The Business Cycle, Aggregate Demand and Aggregate Supply


Business Cycles

In this topic we explore the concept of the business cycle. A business cycle occurs due to the fluctuations that an economy experiences over time resulting from changes in economic growth. Understanding business cycles is the essence of a course in macroeconomics. Economists try to discern where the economy is located and more importantly where it is heading in order to deal with possibly adverse future economic events. When the economy is at or is heading in an undesirable direction, economists may apply fiscal or monetary policy tools to change the course of the economy.

In general, a business cycle describes changes in the demand-side of the economy as measured by GDP, where:

GDP = C + I + G + NX

Over time, GDP does not remain constant and will change for many reasons, economic and non-economic. Economic reasons include changes in government policies such as taxes and interest rates. The non-economic reasons are too many to even consider listing, but include factors such as war, drought, natural and man-made disasters.

 

 

 

Using Figure 7-1 as a guide, the horizontal axis measures time, while the vertical axis yields the real GDP growth rate. As the graph shows, we begin with an increasing growth rate of real GDP during an economic expansion. Eventually, growth approaches and then reaches a peak. Why are peaks reached, or why doesn't economic growth continue to increase indefinitely? The answer is prolonged periods of economic growth (or short periods of very intensive economic growth) are eventually accompanied by rising inflation rates (or the threat of higher inflation). The higher prices (inflation) bring forth counter cyclical policies used to dampen inflationary pressures.

 

Business Cycle Overview

 
  Percentage of time that the US Economy is in a recession Average length of the recession
Before - 1945 40% 21 months
After - 1945 17% 11 months
Since 1980 10%  

The defining part of the business cycle is a recession. Without a recession, the economy doesn't really experience a business cycle, just a period of a prolonged economic expansion. Between 1992 and 2000, the U.S. economy did not see a recession and set the record for the longest period of economic expansion without a recession. There were changes in real GDP growth during this time period, GDP even decreased in the first quarter of 2003, but no recession. The table above shows how the business cycle evolved in the 20th century.

Prior to 1945, periods of recession were almost as common as days when the economy was growing. As we will discuss in Unit 9, until the Great Depression of the 1930s, economic policy makers generally did little to counteract the forces that drove the business cycle, choosing instead to allow the economy to take its own course. The result was long (typically almost 2 years) and frequent recessions that we usually much more severe than modern-day recessions.

Modern economic thought is characterized by the use of both fiscal and monetary policies to counteract and smooth out the business cycle. As the table shows, economists have had success in using these policies to make the dealings of U.S. firms, as well as the life of Americans who work and save in financial markets less turbulent. To better understand the use of fiscal and monetary policies, take another look at the GDP equation:

GDP = C + I + G + NX

GDP is the sum of consumption + investment + government spending + net exports (exports - imports).

This equation can be written in further detail as:

GDP = C(Y - T) + I(r) + G + NX

Y is equal to income and T represents taxes.

(Y - T) gives us disposable income and thus consumption depends on the level of disposable income C(Y - T).

r represents the interest rate and investment responds to changes in the interest rate.

Fiscal Policy is represented by the executive and legislative branches of government and captures changes in taxes (T) and government spending (G). In the United States, the president and Congress make these decisions. As we can see from the equation, a decrease in T will increase disposable income (Y - T), increasing C and therefore increasing the growth rate of GDP. Government spending (G) directly affects GDP growth.

If the economy is in a recession, a combination of tax cuts and increases in government spending can stimulate economic activity. For example, the U.S. economy saw its first recession in a decade in 2001. Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the 7% (at an annual rate) range.

Monetary Policy is conducted by the central bank of a country - in the United States this is the Federal Reserve Board. Details will be present later in the class, but the Federal Reserve can increase and decrease interest rates to change business investment (I) in the equation above. Changes in interest rates will also influence consumption, but our focus in this class will be the effect on investment.

For example, in the year 2000, the federal funds interest rate was 6.5% and by the summer of 2003, the interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal Reserve.

Observers have concluded that economics is a somewhat imprecise field, especially when it comes to dealing with business cycles. Economic indicators such as GDP and the inflation rate are trailing indicators. They tell us a good deal about the economy, but importantly they tell us where the economy is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth in the current or following calendar quarter. Although there is often a correlation between future GDP growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly. Economists need to be able to identify changes in the growth trend and to spot these variations by using leading indicators such as changes in business inventories.

