business cycle research The NBER developed and continues to update the business cycle chronology, a detailed history of business cycles in the United States and other countries The NBER has also sponsored many studies of the business cycle: One landmark study was the 1946 book Measuring Business Cycles, by Arthur Burns (who served as Fed­eral Reserve chairman from 1970 until 1978) and Wesley Mitchell (a principal founder of the NBER) This work was among the first to document and analyze the empirical facts about business cycles It begins with the following definition:

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises A cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in dura­ tion business cycles vary from more than one year to ten or twelve years.'

Five points in this definition should be clarified and emphasized

1 Aggregate economic activity Business cycles are defined broadly as fluctua­tions of "aggregate economic activity" rather than as fluctuations in a single, specific economic variable such as real GDP Although real GDP may be the single variable that most closely measures aggregate economic activity, Burns and Mitchell also thought it important to look at other indicators of activity, such as employment and financial market variables

2 Expansions and contractions Figure 8.1 a diagram of a typical business cycle helps explain what Burns and Mitchell meant by expansions and contractions The dashed line shows the average, or nonnal, growth path of aggregate economic activity, as determined by the factors we considered in Chapter 6 The solid curve shows the rises and falls of actual economic activity The period of time during which aggregate economic activity is falling is a contraction or recession If the recession is particularly severe, it becomes a depression After reaching the low point of the contraction, the trough (T), aggregate economic activity begins to increase The period of time during which aggregate economic activity grows is an expansion or

a boom After reaching the high point of the expansion, the peak (P), aggregate economic activity begins to decline again The entire sequence of decline followed by recovery, measured from peak to peak or trough to trough, is a business cycle

IBurns and Mitchell, Measuring Business Cycles, New York: National Bureau of Economic Research,

1946, p 1

284 Chapter 8 Business Cycles

Figure 8.1

A business cycle

The solid curve graphs

the behavior of aggregate

economic activity over a

typical business cycle

The dashed line shows

the economy's normal

growth path During a

contraction aggregate

economic activity falls

until it reaches a trough,

T The trough is followed

by an expansion during

whkh economic activity

increases until it reaches

a peak, P A complete

cycle is measured from

peak to peak or trough

Peaks and troughs in the business cycle are known collectively as turning points

One goal of business cycle research is to identify when turning points occur Aggre­gate economic activity isn't measured directly by any single variable, so there's no simple formula that tells economists when a peak or trough has been reached.2 In practice, a small group of economists who fonn the NBER's Business Cycle Dating Committee determine that date The committee meets only when its members believe that a turning point may have occurred By examining a variety of economic data, the committee determines whether a peak or trough has been reached and, if so, the month it happened However, the committee's announcements usually come well after a peak or trough occurs, so their judgments are more useful for historical analy­sis of business cycles than as a guide to current policymaking

3 Comovement Business cycles do not occur in just a few sectors or in just a few economic variables Instead, expansions or contractions " occur at about the same time in many economic activities." Thus, although some industries are more sensitive to the business cycle than others, output and employment in most indus­tries tend to fall in recessions and rise in expansions Many other economic vari­ables, such as prices, productivity, investment, and government purchases, also have regular and predictable patterns of behavior over the course of the business cycle

2A conventional definition used by the media-that a recession has occurred when there are two consecutive quarters of negative real GDP growth-isn't widely accepted by economists The reason that economists tend not to like this definition is that real GDP is only one of many possible indicators

of economic a c ti v it y

8.2 The American Business Cycle: The Historical Record 285

The tendency of many economic variables to move together in a predictable way over the business cycle is called comovement

4 Recurrent but not periodic The business cycle isn't periodic, in that it does not occur at regular, predictable intervals and doesn't last for a fixed or predetermined length of time (Box 8.1, p 301, discusses the seasonal cycle or economic fluctuations over the seasons of the year which, unlike the business cycle, is periodic.) Although the business cycle isn't periodic, it is recurrent; that is, the standard pattern of contraction-trough €xpansion-peak recurs again and again in industrial economies

5 Persistence The duration of a complete business cycle can vary greatly, from about a year to more than a decade, and predicting it is extremely difficult However, once a recession begins, the economy tends to keep contracting for a period of time, perhaps for a year or more Similarly, an expansion, once begun, usually lasts a while This tendency for declines in economic activity to be fol­lowed by further declines, and for growth in economic activity to be followed by more growth, is called persistence Because movements in economic activity have some persistence, economic forecasters are always on the lookout for turning points, which are likely to indicate a change in the direction of economic activity

8.2 The American Business Cycle: The H istorical Record

An overview of American business cycle history is provided by the NBER's monthly business cycle chronology? as summarized in Table 8.1 It gives the dates of the troughs and peaks of the thirty-two complete business cycles that the U.s economy has experienced since 1854 Also shown are the number of months that each con­traction and expansion lasted

The P re-World Wa r I P e r i o d

The period between the Civil War (1861-1865) and World War I (1917-1918) was one of rapid economic growth in the United States Nevertheless, as Table 8.1 shows, recessions were a serious problem during that time Indeed, the longest con­traction on record is the 65-month-long decline between October 1873 and March

1879, a contraction that was worldwide in scope and is referred to by economic his­torians as the Depression of the 1870s Overall, during the 1854-1914 period the economy suffered 338 months of contraction, or nearly as many as the 382 months

of expansion In contrast, from the end of World War II in 1945 through October

2006, the number of months of expansion (627) outnumbered months of contraction (104) by more than six to one

The G reat D e p ression a n d Wo rld Wa r I I

The worst economic contraction in the history of the United States was the Great Depression of the 1930s After a prosperous decade in the 1920s, aggregate eco­nomic activity reached a peak in August 1929, two months before the stock market crash in October 1929 Between the 1929 peak and the 1933 trough, real GDP fell by

3For a detailed discussion of the NBER chronologies, see Geoffrey H Moore and Victor Zarnowitz,

"The NBER's Business Cycle Chronologies," in Robert j Gordon, ed., The American BlIsiness Cycle:

CO/llillllily a/ld Change, Chicago: University of Chicago Press, 1986 The NBER chronology is available

at the NBER's Web site, www.nber.org

286 Chapter 8 Business Cycles

Table 8.1 NBER Business Cycle Turning Points and Durations of Post-1854 Business Cycles

Trough

Dec 1854

Dec 1858

june 1861 Dec 1867

june 1938

Oct 1945 Oct 1 949

May 1954

Apr 1958 Feb 1961

Nov 1970

Mar 1975 july 1980

Nov 1982 Mar 1991 Nov 2001

Expansion (months from trough to peak)

jan 1893

Dec 1895

june 1899

Sept 1902 May 1907 jan 1910 jan 1 9 1 3

Aug 1 9 1 8

jan 1920

May 1923 Oct 1926

Aug 1929 May 1937

Although no sector escaped the Great Depression, some were particularly hard hit In the financial sector, stock prices continued to collapse after the crash Depos­itors withdrew their money from banks, and borrowers, unable to repay their

8.2 The American Business Cycle: The Historical Record 287

bank loans, were forced to default; as a result, thousands of banks were forced to go out of business or merge with other banks In agriculture, farmers were bankrupted

by low crop prices, and a prolonged drought in the Midwest turned thousands of farm families into homeless migrants Investment, both business and residential, fell to extremely low levels, and a "trade war" in which countries competed in erecting barriers to imports virtually halted international trade

Although most people think of the Great Depression as a single episode, tech­nically it consisted of two business cycles, as Table 8.1 shows The contraction phase of the first cycle lasted forty-three months, from August 1929 until March

1933, and was the most precipitous economic decline in U.s history After Franklin Roosevelt took office as President in March 1933 and instituted a set of policies known collectively as the New Deal, a strong expansion began and continued for fifty months, from March 1933 to May 1937 By 1937 real GDP was almost back to its 1929 level, although at 14% the unemployment rate remained high Unemploy­ment remained high in 1937 despite the recovery of real GDP because the number

of people of working age had grown since 1929 and because increases in produc­tivity allowed employment to grow more slowly than output

The second cycle of the Great Depression began in May 1937 with a contraction phase that lasted more than a year Despite a new recovery that began in June

1938, the unemployment rate was still more than 17% in 1939

The Great Depression ended dramatically with the advent of World War II Even before the Japanese attack on Pearl Harbor brought the United States into the war in December 1941, the economy was gearing up for increased armaments pro­duction After the shock of Pearl Harbor, the United States prepared for total war With production supervised by government boards and driven by the insatiable demands of the military for more guns, planes, and ships, real GDP almost doubled between 1939 and 1944 Unemployment dropped sharply, averaging less than 2%

of the labor force in 1943-1945 and bottoming out at 1.2% in 1944

P ost - World War I I U S B usi ness Cyc l e s

As World War II was ending in 1945, economists and policymakers were concerned that the economy would relapse into depression As an expression of this concern, Congress passed the Employment Act of 1946, which required the government to fight recessions and depressions with any measures at its disposal But instead of falling into a new depression as feared, the U.s economy began to grow strongly

Only a few relatively brief and mild recessions interrupted the economic expansion

of the early postwar period None of the five contractions that occurred between 1945 and 1970 lasted more than a year, whereas eighteen of the twenty-two previous cycli­cal contractions in the NBER's monthly chronology had lasted a year or more The largest drop in real GDP between 1945 and 1970 was 3.3% during the 1957-1958 reces­sion, and throughout this period unemployment never exceeded 8.1 % of the work force Again, there was a correlation between economic expansion and war: The 1949-1953 expansion corresponded closely to the Korean War, and the latter part of the strong 1961-1969 expansion occurred during the military buildup to fight the Vietnam War

Because no serious recession occurred between 1945 and 1970, some economists suggested that the business cycle had been "tamed," or even that it was "dead." This view was especially popular during the 106-month expansion of 1961-1969, which was widely attributed not only to high rates of military spending during the Vietnam War but also to the macroeconomic policies of Presidents Kennedy and Johnson

288 Chapter 8 Business Cycles

Some argued that policymakers should stop worrying about recessions and focus their attention on inflation, which had been gradually increasing over the 1960s

