In-Depth Notes on Business Cycles and Economic Models

• Business Cycles (Business Fluctuations)

  • Definition: Fluctuations in the growth rate of real GDP around its trend growth rate.

  • Recession: A significant and widespread decline in real income (real GDP) and employment.

  • Graph Analysis: Observe the shaded regions on the graph of Quarterly Growth Rate in Real GDP from 1948–2016.

  Importance of Understanding Business Cycles

  • Net Job Loss: Significant job losses often occur during recessions.

• Civilian Unemployment Rate:

  • Historical data: An illustration from 1948 to 2016 highlights trends in the unemployment rate, indicating the devastating effects of recessions on employment.

Business Cycles and Public Policy

• Contested Area: Economic policy debates often revolve around business cycles and their nature.

• Frameworks to Understand Business Cycles:

  • Examination of aggregate demand (AD) and aggregate supply (AS) models to analyze economic shocks that influence growth rates.

  • Understanding how shocks to AD or AS may cause business fluctuations.

Models of Business Cycles

• Real Business Cycle (RBC) Model:

  • Components:

  • Aggregate Demand (AD)

  • Long-Run Aggregate Supply (LRAS)

• New Keynesian Model:

  • Includes AD, LRAS, and Short-Run Aggregate Supply (SRAS).

Aggregate Demand (AD) Framework

• AD Curve: Indicates combinations of inflation and real growth tied to a defined rate of spending growth (M + v).

Quantity Theory of Money

• In Levels: MV = PY where:

  • M = Money supply

  • V = Velocity of money

  • P = Price Index

  • Y = Real GDP

• In Growth Rates:

  • %ΔM + %ΔV = π + %Δy (where π = inflation rate)

  • Rearranged: π = (%ΔM + %ΔV) - %Δy

• Examples of Calculating Inflation:

  • π = 5% + 0% - 0% = 5%

  • π = 4% + 1% - 3% = 2%

  • Combinations explaining shifts in the AD curve based on inflation and real growth.

Shifts in Aggregate Demand (AD)

• Causes of Shifts:

  • Changes in money growth rate or velocity growth.

  • Central bank influences and consumer behavior can lead to shifts.

  • Positive expectations can increase AD, while negative ones can decrease it.

Long-Run Aggregate Supply (LRAS)

• Solow Growth Rate: Potential growth rate determined by labor, capital, and productivity.

• Characteristics:

  • LRAS is vertical and independent of inflation rate.

• Real Shocks: Economic disruptions (positive or negative) impacting productivity and shifting LRAS.

Real Business Cycle (RBC) Framework

• Business fluctuations mainly result from real shocks to LRAS due to high flexibility of prices.

• Implications:

  • Limited government intervention — focus on long-term stability.

  • Predictions regarding inflation rates and growth outcomes based on AD and LRAS intersections.

Real-World Examples of Shocks

• Oil Price Increase (1979-1981):

  • Spike in oil prices led to decreased productivity, causing a negative productivity shock.

• Technology Boom (1992-2000):

  • Advances in technology enhanced productivity, resulting in an upward shift of the Solow Growth Curve, indicating positive productivity shocks.