lector univ. dr. ec. av. Alexis DAJ Phases of the Business Cycle Business Cycle - Definition: alternating increases and decreases in the level of business activity of varying amplitude and length How do we measure increases and decreases in business activity? Percent change in real GDP! Why do we say varying amplitude and length? Some downturns are mild and some are severe Some are short (a few months) and some are long (over a year) Do not confuse with seasonal fluctuations!
Phases of the Business Cycle Expansion Expansion Recession The Phases of the Business Cycle Secular growth trend Trough Peak 0 Jan.- Mar T o t a l
O u t p u t
Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Note: Shaded areas indicate recessions. Real GDP 1958-2007, in 2000 dollars Note: Years is on horizontal axis and real GDP is on vertical axis. General trend of economic growth Recession years are shaded blue: note downward slope on graph indicating that GDP is decreasing. The GDP Gap, 1945-2000 The GDP gap is the amount of production by which potential GDP exceeds actual GDP 10-9 Actual GDP Actual GDP Potential GDP GDP gap Potential GDP 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Since potential GDP has exceeded actual GDP for most years since World War II, we have had a GDP gap. However in some periods, most recently from 1996 through 2000, actual GDP has been greater than potential GDP U.S. real gross domestic product per person from 1900 to 2004 Long-Run Economic Growth Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades. A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth. The Conventional Three- Phase Business Cycle 10-4 Year Prosperity Peak Trough Trough Peak Peak 2005 2010 2015 Recession What is a recession?
Generally, 2 or more quarters of declining real GDP Implication: its not officially a called a recession until the economy has already been declining for 6 months!
Who decides when were in a recession?
E.g.: National Bureau of Economic Research traditionally declares recessions Private research organization, not a federal agency
Recession dates from peak of business Post-World War II Recessions* *The February 1945October 1945 recession began before the war ended in August 1945. Note: These recessions were of varying duration and severity. Another Look at Expansions and Recessions Can you find a pattern? Neither can economists! Thats why recessions are hard to predict. Business Cycle Theories Endogenous theories:
Innovation theory: innovation leads to saturation. Psychological theory: alternating optimism and pessimism Inventory cycle theory: inventory and demand not in sync Monetary theory: changes in money supply by Federal Reserve Underconsumption theory: or overproduction
Business Cycle Theories Exogenous theories:
The external demand shock theory: effect of foreign economies War theory: war stimulates economy; peace leads to recession The price shock theory: fluctuations in oil prices
Endogenous Starts from within the model Endo- inside, source Genous- born
From outside of the model Exo- outside Genous- born, source Exogenous The Main Instruments of Macroeconomic Policy 18 Objectives and Instruments of Macroeconomic Policy
Objectives of Macroeconomic Policy Instruments of Macroeconomic Policy Birth and Development of Macroeconomic Policy 19 Objectives and Instruments of Macroeconomic Policy Objectives of Macroeconomic Policy
Full Employment Stable Price Economic Growth Balance of Payments 20 Objectives and Instruments of Macroeconomic Policy Instruments of Macroeconomic Policy
Demand Management Supply Management International Economic Policy 21 Objectives and Instruments of Macroeconomic Policy Birth and Development of Macroeconomic Policy
Since 1930s, three phases: Phase 1: 1930s-World war, New Policy Phase 2: After World war , fiscal policy and monetary policy. Phase 3: 1970s, Stagflation appeared. Western countries strengthen the adjustment of market mechanism. The Main Instruments of Macroeconomic Policy Fiscal Policy Government expenditure Taxation Influence on AD / AS Monetary Policy Interest rates Money supply Exchange rates Supply side policies
What is fiscal policy Fiscal policy looks at how government spend their money and how they control their taxes. There are 2 types of fiscal policy: Contractionary fiscal policy: Where the government reduce spending and / or when they make taxes higher. Expansionary fiscal policy: Where the government cut taxes or increase government spending. They will increase the amount the government borrows to fund the expenditure.
Observation: Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. Government Expenditure Government expenditure covers all spending by the public sector The government spends money on many things including: Education Defence Welfare benefits Healthcare Infrastructure Police Government Borrowing As well as gaining revenue through taxation the government can also finance their spending through borrowing The public sector net cash requirement (PSNCR) measures the annual borrowing requirement of the government in an economy The budget deficit has been renamed to the public sector net cash requirement (PSNCR) to avoid confusion with net borrowing. Government Borrowing Public sector borrowing requirement (PSBR) is the old name for the budget deficit in the United Kingdom. PSBR occurs when expenditures for the government activities in the public sector of the economy exceed the income. The resulting deficit is then financed by borrowing funds from the public, usually by the means of government bonds.