Knowing current economic conditions is useful information for economists, but knowing where it is going is critical. As noted, economists use leading indicators to try to accurately predict future changes in GDP and the inflation rate. Interpreting the signals given by the leading indicators on what direction the economy is taking is often weakly understood by economists, sometimes the indicators give conflicting signals and the conclusions made are often controversial.

The goal of this topic is to discover how economic policy makers interpret and react to business cycles. The two most important macroeconomic variables are the real growth rate of GDP and inflation (the unemployment rate is also crucial, but is closely tied to GDP growth). The goals of economic policymakers are simple:

Taking the perspective of the Federal Reserve, ranking the above goals in order of importance yields:


(1) Once the unemployment rate is minimized, the Federal Reserve targets a the non-inflationary growth rate of real GDP. This rate is based on supply-side factors of the growth in the labor supply and worker productivity. For example, if the U.S. labor force increases by about 1.0% annually and the yearly increase in worker productivity or output per worker at private nonfarm businesses is estimated to average about 2% each year then the target growth rate equals 3%.

It is critical to note that monetary and fiscal policies have no effect on the supply-side growth rate. The policies are used to change demand-side (GDP) growth.


No problem we say. It goes without saying that accomplishing these three simple goals simultaneously is equivalent to having a job as the circus lion tamer. The hungry lions in this case are leaping inflation, plunging GDP, snapping politicians and a roaring public. The economic policymaker/lion tamer must not lose his vigilance or these lions may take a large bite out of his rump.

Before we go into the details of the business cycle, here is a summary of some important points to remember.

In an attempt to reduce inflationary pressures, economic policymakers will attempt to slow economic growth. The reduction in the growth rate of real GDP corresponds to an economic downturn, where GDP growth has fallen from its peak level.

Are economic policymakers stupid? Historically, economic downturns are eventually followed by a recession when real GDP growth actually becomes negative. Recessions are often synonymous with rising rates of unemployment. Rising unemployment rates certainly get the attention of economic policy makers who furiously enact expansionary policies (the durations of recessions tend to be much shorter than positive growth periods). The closest that economic policymakers come to nirvana is during the expansionary phase. The worst is over, economic growth is increasing (often very quickly), jobs are being created, and inflation remains muted. Everyone deserves their day in the sun, but after a brief interlude of happiness, rising inflation causes a storm of tears for even the most optimistic economists.

Leading Economic Indicators

As noted earlier, economic policymakers try to predict where the economy is heading in the near future based on leading economic indicators. The Fed follows many economic indicators which can give signs regarding changes in future economic growth and inflation. For example, as these economic indicators reach the danger zone, there is increasing likelihood that the economy is overheating and increasing the danger of rising inflation in the near future. Important leading economic variables that the Fed closely monitors include:

1) The unemployment rate: in relation to full-employment. On average, labor comprises roughly 2/3 of total production costs for businesses. When the unemployment rate reaches and then falls below full-employment, labor shortages build. As producers trying to expand production find new workers becoming increasingly scarce, they are forced to add costly overtime and offer higher wages to entice non-labor force members to work. The result is upward wage pressures. Wage increases translate into higher production costs, higher prices for goods and services and an increase in the inflation rate.

Another important indicator related to employment is new jobless claims. Released every Thursday, new jobless claims give the number of people who are making an initial claim for unemployment benefits. If the number of new jobless claims is rising over time, the indication is that firms are increasingly laying off workers who then are filing for unemployment. A persistent increase in claims indicates that demand for goods and services is falling and unemployment rates will be rising. On the other hand, if new jobless claims remain constant or are falling, then labor markets are in good shape. Currently, economists consider 400,000 new weekly jobless claims to be the dividing line between a labor market to is adding jobs (on a net basis) and one that is experiencing net job losses. Even in the best of times, workers lose jobs and a number of 300,000, for example, signifies that the economy and labor market are doing very well. The lower the number of new jobless claims, the better for the labor market and people seeking employment.

2) The Labor Cost Index: measures what the title indicates – the cost in terms of wages, salaries and benefits paid by firms to their employees. This is a very important indicator since even in the high technology US economy, labor still comprises about 2/3 of the total production costs to a firm. If the index is rising at a fairly rapid pace, and consumer demand is strong, firms are likely to pass on their higher production costs to the consumer by raising prices. In contrast, if the index remains steady, then strong consumer demand may not lead to higher prices and inflation.

3) The utilization of productive capacity: capacity utilization refers to the amount of physical capital available to firms that is in use. At any time, firms have a given stock of capital equipment such as machinery, office space, factories, computers and telecommunications infrastructure available to assist workers in the production of goods and services. In the short run, a firm's, industry's or economy's capital stock is considered fixed, as it often takes awhile to invest in additional capital equipment, especially when new office or factory space is required to increase output to meet growing demand.