Unfortunately, reports of the business cycle's death proved premature Shortly after the Organization of Petroleum Exporting Countries (OPEC) succeeded in quadrupling oil prices in the fall of 1973, the U.s economy and the economies of many other nations fell into a severe recession In the 1973-1975 recession U.s real GDP fell by 3.4% and the unemployment rate reached 9% not a depression but a serious downturn, nonetheless Also disturbing was the fact that inflation, which had fallen during most previous recessions, shot up to unprecedented double-digit levels Inflation continued to be a problem for the rest of the 1970s, even as the economy recovered from the 1973-1975 recession

More evidence that the business cycle wasn't dead came with the sharp 1981-1982 recession This contraction lasted sixteen months, the same length as the 1973-1975 decline, and the unemployment rate reached 11 %, a postwar high Many economists claim that the Fed knowingly created this recession to reduce inflation,

a claim we discuss in Chapter 11 Inflation did drop dramatically, from about 11 %

to less than 4% per year The recovery from this recession was strong, however

The " Lo n g B o o m "

The expansion that followed the 1981-1982 recession lasted almost eight years, until July 1990, when the economy again entered a recession This contraction was relatively short (the trough came in March 1991, only eight months after the peak) and shallow (the unemployment rate peaked in mid 1992 at 7.7% not particularly high for a recession) Moreover, after some initial sluggishness, the 1990-1991 reces­sion was followed by another sustained expansion Indeed, in February 2000, after

107 months without a recession, the expansion of the 1990s became the longest in U.s history, exceeding in length the Vietnam War-era expansion of the 1960s Taking the expansions of the 1980s and 1990s together, you can see that the U.s economy experienced a period of more than eighteen years during which only one relatively minor recession occurred Some observers referred to this lengthy period of prosperity as the "long boom." The long boom ended with the business cycle peak in March 2001, after which the U.s economy suffered a mild recession and sluggish growth

Have American B us i ness Cyc l es B e c o m e Less Severe?

Until recently, macroeconomists believed that, over the long sweep of history, business cycles generally have become less severe Obviously, no recession in the United States since World War II can begin to rival the severity of the Great Depression Even putting aside the Great Depression, economists generally believed that business downturns before 1929 were longer and deeper than those since 1945 According to the NBER business cycle chronology (Table 8.1), for example, the average contraction before 1929 lasted nearly twenty-one months and the average expansion lasted slightly more than twenty-five months Since 1945, contractions have shortened to an average of eleven months, and expansions have lengthened to an average of fifty months, even excluding the lengthy expansion of the 1990s Standard measures of eco­nomic fluctuations, such as real GDP growth and the unemployment rate, also show considerably less volatility since 1945, relative to data available for the pre-1929 era

8.2 The American Business Cycle: The Historical Record 289

Since World War II a major goal of economic policy has been to reduce the size and frequency of recessions If researchers found contrary to the generally accepted view-that business cycles had not moderated in the postwar period, serious doubt would be cast on the ability of economic policymakers to achieve this goal For this reason, although the question of whether the business cycle has moderated over time may seem to be a matter of interest only to economic historians, this issue is of great practical importance

Thus Christina Romer, now at the University of California at Berkeley, sparked

a heated controversy by writing a series of articles denying the claim that the busi­ness cycle has moderated over time 4 Romer's main point concerned the dubious quality of the pre-1929 data Unlike today, in earlier periods the government didn't collect comprehensive data on economic variables such as GDP Instead, economic historians, using whatever fragmentary information they could find, have had to estimate historical measures of these variables

Romer argued that methods used for estimating historical data typically over­stated the size of earlier cyclical fluctuations For example, widely accepted estimates

of pre-1929 GNp5 were based on estimates of just the goods-producing sectors of the economy, which are volatile, while ignoring less-volatile sectors such as wholesale and retail distribution, transportation, and services As a result, the volatility of GNP was overstated Measured properly, GNP varied substantially less over time than the official statistics showed Romer's arguments sparked additional research, though none proved decisively whether volatility truly declined after 1929 Nonetheless, the debate served the useful purpose of forcing a careful reexamination of the historical data

New research shows that economic volatility declined in the mid 1980s and has remained low since then Beca use the quality of the data is not an issue for the period following World War II, the decline in volatility in the mid 1980s, relative to the preceding forty years, probably reflects a genuine change in economic volatility rather than a change in how economic data are produced

Other economic variables, including inflation, residential investment, output of durable goods, and output of structures, also appear to fluctuate less in the past twenty years than they did in the preceding forty years Research by James Stock of Harvard University and Mark Watson of Princeton University6 shows that the volatility, as measured by the standard deviation of a variable, declined by 20 to 40% for many of the twenty-one variables they examine, including a decline of 33% for real GDP, 27% for employment, and 50% for inflation Because the decline in volatility of macroeconomic variables has been so widespread, economists have dubbed this episode "the Great Moderation."?

4The articles included "Is the Stabilization of the Postwar Economy a Figment of the Data?" American

Economic Review, June 1986, pp 314-334; "The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869-1908," journal of Political Economy, February 1989, pp 1-37; and "The

Cyclical Behavior of Individual Production Series, 1889-1984," Quarterly joumal of Econol1lics, February

1991, pp 1-3l

sAs discussed in Chapter 2, unti1 1991 the U.s national income and product accounts focused on

GNP rather than GOP As a result, studies of business cycle behavior have often focused on GNP

rather than GOP

6"Has the Business Cycle Changed and Why?" NBER MacroecOIlOmics Al1IllIal 2002 (Cambridge, MA: MIT Press, 2002), pp 159-218

7See Ben S Bernanke, "The Great Moderation," Speech at the Eastern Economic Association meetings, February 20, 2004, available at wwwfederalreserve.gov

290 Chapter 8 Business Cycles

Somewhat surprisingly, the reduction in volatility seemed to corne from a sudden, one-time drop rather than a gradual decline The break seems to have corne around 1984 for many economic variables, though for some variables the break occurred much later

What accounts for this reduction in the volatility of the economy? Stock and Watson found that better monetary policy is responsible for about 20% to 30% of the reduction in output volatility, with reduced shocks to the economy's produc­tivity accounting for about 15% and reduced shocks to food and commodity prices accounting for another 15% The remainder is attributable to some unknown form

of good luck in terms of smaller shocks to the economy.s

8.3 Business Cycle Facts

Although no two business cycles are identical, all (or most) cycles have features in common This point has been made strongly by a leading business cycle theorist, Nobel laureate Robert E Lucas, Jr., of the University of Chicago:

Though there is absolutely no theoretical reason to anticipate it, one is led by the facts

to conclude that, with respect to the qualitative behavior of comovements among series [that is, economic variables], business cycles are all alike To theoretically inclined economists, this conclusion should be attractive and challenging, for it suggests the possibility of a unified explanation of business cycles, grounded in the general laws governing market economies, rather than in political or institutional characteristics specific to particular countries or periods?

Lucas's statement that business cycles are all alike (or more accurately, that they have many features in common) is based on examinations of comovements among eco­nomic variables over the business cycle In this section, we study these comovements, which we call business cycle facts, for the post-World War II period in the United States Knowing these business cycle facts is useful for interpreting economic data and evaluating the state of the economy In addition, they provide guidance and discipline for developing economic theories of the business cycle When we discuss alternative theories of the business cycle in Chapters 10 and 11, we evaluate the theories principally

by determining how well they account for business cycle facts To be successful, a theory of the business cycle must explain the cyclical behavior of not just a few vari­ables, such as output and employment, but of a wide range of key economic variables

The Cyc l i c a l B e havior of E c o n o m i c Va r i a b l e s : D i rection a n d Ti m i ng

Two characteristics of the cyclical behavior of macroeconomic variables are impor­tant to our discussion of the business cycle facts The first is the direction in which

SSince the Stock and Watson paper was written, much additional research has been undertaken, with mixed results For example, Shaghil Ahmed, Andrew Levin, and Beth Ann Wilson ["Recent Improve­ ments in U.s Macroeconomic Stability: Good Policy, Good Practices, or Good Luck?" Review of Eco­

Ilomics alld Statistics, vol 86 (2004), pp 824-8321 suggest that good luck played the biggest role, while others find a larger role for monetary policy, including Peter M Summers ["What Caused the Great Moderation? Some Cross-Country Evidence," Federal Reserve Bank of Kansas City, Economic Review (Third Quarter 2005), pp 5-321

'Robert E Lucas, Jr., "Understanding Business Cycles," in K Brunner and A H Meltzer, eds., Camegie­

Rochester COllferellce Series 011 Public Policy, vol 5, Autumn 1977, p 10

8.3 Business Cycle Facts 291

a macroeconomic variable moves, relative to the direction of aggregate economic activity An economic variable that moves in the same direction as aggregate economic activity (up in expansions, down in contractions) is procyclical A variable that moves in the opposite direction to aggregate economic activity (up in contractions, down in expansions) is countercyclical Variables that do not display a clear pattern over the business cycle are acyclical

The second characteristic is the timing of the variable's turning points (peaks and troughs) relative to the turning points of the business cycle An economic variable is

a leading variable if it tends to move in advance of aggregate economic activity In other words, the peaks and troughs in a leading variable occur before the corre­sponding peaks and troughs in the business cycle A coincident variable is one whose peaks and troughs occur at about the same time as the corresponding business cycle peaks and troughs Finally, a lagging variable is one whose peaks and troughs tend to occur later than the corresponding peaks and troughs in the business cycle

The fact that some economic variables consistently lead the business cycle sug­gests that they might be used to forecast the future course of the economy Some analysts have used downturns in the stock market to predict recessions, but such

an indicator is not infallible As Paul Samuelson noted: "Wall Street indexes pre­dicted nine out of the last five recessions."lO The idea that recessions can be forecast also underlies the index of leading indicators, discussed in the box, "In Touch with the Macroeconomy: Leading Indicators," on page 292

In some cases, the cyclical timing of a variable is obvious from a graph of its behavior over the course of several business cycles; in other cases, elaborate statis­tical techniques are needed to determine timing Conveniently, The Conference Board has analyzed the timing of dozens of economic variables This information

is published monthly in Business Cycle Indicators, along with the most recent data for these variables For the most part, in this chapter we rely on The Conference Board's timing classifications

Let's now examine the cyclical behavior of some key macroeconomic variables

We showed the historical behavior of several of these variables in Figs 1.1-1.4 Those figures covered a long time period and were based on annual data We can get a better view of short-run cyclical behavior by looking at quarterly or monthly data The direction and timing of the variables considered are presented in Summary table 10 on page 293

