Week 9

Chapter 12: The Business Cycle, Inflation, and Deflation

Introduction

• Exploration of business cycles, inflation, and deflation.

• Learning Objectives:

  • Explain aggregate demand and supply shocks impacting business cycles.

  • Differentiate between demand-pull and cost-push inflation.

  • Analyze causes and consequences of deflation.

  • Discuss the trade-off between inflation and unemployment in short-run and long-run contexts.

The Business Cycle

Overview

• Business Cycle Definition:

  • Fluctuations in economic activity characterized by periods of expansion and contraction.

• Theories:

  • Mainstream Business Cycle Theory: Suggests potential GDP grows steadily while aggregate demand fluctuates, leading to real GDP variations around potential GDP.

  • Real Business Cycle Theory: Attributes economic fluctuations to random productivity changes, influenced by factors like technological advancements and external disruptions.

Potential GDP Dynamics

• Initial potential GDP: $17 trillion, full employment at point A.

• Potential GDP grows to $20 trillion, leading to a rightward shift of the Long-Run Aggregate Supply (LRAS) curve.

Economic Expansion

• Aggregate demand typically increases faster than potential GDP during expansions.

• When aggregate demand expectations rise (e.g., anticipated price level rise from 100 to 110), the Short-Run Aggregate Supply (SRAS) shifts accordingly, maintaining employment at point B.

Situations of Slower and Faster Aggregate Demand Growth

• Slower Demand Growth:

  • Economy shifts to point C, resulting in slower GDP growth and underperformance in inflation expectations.

• Faster Demand Growth:

  • Economy moves to point D, with rapid GDP growth and higher-than-expected inflation.

Real Business Cycle Theory

Impulse Mechanism

• Based on productivity growth from technological change.

• Periods of rapid growth spur expansions, while declines trigger recessions.

Effects of Productivity Changes

• Investment Demand: Changes with productivity, impacting demand for labor.

  • A decline in productivity lowers investment demand, resulting in decreased real interest rates and loanable funds.

• Labor Supply Decisions: Economic participants balance returns from current and future work based on real interest rates.

Criticisms and Defenses of RBC Theory

• Criticisms:

  • Sticky money wage rates contradict RBC assumptions.

  • Intertemporal substitution's impact is deemed minimal for large labor fluctuations.

  • Productivity shocks may arise from aggregate demand changes as well as technological innovations.

• Defense:

  • RBC theory encompasses macroeconomic insights on both cycles and growth.

  • Aligns with microeconomic evidence relative to labor supply and demand dynamics.

Inflation Cycles

Long-Run vs Short-Run

• Inflation occurs if money supply grows faster than potential GDP in the long run.

• Short-run factors leading to inflation include a multitude of demand influences.

Demand-Pull Inflation

• Initiated by increases in aggregate demand due to factors like interest rate cuts, increased government spending, or fiscal stimulus.

• Results in rising price levels and an inflationary gap.

  • Wage Rate Response: Money wage rates increase, shifting the SRAS leftward until GDP returns to potential levels.

  • Ongoing Demand-Pull: Sustained inflation necessitates continuous money supply growth.

Cost-Push Inflation

• Triggered by increased costs, primarily rising wages and raw material prices.

• Results in a leftward shift of the SRAS leading to higher price levels and lower GDP.

  • Stagflation: Coinciding high prices and low GDP.

Deflation

Causes and Consequences

• Persistent price level declines occur when aggregate demand grows slower than supply.

• Unanticipated deflation redistributes wealth, reduces GDP and employment, hindering production resources.

Counteracting Deflation

• Achieved through boosting money supply growth rates beyond GDP growth rates minus velocity change.

The Phillips Curve

Short-Run Phillips Curve (SRPC)

• Illustrates trade-offs between inflation and unemployment with constant expected inflation and natural unemployment rates.

  • Inverse relationship between inflation and unemployment rates.

Long-Run Phillips Curve (LRPC)

• Vertical orientation at the natural unemployment rate; any change in inflation aligns with expected inflation.

  • Changes in expected inflation or natural unemployment prompt shifts in both SRPC and LRPC positions.

Conclusion

• This chapter integrates business cycle dynamics with inflationary and deflationary pressures, materializing insights into how macroeconomic factors interrelate and impact performance.