The Fed regularly surveys different producers to estimate how much of the capital stock in place is actually being used. As various producers within an industry reach full-capacity (100% use of the capital available) due to high demand for their product, firms are likely to begin charging customers higher prices to satisfy additional demand. This is the result of higher production costs resulting from additional shifts, overtime and other costs relating to increased use of the available capital.

For the economy as a whole, the Fed becomes cautious as the capacity utilization rate approaches 84%. The Fed considers this to be the threshold at which inflationary pressures will build in some parts of the manufacturing sector. Although 84% is well below 100%, at this point the Fed judges that some important industries will be approaching 100% capacity utilization. Industries that are likely to reach full capacity before the economy as a whole include manufacturers of basic commodities such as steel, aluminum and paperboard used in shipping final goods.

As an example, consider the auto industry. When demand for autos is growing due to robust economic growth, auto manufacturers increase their output and the use of their capacity. Excess capital equipment and factory space, which had previously been idled, is put into production. Steel is an important input in automobile production and as auto manufacturers increase their output they order more steel used in production. At first, steel producers may also have some spare capacity (also known as slack) or unused capital equipment. However, as orders from the auto producers continue to grow, soon all available capital used in steel production is put into use. Adding extra capital would take several years, so the only way steel firms can boost production to meet additional demands is to add overtime and extra shifts - using the capital more intensively. In most cases, workers are paid higher wages for working overtime or extra shifts, and these higher production costs are passed on to the auto manufacturers. As auto producers pay higher prices for their steel inputs, they pass on the higher cost to the consumer by raising the prices of their final goods.

4) Commodity prices: as noted above, higher raw material and commodity prices (e.g., steel, copper, aluminum, paperboard) are often passed on to the final product.

5) Changes in business inventories: rapid growth in demand for goods and services will deplete business inventories. As businesses increase production to meet additional demand and to rebuild inventories to desired levels, inflationary pressures may build. Of course, falling inventories can also be a sign of weak consumer demand. The trend has to be placed in the context of overall economic conditions.

6) Worker productivity gains: worker productivity refers to output per worker, or how much of a good or service a worker produces during a given time period (e.g. per hour or day). As workers gain job experience, knowledge and skills, they become better at their jobs and their productivity improves. Increases in worker productivity helps to dampen inflationary pressures by decreasing production costs. Rates of change in worker productivity vary only slightly from year-to-year and significant changes are due to long-run economic dynamics. Presently, U.S. worker productivity improves by about 2.0% annually.

The above leading indicators: the unemployment rate, capacity utilization, commodity prices, changes in business inventories and gains in worker productivity all help to give economists a picture of where the economy is going. Consider the U.S. economy in the beginning of 1994. The unemployment rate had fallen into a range consistent with what the Federal Reserve considers to be full employment (a shade below 6%). Capacity utilization had run up past 84%, commodity prices were beginning to show upward spikes and business inventories continued to fall. Combined with other economic indicators followed by the Fed, these conditions signaled an increase in the inflation rate in the near future. Consequently, by raising interest rates, the Fed took action to slow economic growth before inflation rates actually increased.

Bottlenecks and Inflation

The correlation of wages and inflation is fairly evident: higher wages paid to workers (an input in production) are often passed on to consumers in the form of higher prices for final goods and services. In 1994 this item was of little concern to the Fed, as wage gains remained very low. In fact, the U.S. Department of Labor reported that inflation-adjusted (real) wages fell 2.7% from March 1994 through March 1995. However, by late 1994, the unemployment rate had fallen to a level considered by the Fed to be consistent with full employment.

In contrast to the calm wage picture, uncertainty in labor markets, combined with events taking place in the area of productive capacity during 1993, gave the Fed serious alarm. In the area of capacity utilization, we need to consider two key points:

  1. The growth in productive capacity: which refers to the number and skills of workers, the size and quality of the capital stock, and changes in technology.

  2. Changes in the degree to which the capacity is used.

Growth rates in productive capacity tend to remain fairly constant over long intervals and respond positively to increases in the labor force and additions to the capital used in production. The current growth rate of productive capacity is about 3% annually for the U.S. economy. Another way of expressing growth in a nation's productive capacity is as an expansion of the production possibilities frontier. An economy's capability to produce goods and services grows over time at relatively constant annual rates as the population and capital stock increase and technology improves.