Production

Because the level of production is a basic indicator of aggregate economic activity, peaks and troughs in production tend to occur at about the same time as peaks and troughs in aggregate economic activity Thus production is a coincident and pro­cyclical variable Figure 8.2, p 294, shows the behavior of the industrial production index in the United States since 1947 This index is a broad measure of production

in manufacturing, mining, and utilities The vertical lines P and T in Figs 8.2-8.8 indicate the dates of business cycle peaks and troughs, as determined by the NBER (see Table 8.1) The turning points in industrial production correspond closely to the turning points of the cycle

lONewsweek column, September 19, 1966, as quoted in John Bartlett, Bartlett's Familiar QltDtatiDIlS, Boston:

Little Brown, 2002

292 Chapter 8 Business Cycles

WITH T H E MACRO E C O N O M Y

a Leading Indicators

:J

o Many different economic variables are considered to

I- lead the business cycle, but because none give an exact

Z indication of when a turning point may arrive, econo­

- mists have spent considerable effort trying to determine

if a combination of those variables can help indicate

when a peak or trough may occur

The first such index was originally developed in

1938 at the National Bureau of Economic Research

(NBER) by Wesley Mitchell and Arthur Burns: whose

important early work on business cycles was mentioned

earlier in this chapter The NBER's work was made offi­

cial by the U.s Department of Commerce, which first

published the "composite index of leading indicators"

in its publication Business Conditions Digest in November

1968 In 1995, the Commerce Department passed the

composite index back to the private sector, and it is now

prod uced by The Conference Board

Although the composite index of leading indicators was designed to pred ict the onset of recessions and expan­

sions, its history is spotty When the index declines for

two or three consecutive months, it warns that a recession

is likely However, its forecasting acumen in real time has

not been very good because of the following problems:

1 Data on the components of the index are often

revised when more complete data become avail­

able Revisions change the value of the index and may even reverse a signal of a future recession

2 The index is prone to giving false signals, predict­

ing recessions that did not materialize

3 The index does not provide any information on when

a recession might arrive or how severe it might be

4 Changes in the structure of the economy over time

may cause some variables to become better predic­

tors of the economy and others to become worse

For this reason, the index must be revised periodi­

cally, as the list of component indicators is changed

Research by Francis Diebold and Glenn Rudebusch

showed that the revisions were substantia!." The

agency calculating the index (the Commerce Depart­

ment or The Conference Board) often demonstrates the

value of the index with a plot of the index over time,

showing how it turns down just before every recession

But Diebold and Rudebusch showed that such a plot is illusory because the index plotted was not the one used

at the time of each recession, but rather a revised index made many years after the fact In real time, they con­ cluded, the use of the index does not improve forecasts

of industrial production

For example, suppose you were examining the changes over time in the composite index of leading indicators, and used the rule of thumb that a decline in the index for three months in a row meant that a reces­ sion was likely in the next six months to one year You would have noticed in December 1969 that the index had declined two months in a row; by January 1970 you would have seen the third monthly decline In fact, the NBER declared that a recession had begun in December

1969, so the index did not give you any advance warn­ing Even worse, if you had been following the index in

1973 to 1974, you would have thought all was well until September 1974, when the index declined for the second month in a row, or October 1974, when the third monthly decline occurred But the NBER declared that a reces­ sion had actually begun in November 1973, so the index was nearly a year late in calling the recession

After missing a recession's onset so badly, the cre­ ators of the index naturally want to improve it So, they may revise the index with different variables, give the variables different weights, or manipulate the statistics so that, if the new revised index had been available, it would have indicated that a recession were coming For exam­ ple, the revised index published in April 1979 would have given eight months of lead time before the recession that began in December 1969 and six months of lead time before the recession that began in November 1973 But of course, that index was not available to forecasters when it would have been useful-before the recessions began

Because of the problems of the official composite index of leading indicators, James Stock and Mark Watson'" set out to create some new indexes that would improve the value of such indexes in forecasting They created several experimental leading indexes, with the hope that such indexes would prove better at helping economists forecast turning points in the business cycle However, it appears that the two most recent recessions

(Continued)

'Statistical Illdicators of Cyclical Revivals (New York: National Bureau of Economic Research, 1938)

" "Forecasting Output with the Composite Leading Index: A Real-Time Analysis." JOllrnal of the Americall Statistical Associatiol1 (September 1991), pp 603-610

"'*""New Indexes of Coincident and Leading Economic Indicators," in Olivier J Blanchard and Stanley Fischer, eds., NBER

Macroecol1omics Amlllal, 1989 (Cambridge, MA: MIT Press, 1989), pp 351-394

have been sufficiently different from earlier recessions

that the experimental leading indexes did not suggest an

appreciable probability of recession in either 1990 or 2001

In early 1990, the experimental recession index of Stock

and Watson showed that the probability that a recession

would occur in the next six months never exceeded 10%

Also, in late 2000 and early 2001, the index did not rise

above 10% So, although the Stock and Watson approach

8.3 Business Cycle Facts 293

appeared promising in prospect, it did not deliver any improvement in forecasting recessions

The inability of leading indicators to forecast reces­ sions may simply mean that recessions are often unusual events, caused by large, unpredictable shocks such as disruptions in the world oil supply If so, then the pur­ suit of the perfect index of leading indicators may prove

to be frustrating

Although almost all types of production rise in expansions and fall in reces­sions, the cyclical sensitivity of production in some sectors of the economy is greater than in others Industries that produce relatively durable, or long-lasting, goods houses, consumer durables (refrigerators, cars, washing machines), or cap­ital goods (drill presses, computers, factories) respond strongly to the business cycle, producing at high rates during expansions and at much lower rates during recessions In contrast, industries that produce relatively nondurable or short-lived

Investment is more volatile than consumption

labor Market Variables

Employment Unemployment

Average labor productivity Real wage

Money Supply and Inflation

3Timing is not designated by The Conference Board

bOesignated as "unclassified" by The Conference Board

Procyclical Procyclical Procyclical Procyclical Procyclical

Procyclical Countercyclical Procyclical

Procyclical

Procyclical Procyclical

Procyclical Procyclical Acyclical

Timing

Coincident

Coincident Coincident leading leading

Coincident Unclassifiedb leadinga

- '

leading lagging

leading lagging

500 common stocks); nominal interest rates: series 1 1 9 (Federal funds rate) series 1 14 (discount rate on new 91-day Treasury bills) series

109 (average prime rate charged by banks)

294 Chapter 8 Business Cycles

Figure 8.2

Cyclical behavior of

the index of industrial

production

The index of industrial

production, a broad mea·

sure of production in

manufacturing, mining,

and utilities, is procycli­

cal and coincident The

peaks and troughs of the

business cycle are shown

by the vertical lines P

and T The shaded areas

represent recessions

SOllrce: Federal Reserve Bank

of 51 Louis FRED database at

resea rell.sf lOll isfcd orglfred 2/series/

goods (foods, paper products) or services (education, insurance) are less sensitive

to the business cycle

Ex pen d iture

For components of expenditure, as for types of production, durability is the key to determining sensitivity to the business cycle Figure 8.3 shows the cyclical behavior of consumption of nondurable goods, consumption of services, consumption expendi­tures on durable goods, and investment Investment is made up primarily of spending

on durable goods and is strongly procyclical In contrast, consumption of nondurable goods and consumption of services are both much smoother Consumption expendi­tures on durable goods are more strongly procyclical than consumption expenditures

on nondurable goods or consumption of services, but not as procyclical as investment expenditures With respect to timing, consumption and investment are generally coin­cident with the business cycle, although individual components of fixed investment vary in their cyclical timing.ll

One component of spending that seems to follow its own rules is inventory investment, or changes in business inventories (not shown), which often displays large fluctuations that aren't associated with business cycle peaks and troughs In general, however, inventory investment is procyclical and leading Even though goods kept in inventory need not be durable, inventory investment is also very volatile Although, on average, inventory investment is a small part (about 1%) of

11 Summary table 10 shows that residential investment leads the cycle

Figure 8.3

Cyclical behavior of

consumption and

investment

Both consumption and

investment are procycli­

cal However, investment

is more sensitive than

consumption to the busi­

ness cycle, reflecting the

fact that durable goods

are a larger part of invest­

ment spending than they

are of consumption

spending Similarly,

expenditures on con­

sumer durables are more

sensitive to the business

cycle than is consumption

of nondurable goods or

•

servICes

Source: Federal Reserve Bank

of St Louis FRED database at

research.stloll isfed orglfred2 series

PCDGCC96 (durable goods),

PCNDGC96 (nondurable

goods), PCESVC96 (services),

and GPDICl (investment)

CONSU M PTION OF NONDURABLE

GOODS

INVESTMENT

PENDITURE ON DURABLE GOODS

Year

total spending, sharp declines in inventory investment represented a large part of the total decline in spending in some recessions, most notably those of 1973-1975, 1981-1982, and 200l

Government purchases of goods and services generally are procyclical Rapid military buildups, as during World War II, the Korean War, and the Vietnam War, are usually associated with economic expansions

E m p l oyment a n d U n e m ployment

Business cycles are strongly felt in the labor market In a recession, employment grows slowly or falls, many workers are laid off, and jobs become more difficult to find

Figure 8.4 shows the number of civilians employed in the United States since

1955 Employment clearly is procyclical, as more people have jobs in booms than in recessions, and also is coincident with the cycle

Figure 8.5 shows the civilian unemployment rate, which is the fraction of the civilian labor force (the number of people who are available for work and want to work) that is unemployed The civilian unemployment rate is strongly counter­cyclical, rising sharply in contractions but falling more slowly in expansions Although The Conference Board has studied the timing of unemployment, Summary table 10 shows that the timing of this variable is designated as "unclassified," owing to the absence of a clear pattern in the data Figures 8.4 and 8.5 illustrate

a worrisome change in the patterns of recent recessions: namely in both the 1990-1991 and 2001 recessions, employment growth stagnated and unem­ployment tended to rise for some time even after the recession's trough was

296 Chapter 8 Business Cycles

Figure 8.4

Cyclical behavior of

civilian employment

Civilian employment is

procycUcal and coinci­

dent with the business

cycle

Source: Federal Reserve Bank

of St Louis FRED database at

researdt.stlouisfed.orglfred2/seriesl

CE160V:

Figure 8.5

Cyclical behavior of

the unemployment rate

The unemployment rate

is countercyclical and

very sensitive to the

business cycle Its timing

pattern relative to the

cycle is unclassified,

meaning that it has no

definite tendency to lead,

be coincident, or lag

Source: Federal Reserve Bank

of St Louis FRED database at

.

