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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.