A contrast to the steady, long-run growth in productive capacity is the fluctuation in the use of the productive capacity (capacity utilization) that occurs during the course of a business cycle. Consider the relation of a typical business cycle to changes in capacity utilization. We can identify three stages:

  1. Recession: Workers are laid off and the unemployment rate climbs. Factories and machinery are idled and capacity utilization falls significantly. A good deal of slack is created as capacity utilization falls.

  2. Noninflationary growth: As the economy emerges from a recession, unemployed resources (workers, factories, machinery, and other capital goods) are put back to work. Economic growth is characterized by a falling unemployment rate and the absorption of excess capacity. Growth is robust, and the combination of excess capacity and the steady growth in productive capacity keep a lid on price pressures.

    The situation is one where there is a large gap between actual output and potential output. If output is well below its potential (maximum), there is plenty of excess capacity (or slack) in the economy and producers can easily expand output with the existing productive capacity available. Since there is a surplus of unemployed labor, wage demands remain muted and the utilization of mothballed equipment is cheaper than buying new capital. Importantly, higher supplies easily satisfy the increased demand for goods and services..

In a typical business cycle, the period of noninflationary growth correlates to a time of significant job growth in the economy. For the U.S. economy, we can expect over 200,000 new jobs to be created each month on a net basis. For example, during the long economic expansion during the Clinton administration (eight years without a recession, there were almost 22 million new jobs added to the economy with average job growth of 225,000 per month.

  1. Inflationary pressures: As the economy continues growing, the excess capacity present begins to shrink. Finally, the economy begins to reach potential output or full capacity. The resulting bottlenecks most often occur in critical areas such as raw materials and commodities (e.g., steel, copper, aluminum). 
 

 

 

Figure 7-2 shows the case where the steel industry has reached full capacity. Capacity limits are shown by a nearly vertical portion of the supply curve, indicating that increases in demand bring forth little additional output. All firms can do to increase output is to add overtime, since all capital used in production is utilized. The main impact is an increase in prices when supply bottlenecks are present and demand increases. Consequentially, the growth in demand outraces the long-term growth in supply, forcing up steel prices.

For critical commodities like steel, that is an intermediate good used in many final consumer goods (such as automobiles, washing machines, household gutters). Higher prices are often passed along. As automobile manufacturers pay higher prices for their steel inputs, they will raise the price to the consumer to recoup the added cost.

Returning to the recent business cycle in the United States, the recession of the early 1990s created a good deal of excess capacity. As economic growth resumed in 1992, accelerating through 1993 and into 1994, the excess capacity was rapidly absorbed and the economy approached potential output. The warning number the Fed uses is roughly an 84% capacity utilization rate, and this was reached in early 1994. Although an economy with a 84% capacity utilization rate is well below 100%, this number is for the general economy. Specific industries may be reaching a capacity of 100% (such as steel and aluminum). Those industries reaching full capacity will soon experience bottlenecks, creating increased inflationary pressures on the overall economy. Thus, in 1994 the Fed attempted to slow U.S. economic growth by raising interest rates.

In the next section we will investigate the topic of business cycles using the tools of aggregate demand and aggregate supply.

Macroeconomic Equilibrium

We have studied the demand and supply curves for individual markets. Now we take all the markets in a domestic economy and combine them into an aggregate. The aggregate demand curve accounts for the purchases of all consumers, businesses, the government, and foreign trade in an entire domestic economy. The aggregate supply curve looks at the total production in an economy. Studying the concepts of aggregate demand and supply is fundamental to understanding macroeconomics. We will begin by looking at each in isolation and then combine the two. As you will see, the topic is very similar to the analysis of demand and supply for a specific good.

Aggregate Demand and Supply

 

 

 


Figure 7-3 illustrates the aggregate demand curve for an economy. Note the labels on the axes. The horizontal axis measures total economic output or GDP. The vertical axis uses the overall price level for the economy as a measure of prices. The aggregate demand curve shows the relationship between the price level and output. As the curve shows, there is an inverse relationship between prices and output. 

 

 

 


Figure 7-4 illustrates the aggregate supply curve for an economy that has the same measures as aggregate demand on the horizontal and vertical axis. The aggregate supply curve shows the total output by producers of all goods and services in our economy. Note that the aggregate supply curve has a relatively flat region that rapidly becomes vertical.

The flat section of aggregate supply is characterized by an economy with a good deal of excess capacity or slack. The vertical section of the aggregate supply curve indicates that our economy has reached full capacity, or potential output. Potential output is noted on the graph as Yf, or full-employment. Full employment is consistent with an unemployment rate where all those who desire to work can find employment. Individuals who are unemployed, are considered voluntarily unemployed.