-.;: e - -

Figure 8.6

Cyclical behavior

of average labor

productivity and

the real wage

Average labor produc­

tivity, measured as real

output per employee

hour in the nonfarm

business sector, is pro­

cyclical and leading The

economywide average

real wage is mildly pro­

cyclical, and its growth

slowed sharply between

1973 and 1997

Source: Federal Reserve Bank

of St Louis FRED database at

research st /O ll is/ed orglfred2 series

OPHNFB (productivity) and

COMPRNFB (real wage)

Ave rage Labor Productiv ity a n d the Real Wage

Two other significant labor market variables are average labor productivity and the real wage As discussed in Chapter 1, average labor productivity is output per unit of labor input Figure 8.6 shows average labor productivity measured as total real output

in the u.s economy (excluding farms) divided by the total number of hours worked

to produce that output Average labor productivity tends to be procydical: In booms workers produce more output during each hour of work than they do in recessions.12 Although The Conference Board doesn't deSignate the timing of this variable, studies show that average labor productivity tends to lead the business cycle.B

Recall from Chapter 3 that the real wage is the compensation received by workers per unit of time (such as an hour or a week) measured in real, or purchasing-power,

12The Application in Chapter 3, "The Production Function of the U.s Economy and u.s Productivity Growth," p 64, made the point that total factor productivity A also tends to be procyclical

"See Robert J Gordon, "The 'End of Expansion' Phenomenon in Short-Run Productivity Behavior,"

Brookil1gs Papers 011 Ecol1omic Activity, 1979:2, pp 447-461

298 Chapter 8 Business Cycles

Figure 8.7

Cyclical behavior

of nominal money

growth and inflation

Nominal money growth,

here measured as the six­

month m o v ing average

of monthly growth rates

in M2 (expressed in

annual rates), is volatile

However, the figure

shows tha t money

g r ow t h often falls a t or

just before a c y c li c al peak

Statistical and historical

studies suggest that, gen­

erally, money growth is

procyclical and leading

Inflation, here measured

as the six-month moving

average of monthly

growth ra tes of the CPI

(expressed in annual

r a t es) , is p r ocy c li c al and

lags the business cycle

Source: Federal Reserve Bank

of SL Louis FRED database at

resea rell sf 1011 isfed orglfred2 series

of labor supplied by workers and demanded by firms Most of the evidence points

to the conclusion that real wages are mildly procyclical, but there is some contro­versy on this point.14

14See, for example, Mark Mitchell, Myles Wallace, and John Warner, "Real Wages Over the Business Cycle: Some Further Evidence," Southem Ecol1omic journal, April 1985, pp 1162-1173; and Michael Keane, Robert Moffitt, and David Runkle, "Real Wages Over the Business Cycle: Estimating the Impact of Heterogeneity with Micro Data," joumal of Political Economy, December 1988, pp 1232-1266 Stronger procyclicality for the real wage is claimed by Gary Solon, Robert Barsky, and Jonathan Parker,

"Measuring the Cyclicality of Real Wages: How Important Is Composition Bias?" Quarterly jountal of Economics, February 1994, pp 1-25

I'See Table 7.1 for a definition of M2 To reduce the effect of high month-to-month volatility in money growth, Fig 8.7 presents a six-month moving average of money growth rates; that is, the reported

growth rate in each month is actually the average of the growth rate in the current month and in the previous five months

Figure S S

Cyclical behavior

of the nominal

interest rate

The nominal interest

rate, measured here as

the interest rate on three­

month Treasury bills, is

procyclical and lagging

Source: Federal Reserve Bank

of St Louis FRED database at

The cyclical behavior of inflation, also shown in Fig 8.7, presents a somewhat clearer picture Inflation is procyclical but with some lag Inflation typically builds during an economic expansion, peaks slightly after the business cycle peak, and then falls until some time after the business cycle trough is reached Atypically, inflation did not increase during the long boom of the 1990s

F i n a n c i a l Va r i a b l es

Financial variables are another class of economic variables that are sensitive to the cycle For example, stock prices are generally procyclical (stock prices rise in good economic times) and leading (stock prices usually fall in advance of a recession)

Nominal interest rates are procyclical and lagging The nominal interest rate shown in Fig 8.8 is the rate on three-month Treasury bills However, other inter­est rates, such as the prime rate (charged by banks to their best customers) and the Federal funds rate (the interest rate on overnight loans made from one bank to another) also are procyclical and lagging Note that nominal interest rates have the same general cyclical pattern as inflation; in Chapter 7 we discussed why nominal interest rates tend to move up and down with the inflation rate

16A MO/1etary History of tlIe Ul1ited States, 1867-1960, Princeton, N.j.: Princeton University Press for

NBER, 1963 We discuss this study further in Chapter 10

300 Chapter 8 Business Cycles

Figure 8.9

Industrial production

indexes in six major

countries

The world wide effect of

business cycles is reflected

in the similarity of the

behavior of industrial

production in each of

the six countries shown

But individual countries

also have fluctuations

not shared with other

countries

Note: The scales for the indus­

trial production indexes differ

by country; for example, the

figure does not imply that the

United Kingdom's total indus­

trial production is higher than

that of Japan

Source: Illtematiollal Fillal/ciaJ

national Monetary Fund (with

scales adjusted for clarity)

I nternat i o n a l Asp ects of the B u s i n e ss Cyc l e

So far we have concentrated on business cycles in the United States However, business cycles are by no means unique to the United States, having been regularly observed in all industrialized market economies In most cases the cyclical behav­ior of key economic variables in these other economies is similar to that described for the United States

The business cycle is an international phenomenon in another sense: Fre­quently, the major industrial economies undergo recessions and expansions at about the same time, suggesting that they share a common cycle Figure 8.9 illustrates this common cycle by showing the index of industrial production since 1960 for each of six major industrial countries Note in particular the effects

of worldwide recessions in about 1975, 1982, 1991, and 2001 Figure 8.9 also shows that each economy experiences many small fluctuations not shared by the others

8.4 Business Cycle Anaiysis:A Preview 301

8.4 Bus iness Cycle Analysis: A Preview

The business cycle facts presented in this chapter would be useful even if we took them no further For example, being familiar with the typical cyclical pat­terns of key macroeconomic variables may help forecasters project the course of the economy, as we showed when discussing leading indicators Knowing the facts about cycles also is important for businesspeople making investment and hiring decisions and for financial investors trying to choose portfolios that pro­vide the desired combinations of risk and return However, macroeconomists are interested not only in what happens during business cycles but also in why it

1

The Seasonal Cyc l e a n d the Business Cyc le

Did you know that the United States has a large eco­

nomic boom, followed by a deep recession, every year?

The boom always occurs in the fourth quarter of the year

(October through December) During this quarter output

is 5% higher than in the third quarter (July-September)

and about 8% higher than in the following first quarter

(January-March) Fortunately, the first-quarter recession

is always a short one, with output rising by almost 4%

in the second quarter (April-June) This regular seasonal

pattern, known as the seasonal cycle, actually accounts

for more than 85% of the total fluctuation in the growth

rate of real output!

Why don't large seasonal fluctuations appear in Figs 8.2-8.9? Normally, macroeconomic data are sea­

sonally adjusted, meaning that regularly recurring sea­

sonal fluctuations are removed from the data Seasonal

adjustment allows users of economic data to ignore sea­

sonal changes and focus on business cycle fluctuations

and longer-term movements in the data However,

Robert Barsky of the University of Michigan and Jeffrey

Miron of Boston University' argue that the practice of

seasonally adjusting macroeconomic data may throw

away information that could help economists better

understand the business cycle Using data that hadn't

been seasonally adjusted, Barsky and Miron deter­

mined that the comovements of variables over the sea­

sonal cycle are similar to their comovements over the

business cycle Specifically, they obtained the follow­

ing results:

1 Of the types of expenditure, expenditures on durable

goods vary most over the seasonal cycle and expen­

ditures on services vary least

2 Government spending is seasonally procyclical

3 Employment is seasonally procyclical, and the

unemployment rate is seasonally countercyclical

4 Average labor productivity is seasonally procyclical,

and the real wage hardly varies over the seasonal cycle

5 The nominal money stock is seasonally procyclical

Each observation appears to be true for both the business cycle and the seasonal cycle (although, as dis­ cussed, there is some controversy about the cyclical behavior of the real wage) However, the seasonal fluc­ tuations of inventory investment, the price level, and the nominal interest rate are much smaller than their fluctuations over the business cycle

The seasonal cycle illustrates three potential sources

of aggregate economic fluctuations: (1) changes in con­ sumer demand, as at Christmastime; (2) changes in pro­ ductivity, as when construction workers become less productive because of winter weather in the first quarter; and (3) changes in labor supply, as when people take summer vacations in the third quarter Each of these three sources of fluctuation may also contribute to the business cycle

As we discuss in Chapter 10, classical economists believe that business cycles generally represent the economy's best response to changes in the economic environment, a response that macroeconomic policy need not try to eliminate Although it doesn't necessarily confirm this view, the seasonal cycle shows that large economic fluctuations may be desirable responses to various factors (Christmas, the weather) and do not need

to be offset by government policy

'''The Seasonal Cycle and the Business Cycle," Journal of Political Economy, June 1989, pp 503-534

302 Chapter 8 Business Cycles

happens This desire to understand cycles isn't just idle intellectual curiosity For example, as we demonstrate in Chapters 9-11, the advice that macroeconomists give to policymakers about how to respond to a recession depends on what they think is causing the recession Thus, with the business cycle facts as back­ground, in the rest of Part 3 we describe the primary alternative explanations of business cycle fluctuations, as well as policy recommendations based on these explanations

In general, theories of the business cycle have two main components The first

is a description of the types of factors that have major effects on the economy wars, new inventions, harvest failures, and changes in government policy are examples Economists often refer to these (typically unpredictable) forces hitting the economy

as shocks The other component of a business cycle theory is a model of how the economy responds to the various shocks Think of the economy as a car moving down a poorly maintained highway: The shocks can be thought of as the potholes and bumps in the road; the model describes how the components of the car (its tires and shock absorbers) act to smooth out or amplify the effects of the shocks on the passengers

