15sg - Chapter 15 THE BUSINESS CYCLE* Key Concepts Cycle...

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227 15 THE BUSINESS CYCLE* Key Concepts ± Cycle Patterns, Impulses, and Mechanisms The business cycle is the irregular and nonrepeating up- and-down movement of business activity. The average recession lasts a bit more than one year, and GDP falls 6 percent from peak to trough. The average expansion lasts almost four years, and GDP rises 22 percent from trough to peak. Some cycles (e.g., tennis matches) require impulses to start each cycle. Some cycles (e.g., sunrise and sunset) reflect the design of the system. Some cycles (e.g., rocking horses) combine im- pulses and design. Investment and capital accumulation play key roles in the business cycle. Recessions occur when investment decreases; expansions occur when investment increases. Business cycles can be classified as aggregate demand theories and real business cycle theory. ± Aggregate Demand Theories of the Business Cycle The Keynesian theory of the business cycle regards volatile expectations as the main source of economic fluctuations. The Keynesian impulse is changes in firms’ expec- tations about future sales and profits. This change affects investment. * This is Chapter 30 in Economics . FIGURE 15.1 Price level (GDP deflator, 1996 = 100) 100 110 120 130 140 Real GDP (trillions of 1996 dollars) Keynesian Theory 789 1 0 11 AD 0 SAS 1 The Keynesian mechanism has two aspects. First, a change in investment has a multiplier effect on ag- gregate demand. Second, the short-run aggregate supply curve is horizontal, so, as illustrated in Fig- ure 15.1, shifts in the AD curve have a large effect on GDP. The response of money wages is asymmetric; wages do not fall in response to decreases in aggregate demand but they do rise in response to increases in aggregate demand. Hence the economy can remain stuck in a recession. Chapter
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228 CHAPTER 15 (30) FIGURE 15.2 Price level (GDP deflator, 1996 = 100) 100 110 120 130 140 Real GDP (trillions of 1996 dollars) Monetarist and Rational Expectations Theory 789 1 0 11 AD 0 SAS 1 The monetarist theory of the business cycle regards fluctuations in the money stock as the main source of economic fluctuation. The impulse in the monetarist theory is changes in the growth rate of the quantity of money. The monetarist mechanism is changes in the growth rate of the quantity of money that shift the AD curve. The economy moves along an upward- sloping SAS curve, as is illustrated in Figure 15.2, for a decline in the monetary growth rate. Aggre- gate demand decreases from ), 0 to ), 1 . Eventually, money wages respond to the change in the price level so that the SAS curve shifts and the economy returns to potential GDP. A rational expectation is a forecast based on all avail- able information. Rational expectations theories of business cycles focus on the rationally expected money wage rate. The two rational expectations theories are the new classical theory and new Keynesian theory .
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This note was uploaded on 04/06/2010 for the course MIS econ, mis, taught by Professor Mohammed during the Spring '10 term at École Normale Supérieure.

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15sg - Chapter 15 THE BUSINESS CYCLE* Key Concepts Cycle...

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