Direct & indirect taxes Direct taxes are taxes of income and expenditure e.g. income tax, corporation tax (levied on company profits). Indirect taxes are taxes such as VAT (value added tax), changes in this type of tax has a rapid effect on the level of economic activity. E.g. an increase in VAT will cut consumption
Fiscal Policy and AD Taxation influences the AD curve because: An increase in taxation will decrease the level of consumption in the economy An increase in taxation will increase the level of government spending in the economy A decrease in taxation will increase the level of consumption in the economy A decrease in taxation can decrease the level of government expenditure in the economy The impact of a change in government expenditure depends on the size of the multiplier Fiscal Policy and AD Governments can utilise fiscal policy to control the level of AD in the economy There can be problems with this due to: Time lags The size of the multiplier Fiscal crowding out Peoples reaction to cuts / rises in taxation Fiscal Policy and AS Fiscal policy can be used to increase the productive capacity of the economy This is because government expenditure can be used to: Increase the skill levels of workers Provide economic incentives to firms Increase factor mobility Monetary Policy Monetary policy is the use of interest rates, money supply and exchange rates to influence economic growth and inflation Interest rates are the cost of borrowing money Exchange rates the value of one currency in terms of another Money supply the amount of money in circulation in an economy Interest Rates The Central Banks are responsible for setting interest rates in a national economy The Bank sets the rate after analysing macroeconomic trends and risks associated with inflation E.g.: Since 1997 the UK government has used interest rates to control the level of inflation in the economy (at a level of 1.5-3.5% - target = 2.5%) If the Bank believes the level of AD is rising too quickly (potentially causing demand pull inflation), they will decide to raise interest rates Interest Rates and The Economy Changes to interest rates influence many things in the economy: Housing prices and housing market if interest rates rise the cost of mortgages increases therefore reducing demand for housing in theory Disposable income of house owners if interest rates rise the real disposable income of home owners falls as they have larger mortgage payments (variable rate only) Interest Rates and The Economy Credit demand if interest rates rise the amount of credit sales should decrease as it becomes more expensive Investment if interest rates rise they lead to a decrease in the level of investment Exchange rates E.g.: An increase in interest rates may lead to an appreciation of UK currency making exports less attractive
Interest rates and Inflation Interest rates are used to control inflation as when interest rates are increased consumption decreases as peoples real incomes are eroded by mortgage payments and credit payments and the opportunity cost of spending has increased By controlling interest rates the government aims to keep inflation at a low level Interest and Exchange Rates E.g., changes in the UKs interest rates will lead to changes in the exchange value of the pound. If interest rates rise the value of the pound will rise so the pound will now buy more US dollars, Japanese Yen, Euros etc. If interest rates fall the value of the pound will fall so the pound will now buy less US dollars, Japanese Yen, Euros etc Exchange rates A fall in the exchange rate reduces the price of exports and increases the price of imports Domestic demand will be stimulated and more people will buy exports as they are cheaper This will create a deficit on the current account of the balance of payments As consumption will increase it will increase AD which will increase the level of output in the economy and more it towards full employment
Supply Side Policies Supply side policies are policies that improve the supply-side of the economy increasing its efficiency and thereby resulting in economic growth Supply side policies can act in the product and labour markets Supply side policies Trade union reforms Increased expenditure on training and education Changes in taxation Changes to welfare system Privatisation Deregulation Free trade Incentives for small businesses Supply side policies Supply side policies cause economic growth as they cause the LRAS to shift outwards increasing the potential output of the economy If the economy is operating near full potential increases in aggregate demand can cause cost push inflation, by the LRAS curve shifting outwards this inflationary pressure is reduced
Supply side policies As supply side policies can cause the LRAS to shift outwards they can lead to a fall in unemployment levels Many supply side policies concentrate on the labour market and increase skills for workers which help reduce structural unemployment in the economy Supply Side Policies As the LRAS shifts outwards businesses will have lower average costs as productivity has increased Lower costs mean that businesses are able to compete more internationally therefore making the balance of payments more healthy Summary Fiscal Policy is the use of government expenditure and taxation to influence the level of inflation / economic growth Government expenditure covers all things the public sector spends money on Taxation earns revenue for the government either directly through income taxes or indirectly through VAT Monetary Policy is the control of the economy through interest rates, money supply and exchange rates The central bank sets the rate of interest in a national economy The government uses interest rates to control the rate of inflation around its target of 2.5% Supply side policies aim to increase productivity in the economy therefore stimulating economic growth