The two principal business cycle theories that we discuss in this book are the

classical and the Keynesian theories Fortunately, to present and discuss these two the­ories we don't have to develop two completely different models Instead, both can

be considered within a general framework called the aggregate demand-aggregate supply, or AD-AS, model To introduce some of the key differences between the clas­sical and Keynesian approaches to business cycle analysis, in the rest of this chapter

we preview the AD-AS model and how it is used to analyze business cycles

Aggregate D e m a n d a n d Ag g reg ate S u p p ly: A B ri ef I ntrod uction

We develop and apply the AD-AS model, and a key building block of the

AD-AS model, the IS-LM model, in Chapters 9-11 Here, we simply introduce and briefly explain the basic components of the AD-AS model The AD-AS

model has three components, as illustrated in Fig 8.10: (1) the aggregate demand curve, (2) the short-run aggregate supply curve, and (3) the long-run aggregate supply curve Each curve represents a relationship between the aggregate price level, P, measured on the vertical axis in Fig 8.10, and output, Y, measured along the horizontal axis

The aggregate demand (AD) curve shows for any price level, P, the total quantity

of goods and services, Y, demanded by households, firms, and governments The AD

curve slopes downward in Fig 8.10, implying that, when the general price level is higher, people demand fewer goods and services We give the precise explanation for this downward slope in Chapter 9 The intuitive explanation for the downward slope of the A D curve that when prices are higher people can afford to buy fewer goods is not correct The problem with the intuitive explanation is that, although

an increase in the general price level does reflect an increase in the prices of most goods, it also implies an increase in the incomes of the people who produce and sell those goods Thus to say that a higher price level reduces the quantities of goods and services that people can afford to buy is not correct, because their incomes, as well as prices, have gone up

The A D curve relates the amount of output demanded to the price level, if

we hold other economic factors constant However, for a specific price level, any

Figure 8 1 0

The aggregate

demand-aggregate

supply model

The aggregate demand

ward, reflecting the fact

that the aggregate quan­

tity of goods and services

demanded, Y, falls when

the price level, P, rises

The short-run aggregate

supply (SRAS) curve is

horizontal, reflecting the

assumption that, in the

short run, prices are

fixed and firms simply

produce whatever quan­

tity is demanded In the

long run, firms produce

their normal levels of

output, so the long-run

aggregate supply (LRAS)

curve is vertical at the

full-employment level of

output, Y The economy's

short-run equilibrium is

at the point where the

intersect, and its long­

run equiUbrium is where

intersect ln this example,

the economy is in both

short-run and long-run

equilibrium at point E

�

• -

to the left) For example, a sharp rise in the stock market, by making consumers wealthier, would likely increase households' demand for goods and services, shifting the AD curve to the right Similarly, the development of more efficient capital goods would increase firms' demand for new capital goods, again shift­ing the AD curve to the right Government policies also can affect the AD curve For example, a decline in government spending on military hardware reduces the aggregate quantity of goods and services demanded and shifts the AD curve

to the left

An aggregate supply curve indicates the amount of output producers are will­ing to supply at any particular price level Two aggregate supply curves are shown

in Fig 8.10 one that holds in the short run and one that holds in the long run The

short-run aggregate supply (SRAS) curve, shown in Fig 8.10, is a horizontal line The horizontal SRAS curve captures the ideas that in the short run the price level is fixed and that firms are willing to supply any amount of output at that price If the short run is a very short period of time, such as a day, this assumption is realistic For instance, an ice cream store posts the price of ice cream in the morning and sells

as much ice cream as is demanded at that price (up to its capacity to produce ice cream) During a single day, the owner typically won't raise the price of ice cream

if the quantity demanded is unusually high; nor does the owner lower the price of ice cream if the quantity demanded is unusually low The tendency of a producer

to set a price for some time and then supply whatever is demanded at that price is represented by a horizontal SRAS curve

304 Chapter 8 Business Cycles

However, suppose that the quantity of ice cream demanded remains high day after day, to the point that the owner is straining to produce enough ice cream to meet demand In this case, the owner may raise her price to reduce the quantity of ice cream demanded to a more manageable level The owner will keep raising the price of ice cream as long as the quantity demanded exceeds normal production capacity In the long run, the price of ice cream will be whatever it has to be to equate the quantity demanded to the owner's normal level of output Similarly, in the long run, all other firms in the economy will adjust their prices as necessary so

as to be able to produce their normal level of output As discussed in Chapter 3, the normal level of production for the economy as a whole is called the full-employ­ment level of output, denoted Y In the long run, then, when prices fully adjust, the aggregate quantity of output supplied will simply equal the full-employment level

of output, Y Thus the long-run aggregate supply (LRAS) curve is vertical, as shown in Fig 8.10, at the point that output supplied, Y, equals Y

Figure 8.10 represents an economy that is simultaneously in short-run and long-run equilibrium The short-run equilibrium is represented by the intersection

of the AD and SRAS curves, shown as point E The long-run equilibrium is repre­sented by the intersection of the AD and LRAS curves, also shown as point E However, when some change occurs in the economy, the short-run equilibrium can differ from the long-run equilibrium

Aggreg ate D e m a n d S h ocks Recall that a theory of business cycles has to include a description of the shocks hitting the economy The AD-AS framework identifies shocks by their initial effects on aggregate demand or aggregate supply

An aggregate demand shock is a change in the economy that shifts the AD curve For example, a negative aggregate demand shock would occur if consumers became more pessimistic about the future and thus reduced their current consumption spending, shifting the AD curve to the left

To analyze the effect of an aggregate demand shock, let's suppose that the econ­omy initially is in both short-run and long-run equilibriwn at point E in Fig 8.11 We assume that, because conswners become more pessimistic, the aggregate demand curve shifts down and to the left from ADI to AD2 In this case, the new short-run equilibrium (the intersection of AD2 and SRAS) is at point F, where output has fallen

to Y2 and the price level remains unchanged at PI' Thus the decline in household con­sumption demand causes a recession, with output falling below its normal level However, the economy will not stay at point F forever, because firms won't be con­tent to keep producing below their normal capacity Eventually firms will respond to lower demand by adjusting their prices in this case downward until the economy reaches its new long-run equilibrium at point H, the intersection of AD2 and LRAS At point H, output is at its original level, Y, but the price level has fallen to P 2'

Our analysis shows that an adverse aggregate demand shock, which shifts the

AD curve down, will cause output to fall in the short run but not in the long run How long does it take for the economy to reach the long run? This question is crucial

to economic analysis and is one to which classical economists and Keynesian econo­mists have very different answers Their answers help explain why classicals and Keynesians have different views about the appropriate role of government policy in fighting recessions

The classical answer is that prices adjust quite rapidly to imbalances in quantities supplied and demanded so that the economy gets to its long-run equilibrium

Figure 8 1 1

An adverse aggregate

demand shock

An adverse aggregate

demand shock red uces

the aggregate quantity

of goods and services

demanded at a given

price level; an example is

that consumers become

more pessimistic and

thus reduce their spend­

ing This shock is repre­

sented by a shift to the

left of the aggregate

demand curve from AD'

to ADO In the short run,

the economy moves to

point F At this short-run

equilibrium, output has

fallen to Y, and the price

level is unchanged Even­

tually, price adjustment

causes the economy to

move to the new long­

run equilibrium at point

H, where output returns

to its full-employment

level, Y, and the price

level falls to P , In the

strict classical view, the

economy moves almost

immediately to point H,

so the adverse aggregate

demand shock essentially

has no effect on output in

both the short run and

the long run Keynesians

argue that the adjustment

process takes longer, so

that the adverse aggre­

gate demand shock may

quickly in a few months or less Thus a recession caused by a downward shift of the

AD curve is likely to end rather quickly, as the price level falls and the economy reaches the original level of output, Y In the strictest versions of the classical model, the economy is assumed to reach its long-run equilibrium essentially immediately, imply­ing that the short-run aggregate supply curve is irrelevant and that the economy always operates on the long-run aggregate supply (LRAS) curve Because the adjust­ment takes place quickly, classical economists argue that little is gained by the govern­ment actively trying to fight recessions Note that this conclusion is consistent with the

"invisible hand" argument described in Chapter 1, according to which the free market and unconstrained price adjustments are sufficient to achieve good economic results

In contrast to the classical view, Keynesian economists argue that prices (and wages, which are the price of labor) do not necessarily adjust quickly in response to shocks Hence the return of the economy to its long-run equilibrium may be slow, taking perhaps years rather than months In other words, although Keynesians agree with classicals that the economy's level of output will eventually return from its recessionary level (represented by Y2 in Fig 8.11) to its full-employment level, Y,

they believe that this process may be slow Because they lack confidence in the self-correcting powers of the economy, Keynesians tend to see an important role for the government in fighting recessions For example, Keynes himself originally argued that government could fight recessions by increasing spending In terms of Fig 8.11,

an increase in government spending could in principle shift the AD curve up and to the right, from AD2 back to ADJ, restoring the economy to full employment

gate demand shocks don't cause sustained fluctuations in output, they generally view aggregate supply shocks as the major force behind changes in output and

306 Chapter 8 Business Cycles

An adverse aggregate

supply shock

An adverse aggregate

supply shock, such as a

drought, reduces the full­

employment level of

output from Y, to Y,

Equivalently, the shock

shifts the long-run aggre­

gate supply curve to the

left, from LRAS' to

LRAS2 As a result of the

adverse supply shock,

the long-run equilibrium

moves from point E to

point F In the new long­

run equilibrium, output

has fallen from YI to Y,

and the price level has

Figure 8.12 illustrates the effects of an adverse supply shock that is, a shock that reduces the full-employment level of output (an example would be a severe drought that greatly reduces crop yields) Suppose that the economy is initially in long-run equilibrium at point E in Fig 8.12, where the initial long-run aggregate supply curve, LRAS1, intersects the aggregate demand curve, AD Now imagine that the adverse supply shock hits, reducing full-employment output from Y1 to Y2

and causing the long-run aggregate supply curve to shift to the left from LRASl to

LRAS2 The new long-run equilibrium occurs at point F, where the level of output

is lower than at point E According to the classical view, the economy moves quickly from point E to point F and then remains at point F The drop in output as the econ­omy moves from point E to point F is a recession Note that the new price level, P2'

is higher than the initial price level, Pl' so adverse supply shocks cause prices to rise during recessions We return to this implication for the price level and discuss its relation to the business cycle facts in Chapter 10

Although classical economists first emphasized supply shocks, Keynesian economists also recognize the importance of supply shocks in accounting for busi­ness cycle fluctuations in output Keynesians agree that an adverse supply shock will reduce output and increase the price level in the long run In Chapter 11, we discuss the Keynesian view of the process by which the economy moves from the short run to the long run in response to a supply shock

C H A P T E R S U M M A RY

1 A business cycle consists of a period of declining

aggregate economic activity (a contraction or reces­

sion) followed by a period of rising economic activity

(an expansion or a boom) The low point of the con­

traction is called the trough, and the high point of the

expansion is called the peak Business cycles have

been observed in market economies since the begin­

ning of industrialization

2 The tendency of many economic variables to move

together in regular and predictable ways over the

course of the cycle is called comovement We refer to

the typical cyclical patterns of key macroeconomic

variables as the "business cycle facts."

3 The fluctuations in aggregate economic activity that

constitute business cycles are recurrent, having been

observed again and again in industrialized market

economies However, they aren't periodic, in that they

don't occur at regular or predictable intervals Busi­

ness cycle fluctuations also are persistent, which

means that once a recession or expansion begins, it

usually lasts for a while

4 Many economists believe that the U.S economy

before 1929 had longer recessions and more cyclical

volatility than the post-World War II economy How­

ever, data problems prevent precise measurements

of how much more cyclical the pre-1929 economy

was The Great Depression that began in 1929 and

didn't end until the onset of World War II was the

most severe cyclical decline in U.S history Modera­

tion of the business cycle after World War II led to

premature pronouncements that the cycle was

"dead." However, the U.s economy suffered severe

recessions in 1973-1975 and 1981-1982 Between 1982

and the end of the millennium the economy enjoyed

a "long boom," with only one minor recession in

1990-1991

5 The direction of a variable relative to the business

cycle can be procyclical, countercyclical, or acycHcal

A procyclical variable moves in the same direction as

aggregate economic activity, rising in booms and

falling in recessions A countercyclical variable moves

in the opposite direction to aggregate economic activ­

ity, falling in booms and rising in recessions An

acyclical variable has no clear cyclical pattern

Chapter Summ ary 307

6 The timing of a variable relative to the business cycle

may be coincident, leading, or lagging A coincident variable's peaks and troughs occur at about the same time as peaks and troughs in aggregate economic activity Peaks and troughs in a leading variable come before, and peaks and troughs in a lagging variable come after, the corresponding peaks and troughs in aggregate economic activity

7 The cyclical direction and timing of major macroeco­

nomic variables-the business cycle facts-are described in Summary table 10 In brief, production, consumption, and investment are procyclical and coincident Investment is much more volatile over the business cycle than consumption is Employment is procyclical, but the unemployment rate is counter­ cyclical Average labor productivity and the real wage are procyclical, although according to most studies the real wage is only mildly so Money and stock prices are procyclical and lead the cycle Inflation and nominal interest rates are procyclical and lagging The real interest rate is acyclical

8 A theory of business cycles consists of (1) a descrip­

tion of shocks that affect the economy and (2) a model, such as the aggregate demand-aggregate supply (AD-AS) model, that describes how the econ­ omy responds to these shocks In the AD-AS model, shocks to the aggregate demand (AD) curve cause output to change in the short run, but output returns

to its full-employment level, Y, in the long run Shocks

to the aggregate supply curve can affect output both

in the long run and the short run

9 Classical economists argue that the economy reaches

its long-run equilibrium quickly, because prices adjust rapidly This view implies that aggregate demand shocks have only very short-lived effects on real vari­ ables such as output; instead, classical economists emphasize aggregate supply shocks as the source of business cycles Classicals also see little role for gov­ ernment poHcies to fight recessions Keynesian econo­ mists, in contrast, believe that it takes a long time for the economy to reach long-run equilibrium They conclude, therefore, that aggregate demand shocks can affect output for substantial periods of time Furthermore, they believe that government policies may be useful in speeding the economy's return to full employment

308 Chapter 8 Business Cycles

Questions marked with a brown circle are available in

MyEconLab at www.m y econ l ab com

Draw a diagram showing the phases and turning

points of a business cycle Using the diagram, illustrate

the concepts of recurrence and persistence

What is comovement? How is comovement related to

the business cycle facts presented in this chapter?

What is the evidence for the view that the U.s business

cycle has become less severe over time? Why is the

question of whether the cycle has moderated over time

an important one?

4 What terms are used to describe the way a variable

moves when economic activity is rising or falling?

What terms are used to describe the timing of cyclical

changes in economic variables?

A N A LY T I C A L P RO B L E M S

Questions marked with a brown circle are available in

1 Figure 8.1 shows that business cycle peaks and

troughs are identified with peaks and troughs in the

level of aggregate economic activity, which is consis­

tent with current NBER methodology However, for

business cycles before 1927, the NBER identified busi­

ness cycle peaks and troughs with peaks and troughs

in detrended aggregate economic activity (aggregate

economic activity minus the "normal growth path"

If you knew that the economy was falling into a reces­ sion, what would you expect to happen to production during the next few quarters? To investment? To aver­ age labor productivity? To the real wage? To the unem­ ployment rate?

6 How is the fact that some economic variables are

known to lead the cycle used in macroeconomic fore­ casting?

7 What are the two components of a theory of business

cycles?

about how long it takes the economy to reach long­ run equilibrium? What implications do these differ­ ences in beliefs have for Keynesian and classical views about the usefulness of antirecessionary policies? About the types of shocks that cause most recessions?

shown in Fig 8.1) Show that this alternative method­ ology implies that peaks occur earlier and that troughs occur la ter than you would find when using the current methodology Compared to the current methodology, does the alternative methodology increase or decrease the computed length of contrac­ tions and expansions? How might this change in mea­ surement account for the differences in the average measured lengths of expansions and contractions since World War II compared to the period before World War I?17

17For further discussion of these issues, see Christina D Romer, "Remeasuring Business Cycles." Journal of Economic History,

September 1994, pp 573-609; and Randall E Parker and Philip Rothman, "Further Evidence on the Stabilization of Postwar

Economic Fluctuations," JOllrnal of Macroecol1omics, Spring 1996, pp 289-298 Romer was the first to emphasize the potential

importance of the change in business cycle dating methodology

2 Consumer expenditures on durable goods such as cars

and furniture, as well as purchases of new houses, fall

much more than expenditures on nondurable goods

and services during most recessions Why do you think

that is?

Output, total hours worked, and average labor pro­

ductivity all are procyclical

a Which variable, output or total hours worked,

increases by a larger percentage in expansions and falls by a larger percentage in recessions? (Hint: Aver­

age labor productivity = output -;- total hours worked,

so that the percentage change in average labor pro­

ductivity equals the percentage change in output minus the percentage change in total hours worked.)

productivity related to Okun's Law, discussed in Chapter 3?

4 During the period 1973-1975, the United States experi­

enced a deep recession with a simultaneous sharp rise

in the price level Would you conclude that the reces­ sion was the result of a supply shock or a demand shock? Illustrate, using AD-A S analysis

It is sometimes argued that economic growth that is

"too rapid" will be associated with inflation Use

true When this claim is made, what type of shock is implicitly assumed to be hitting the economy?

W O R K I N G W I T H M A C R O E C O N O M I C DATA

For data to use in these exercises, go to the Federal Reserve Bank

of St Louis FRED database at research.stlouisfed.org/ fred

variable tend to be followed by more declines, and

increases by more increases This question asks you to

study the persistence of the civilian unemployment

rate

Using data since 1961, identify all quarters in which the unemployment rate (in the last month of the

quarter) changed by at least 0.2 percentage points from

the previous quarter (either up or down) How many of

these changes by 0.2 percentage points or more were

followed in the subsequent quarter by (1) another

change in the same direction, (2) a change in the oppo­

site direction, or (3) no change? Based on your count,

would you say that the unemployment rate is a persis­

tent variable?

2 How does each of the following variables respond to

the business cycle? Develop graphs to show your

results and give economic explanations

sions Using quarterly data since 1961, plot the real value of the stock market index (the S&P 500 index in the last month of the quarter divided by the GOP defla­ tor) [Note that data on the S&P 500 index may be

peaks and troughs Do you find the stock market to be

a good economic forecaster?

4 Graph the levels of real GOP for the United Sta tes,

Canada, and Germany (data can be found at www

oeed.org under Statistics and then under National

Accounts) Are U.s and Canadian business cycles closely related? U.s and German business cycles?

in both a seasonally adjusted form and a not season­ ally adjusted form Plot both over time and describe how large the seasonal variation in the variable is

us to analyze them simultaneously This chapter, then, consolidates our previous analyses to provide the theoretical structure for the rest of the book

The basic macroeconomic model developed in this chapter is known as the

IS-LM model (As we discuss later, this name originates in two of its basic equilib­rium conditions: that investment, I, must equal saving, S, and that money demanded,

L, must equal money supplied, M.) The IS-LM model was developed in 1937 by Nobel laureate Sir John Hicks,l who intended it as a graphical representation of the ideas presented by Keynes in his famous 1936 book, The General Theory of Employ­ ment, Interest, and Money Reflecting Keynes's belief that wages and prices don't adjust quickly to clear markets (see Section 1.3), in his original IS-LM model Hicks assumed that the price level was fixed, at least temporarily Since Hicks, several generations of economists have worked to refine the IS-LM model, and it has been widely applied in analyses of cyclical fluctuations and macroeconomic policy, and

in forecasting

Keynesian approach to business cycle analysis Classical economists who believe that wages and prices move rapidly to clear markets would reject

'Hicks outlined the IS-LM framework in an article entitled "Mr Keynes and the Classics: A Suggested Interpretation," Ecol1ometrica, April 1937, pp 137-159

9.1

9.1 The FE Line: Equilibrium in the Labor Market 3 1 1

However, the conventional lS-LM model may be easily adapted to allow for rapidly adjusting wages and prices Thus the IS-LM framework, although originally devel­oped by Keynesians, also may be used to present and discuss the classical approach

to business cycle analysis In addition, the IS-LM model is equivalent to the AD-AS model that we previewed in Section 8.4 We show how the AD-AS model is derived from the IS-LM model and illustrate how the AD-AS model can be used with either a classical or a Keynesian perspective

Using the IS-LM model (and the equivalent AD-AS model) as a framework for both classical and Keynesian analyses has several practical benefits: First, it avoids the need to learn two different models Second, utilizing a single framework emphasizes the large areas of agreement between the Keynesian and classical approaches while showing clearly how the two approaches differ Moreover, because versions of the IS-LM model (and its concepts and terminology) are so often applied in analyses of the economy and macroeconomic policy, studying this framework will help you understand and participate more fully in current eco­nomic debates

We use a graphical approach to develop the IS-LM model Appendix 9.B pre­sents the identical analysis in algebraic form If you have difficulty understanding why the curves used in the graphical analysis have the slopes they do or why they shift, you may find the algebra in the appendix helpful

To keep things as simple as possible, in this chapter we assume that the econ­omy is closed In Chapter 13 we show how to extend the analysis to allow for a foreign sector

In previous chapters, we discussed the three main markets of the economy: the labor market, the goods market, and the asset market We also identified some of the links among these markets, but now we want to be more precise about how they fit into a complete macroeconomic system

Let's turn first to the labor market and recall from Chapter 3 the concepts of the full-employment level of employment and full-employment output The full­ employment level of employment, N, is the equilibrium level of employment reached after wages and prices have fully adjusted, so that the quantity of labor supplied equals the quantity of labor demanded Full-employment output, Y, is the amount of output produced when employment is at its full-employment level, for the current level of the capital stock and the production function Algebraically, full-employment output, Y, equals AF(K, N), where K is the capital stock, A is productivity, and F is the production function (see Eq 3.4)

Our ultimate goal is a diagram that has the real interest rate on the vertical axis and output on the horizontal axis In such a diagram equilibrium in the labor market is represented by the full-employment line, or FE, in Fig 9.1 The FE line

is vertical at Y = Y because, when the labor market is in equilibrium, output equals its full-employment level, regardless of the interest rate.2

2The real interest rate affects investment and thus the amount of capital that firms w ill have in the future, but it doesn't affect the current capital stock, and hence does not affect current full-employment output

3 1 2 Chapter 9 The IS-LMIAD-AS Model

regardless of the value

of the real interest rate

Thus the FE line is verti­

S U M M A RY 1 1

Factors That Shift the Full-EmpLoyment (FE ) Line

Beneficial supply shock

I ncrease in labor supply

Increase in the capital stock

Right

Right

Right

1 More output can be produced for the same

amount of capital and labor

2 If the f\1PN rises, labor demand increases

and raises employment

Full-employment output increases for both reasons

Equilibrium em ployment rises, raising full-employment output

More output can be produced with the same amount of labor In addition, increased capital may increase the tvlPN, which increases labor demand and equilibrium employment

9.2 The IS Curve: EquiJ i hri

9.2 The IS Curve: Equilibrium in the Goods Market 3 1 3

in the Goods Market

The second of the three markets in our model is the goods market Recall from Chapter 4 that the goods market is in equilibrium when desired investment and desired national saving are equal or, equivalently, when the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded Recall that adjustments in the real interest rate help bring about equilibrium in the goods market

In a diagram with the real interest rate on the vertical axis and real output on the horizontal axis, equilibrium in the goods market is described by a curve called the IS curve For any level of output (or income), Y, the IS curve shows the real interest rate, r, for which the goods market is in equilibrium The IS curve is so named because at all points on the curve desired investment, Id, equals desired national saving, Sd

Figure 9.2 shows the derivation of the IS curve from the saving-investment dia­gram introduced in Chapter 4 (see Key Diagram 3, p 149) Figure 9.2(a) shows the saving-investment diagram drawn for two randomly chosen levels of output, 4000 and 5000 Corresponding to each level is a saving curve, with the value of output indicated in parentheses next to it Each saving curve slopes upward because an increase in the real interest rate causes households to increase their desired level of saving An increase in current output (income) leads to more desired saving at any real interest rate, so the saving (S) curve for Y = 5000 lies to the right of the saving

or Y = 5000

Each level of output implies a different market-clearing real interest rate When output is 4000, goods market equilibrium is at point D and the market-clearing real interest rate is 7% When output is 5000, goods market equilibrium occurs at point

F and the market-clearing real interest rate is 5%

Figure 9.2(b) shows the IS curve for this economy, with output on the hori­zontal axis and the real interest rate on the vertical axis For any level of output, the

IS curve shows the real interest rate that clears the goods market Thus Y = 4000 and

r = 7% at point D on the IS curve (Note that point D in Fig 9.2b corresponds to point D in Fig 9.2a.) Similarly, when output is 5000, the real interest rate that clears the goods market is 5% This combination of output and the real interest rate occurs

at point F on the IS curve in Fig 9.2(b), which corresponds to point F in Fig 9.2(a)

In general, because a rise in output increases desired national saving, thereby reducing the real interest rate that clears the goods market, the IS curve slopes downward

The slope of the IS curve may also be interpreted in terms of the alternative (but equivalent) version of the goods market equilibrium condition, which states that in equilibrium the aggregate quantity of goods demanded must equal the aggregate quantity of goods supplied To illustrate, let's suppose that the economy

is initially at point F in Fig 9.2(b) The aggregate quantities of goods supplied and

3 1 4 Chapter 9 The IS-LMIAD-AS Model

Desired national saving, Sd, Output, Y

and desired investment, I d

Figure 9 2

(a) The graph shows the goods market equilibrium for two different levels of output: 4000 and 5000 (the output correspond­ ing to each saving curve is indicated in parentheses next to the curve) Higher levels of output (income) increase desired

national saving and shift the saving curve to the right When output is 4000, the real interest rate that clears the goods

market is 7% (point 0) When output is 5000, the market-clearing real interest rate is 5% (point F)

(b) For each level of output the IS curve shows the corresponding real interest rate that clears the goods market Thus each

point on the IS curve corresponds to an equilibrium point in the goods market As in (a), when output is 4000, the real interest rate that clears the goods market is 7% (point 0); when output is 5000, the market-clearing real interest rate is 5% (point F)

Because higher output raises saving and leads to a lower market-clearing real interest rate, the IS curve slopes downward

demanded are equal at point F because F lies on the IS curve, which means that the goods market is in equilibrium at that point.3

Now suppose that for some reason the real interest rate r rises from 5% to 7%

Recall from Chapter 4 that an increase in the real interest rate reduces both desired consumption, Cd (because people desire to save more when the real interest rate rises), and desired investment, Id, thereby reducing the aggregate quantity of goods demanded

If output, Y, remained at its initial level of 5000, the increase in the real interest rate would imply that more goods were being supplied than demanded For the goods

3We have just shown that desired national saving equals desired investment at point F, Of Sd :;:: Jd

Substituting the definition of desired national saving, Y - Cd - G, for Sd in the condition that desired national saving equals desired investment shows also that Y :;:: Cd + Td + G at F

S U M M A RY 1 2

9.2 The IS Cu r v e : Equilibrium in the Goods Market 3 1 5

Factors That Shift the IS Curve

U p and to the right

U p and to the right

No change

or down and

to the left

Up and to the right Down and

to the left

Reason

Desired saving falls (desired consumption rises), raising the real interest rate that clears the goods market

Desired saving falls (desired consumption rises)

raising the real interest rate that clears the goods market

Desired saving falls (demand for goods rises), raising the real interest rate that clears the goods market

No change, if consumers take into account an offsetting future tax cut and do not change consumption (Ricardian equivalence); down and

to the left, if consumers don't take into account a future tax cut and reduce desired consumption, increasing desired national saving and lowering the real interest rate that clears the goods

Factors T h at S h ift the IS C u rve

For any level of output, the IS curve shows the real interest rate needed to clear the goods market With output held constant, any economic disturbance or policy change that changes the value of the goods-market-clearing real interest rate will cause the

IS curve to shift More specifically, for constant output, any change in the economy that reduces desired national saving relative to desired investment will increase the real interest rate that clears the goods market and thus shift the IS curve up and to the right Similarly, for constant output, changes that increase desired saving relative to desired invest­ment, thereby reducing the market-clearing real interest rate, shift the [S curve down and to the left Factors that shift the IS curve are described in Summary table 12

'Although a drop in output, Y, obviously reduces the quantity of goods supplied, it also reduces the quantity of goods demanded The reason is that a drop in output is also a drop in income, which

reduces desired consumption However, although a drop in output of one dollar reduces the supply

of output by one dollar, a drop in income of one dollar reduces desired consumption, Cd, by less than one dollar (that is, the marginal propensity to consume, defined in Chapter 4, is less than 1) Thus a

drop in output, Y, reduces goods supplied more than goods demanded and therefore reduces the

excess supply of goods

3 1 6 Chapter 9 The IS-LMIAD-AS Model

and desired investment, Id

Figure 9.3

Effect on the IS curve of a temporary increase in government purchases

(a) The saving-investment diagram shows the effects of a temporary increase in government purchases, G, with output, Y,

constant at 4500 The increase in G reduces desired national saving and shifts the saving curve to the left, from S' to S2

The goods market equilibrium point moves from point E to point F, and the real interest rate rises from 6% to 7%

(b) The increase in G raises the real interest rate that clears the goods market for any level of output Thus the IS curve shifts

up and to the right from IS I to IS2 In this example, with output held constant at 4500, an increase in government purchases raises the real interest rate that clears the goods market from 6% (point E) to 7% (point F)

We can use a change in current government purchases to illustrate IS curve shifts in general The effects of a temporary increase in government purchases on the

IS curve are shown in Fig 9.3 Figure 9.3(a) shows the saving-investment diagram, with an initial saving curve, Sl, and an initial investment curve, 1 The Sl curve rep­resents saving when output (income) is fixed at Y = 4500 Figure 9.3(b) shows the ini­tial IS curve, IS1 The initial goods market equilibrium when output, Y, equals 4500

is represented by point E in both (a) and (b) At E, the initial market-clearing real interest rate is 6%

Now suppose that the government increases its current purchases of goods, G

Desired investment at any level of the real interest rate isn't affected by the increase

in government purchases, so the investment curve doesn't shift However, as dis­cussed in Chapter 4, a temporary increase in government purchases reduces desired national saving, Y - Cd - G (see Summary table 5, p 125), so the saving curve shifts to the left from Sl to S2 in Fig 9.3(a) As a result of the reduction in

9.3 The LM Curve: Asset Market Equilibrium 3 1 7

desired national saving, the real interest rate that clears the goods market when output equals 4500 increases from 6% to 7% (point F in Fig 9.3a)

The effect on the IS curve is shown in Fig 9.3(b) With output constant at 4500, the real interest rate that clears the goods market increases from 6% to 7%, as shown by the shift from point E to point F The new IS curve, IS2, passes through F

and lies above and to the right of the initial IS curve, IS1 Thus a temporary increase

in government purchases shifts the IS curve up and to the right

So far our discussion of IS curve shifts has focused on the goods market equi­librium condition that desired national saving must equal desired investment However, factors that shift the IS curve may also be described in terms of the alter­native (but equivalent) goods market equilibrium condition that the aggregate quantities of goods demanded and supplied are equal In particular, for a given level of output, any change that increases the aggregate demand for goods shifts the IS

curve up and to the right

This rule works because, for the initial level of output, an increase in the aggre­gate demand for goods causes the quantity of goods demanded to exceed the quantity supplied Goods market equilibrium can be restored at the same level of output by an increase in the real interest rate, which reduces desired consumption,

Cd, and desired investment, Id For any level of output, an increase in aggregate demand for goods raises the real interest rate that clears the goods market, so we conclude that an increase in the aggregate demand for goods shifts the IS curve up and to the right

To illustrate this alternative way of thinking about shifts in the IS curve, we again use the example of a temporary increase in government purchases Note that an increase in government purchases, G, directly raises the demand for goods,

Cd + rd + G, leading to an excess demand for goods at the initial level of output The excess demand for goods can be eliminated and goods market equilibrium at the initial level of output restored by an increase in the real interest rate, which reduces

Cd and [d Because a higher real interest rate is required for goods market equilibrium when government purchases increase, an increase in G causes the IS curve to shift

up and to the right

The third and final market in our macroeconomic model is the asset market, pre­sented in Chapter 7 The asset market is in equilibrium when the quantities of assets demanded by holders of wealth for their portfolios equal the supplies of those assets in the economy In reality, there are many different assets, both real (houses, consumer durables, office buildings) and financial (checking accounts, government bonds) Recall, however, that we aggregated all assets into two categories money and nonmonetary assets We assumed that the nominal supply

of money is M and that money pays a fixed nominal interest rate, in! Similarly, we assumed that the nominal supply of nonmonetary assets is NM and that these assets pay a nominal interest rate, i, and (given expected inflation, rr') an expected real interest rate, r

With this aggregation assumption, we showed that the asset market equilib­rium condition reduces to the requirement that the quantities of money supplied

3 1 8 Chapter 9 The IS-LMIAD-AS Model

and demanded be equal In this section we show that asset market equilibrium can be represented by the LM curve However, to discuss how the asset market comes into equilibrium a task that we didn't complete in Chapter 7 we first introduce an important relationship used every day by traders in financial markets: the relationship between the price of a nonmonetary asset and the interest rate on that asset

The I nte rest Rate a n d the P r i c e of a N o n m o n eta ry Asset

The price of a nonmonetary asset, such as a government bond, is what a buyer has

to pay for it Its price is closely related to the interest rate that it pays (sometimes called its yield) To illustrate this relationship with an example, let's consider a bond that matures in one year At maturity, we assume, the bondholder will redeem it and receive $10,000; the bond doesn't pay any interest before it matures s Suppose that this bond can now be purchased for $9615 At this price, over the coming year the bond will increase in value by $385 ($10,000 - $9615), or approxi­mately 4% of its current price of $9615 Therefore the nominal interest rate on the bond, or its yield, is 4% per year

Now suppose that for some reason the current price of a $10,000 bond that matures in one year drops to $9524 The increase in the bond's value over the next year will be $476 ($10,000 - $9524), or approximately 5% of the purchase price of

$9524 Therefore, when the current price of the bond falls to $9524, the nominal interest rate on the bond increases to 5% per year More generally, for the promised schedule of repayments of a bond or other nonmonetary asset, the higher the price

of the asset, the lower the nominal interest rate that the asset pays Thus a media report that, in yesterday'S trading, the bond market "strengthened" (bond prices rose), is equivalent to saying that nominal interest rates fell

We have just indicated why the price of a nonmonetary asset and its nominal interest rate are negatively related For a given expected rate of inflation, 1T!, move­ments in the nominal interest rate are matched by equal movements in the real interest rate, so the price of a nonmonetary asset and its real interest rate are also inversely related This relationship is a key to deriving the LM curve and explain­ing how the asset market comes into equilibrium

The E q u a l i ty of M o n e y D e m a n d ed a n d M o n e y S u p p l i e d

To derive the LM curve, which represents asset market equilibrium, we recall that the asset market is in equilibrium only if the quantity of money demanded equals the currently available money supply We depict the equality of money supplied and demanded using the money supply-money demand diagram, shown

in Fig 9.4(a) The real interest rate is on the vertical axis and money, measured

in real terms, is on the horizontal axis.6 The MS line shows the economy's real money supply, M/P The nominal money supply M is set by the central bank Thus, for a given price level, P, the real money supply, M/P, is a fixed number

SA bond that doesn't pay any interest before maturity is called a discount bond

6Asset market equilibrium may be expressed as either nominal money supplied equals nominal money demanded, Of as real money supplied equals real money demanded As in Chapter 7, we work with the condition expressed in real terms

and real money demand, MdlP

Figure 9.4

Deriving the LM curve

(a) The curves show real money demand and real money supply Real money supply is fixed at 1000 When output is 4000, the real money demand curve is MD (Y = 4000); the real interest rate that clears the asset market is 3% (point A) When

output is 5000, more money is demanded at the same real interest rate, so the real money demand curve shifts to the right

to MD (Y = 5000) In this case the real interest rate that clears the asset market is 5% (point C)

(b) The graph shows the corresponding LM curve For each level of output, the LM curve shows the real interest rate that

clears the asset market Thus when output is 4000, the LM curve shows that the real interest rate that clears the asset market is

3% (point A) When output is 5000, the LM curve shows a market-clearing real interest rate of 5% (point C) Because higher

output raises money demand, and thus raises the real interest rate that clears the asset market, the LM curve slopes upward

and the MS line is vertical For example, if M = 2000 and P = 2, the MS line is vertical

at M/P = 1000

Real money demand at two different levels of income, Y, is shown by the two

MD curves in Fig 9.4(a) Recall from Chapter 7 that a higher real interest rate, r,

increases the relative attractiveness of nonmonetary assets and causes holders of wealth to demand less money Thus the money demand curves slope downward The money demand curve, MD, for Y = 4000 shows the real demand for money when output is 4000; similarly, the MD curve for Y = 5000 shows the real demand for money when output is 5000 Because an increase in income increases the amount of money demanded at any real interest rate, the money demand curve for

Y = 5000 is farther to the right than the money demand curve for Y = 4000

Graphically, asset market equilibrium occurs at the intersection of the money supply and money demand curves, where the real quantities of money supplied and demanded are equal For example, when output is 4000, so that the money

320 Chapter 9 The IS-LMIAD-AS Model

demand curve is MD (Y = 4000), the money demand and money supply curves intersect at point A in Fig 9.4(a) The real interest rate at A is 3% Thus when output is 4000, the real interest rate that clears the asset market (equalizes the quantities of money supplied and demanded) is 3% At a real interest rate of 3% and an output of 4000, the real quantity of money demanded by holders of wealth

is 1000, which equals the real money supply made available by the central bank

What happens to the asset market equilibrium if output rises from 4000 to 5000? People need to conduct more transactions, so their real money demand increases at any real interest rate As a result, the money demand curve shifts to the right, to MD (Y = 5000) If the real interest rate remained at 3%, the real quantity of money demanded would exceed the real money supply At point B in Fig 9.4(a) the real quantity of money demanded is 1200, which is greater than the real money supply of 1000 To restore equality of money demanded and supplied and thus bring the asset market back into equilibrium, the real interest rate must rise to 5% When the real interest rate is 5%, the real quantity of money demanded declines to

1000, which equals the fixed real money supply (point C in Fig 9.4a)

How does an increase in the real interest rate eliminate the excess demand for money, and what causes this increase in the real interest rate? Recall that the prices

of nonmonetary assets and the interest rates they pay are negatively related At the initial real interest rate of 3%, the increase in output from 4000 to 5000 causes people to demand more money (the MD curve shifts to the right in Fig 9.4a) To satisfy their desire to hold more money, people will try to sell some of their non­monetary assets for money But when people rush to sell a portion of their non­monetary assets, the prices of these assets will fall, which will cause the real interest rates on these assets to rise Thus it is the public's attempt to increase its holdings

of money by selling nonmonetary assets that ca uses the real interest rate to rise

Because the real supply of money in the economy is fixed, the public as a whole cannot increase the amount of money it holds As long as people attempt to

do so by selling nonmonetary assets, the real interest rate will continue to rise But the increase in the real interest rate paid by nonmonetary assets makes those assets more attractive relative to money, reducing the real quantity of money demanded (here the movement is along the MD curve for Y = 5000, from point B to point C in Fig 9.4a) The real interest rate will rise until the real quantity of money demanded again equals the fixed supply of money and restores asset market equilibrium The new asset market equilibrium is at C, where the real interest rate has risen from 3% to 5%

The preceding example shows that when output rises, increasing real money demand, a higher real interest rate is needed to maintain equilibrium in the asset market In general, the relationship between output and the real interest rate that clears the asset market is expressed graphically by the LM curve For any level of output, the LM curve shows the real interest rate for which the asset market is in equilibrium, with equal quantities of money supplied and demanded The term LM

comes from the asset market equilibrium condition that the real quantity of money demanded, as determined by the real money demand function, L, must equal the real money supply, M/P

The LM curve corresponding to our numerical example is shown in Fig 9.4(b), with the real interest rate, Y, on the vertical axis and output, Y, on the horizontal axis Points A and C lie on the LM curve At A, which corresponds to point A in the money supply-money demand diagram of Fig 9.4(a), output, Y, is 4000 and the