 

 

 

Potential output is not a static concept but changes over time as our economic capability to produce goods and services expands. This concept is analogous to an outward shift in the production possibilities frontier (PPF). As you may recall, the PPF shifts outward with growth in the labor supply, improvements in technology, and the addition of new productive resources such as capital.

Figure 7-5 shows the rightward shift in aggregate supply as potential output increases along with the economy's productive capacity. We see that the vertical portion of the aggregate supply that corresponds to potential output has expanded. The expansion of aggregate supply is consistent with growth in the labor force and the creation of new jobs. As a result, the level of output consistent with full-employment moves from Yf 0 to Yf 1.

Changes in productive capacity move gradually as the factors that influence it tend to move in long-term cycles. For example, changes in the labor supply are predominantly reflected in birth rates, which take generations to show any substantial change. The research and development that allow for technological change also take years to mature and be effectively implemented. Technological advancement tends to be self-reinforcing, leading to moderate increases and decreases in the pace of change over time.

 

 

 

Finally, our macroeconomic equilibrium is determined by the intersection of aggregate demand and supply. As Figure 7-6 shows, Po is the price level at equilibrium. In a macroeconomic context, the price level can be used to indicate relative rates of inflation. Yo is the level of output (GDP) our economy achieves at equilibrium.
Although not shown here explicitly, output growth can be used as an indicator for the unemployment rate. In general, output expansion should lead to lower levels of unemployment. A reduction in output will usually cause unemployment rates to rise.

As we noted above, changes in aggregate supply are relatively constant and reflect the steady expansion of the economy's productive capacity. For the United States, we can expect an outward shift in aggregate supply to correspond to a 3.0% annual rate of growth in potential output or productive capacity.

Given the steady growth in aggregate supply that can be expected to be relatively constant for sustained intervals, we will focus most of our attention on economic policies that affect aggregate demand. As you can see from the above graph, changes in aggregate demand will impact prices (inflation rates) and unless we are at potential output, output (GDP and unemployment rates) will also change. The two most important macroeconomic policies studied in this course are:

Changes in either fiscal or monetary policy can be expected to have little impact on the rate of change of aggregate supply in the short run. Consequently, the focus of macroeconomics is understanding the impact of macroeconomic policies on aggregate demand, where changes in aggregate demand affect the economy's inflation and unemployment rates.

What about the long run you ask? Politicians, and thus economic policymakers, tend to be very myopic or shortsighted. The health of the economy has a critical influence on the incumbent in an election. How many politicians would be successful running on the following platform:

"I know the economy stinks, and you haven't worked since I was elected, but try to be reasonable.
Because of my foresight, legislation has been passed that should create strong economic growth by next year, and many years thereafter; I promise."

Throughout this course, we will study the long-run consequences of economic policy. However, keep in mind that much of the economic policy discussed here will focus on the short-run impacts on aggregate demand, economic growth, inflation, and unemployment. In the next section we will develop the relationship between macroeconomic policies and changes in aggregate demand during the business cycle.

Once More to the U.S. Business Cycle

Using our graphical presentation of aggregate demand and supply, let us revisit the topic of the U.S. business cycle of the early 1990s discussed in previously. We can begin in 1991, with the U.S. economy mired in a recession. The unemployment rate had risen by roughly 3% since 1989, reaching 7.7% at its maximum level. His fiscal hands tied by large deficits and facing an election in the fall of 1992, President George Bush exhorted the Federal Reserve Board (Fed) to take counter cyclical action. Fed Chairman Greenspan complied, lowering short-term interest rates with the intention of stimulating economic growth. But as 1992 began, U.S. economic growth remained catatonic, barely stirring in response to falling short-term interest rates. The problem belonged with long-term interest rates, which remained stubbornly high due to the deficit hangover the economy was dealing with.

The Reagan-Bush budget deficits caused financial markets to add an inflationary premium to long-term interest rates, an issue we will discuss in greater detail later on. Consequently, while the Fed was effective in reducing short-term interest rates, long-term interest rates remained nearly unmoved. Critically, for economic growth to respond to interest rate changes, long-term rates must decline. As the 1992 election neared, reluctant long-term interest rates perpetuated stagnant economic growth, and President Bush paid for the budget excesses of the previous decade.

Aggregate Demand and Supply

 

 

 

Figure 7-7 shows the relationship of aggregate demand to aggregate supply in early 1992. You may recall the flat portion of the aggregate supply curve corresponds to the slack of excess capacity that an economy builds during a recession and times of weak economic growth. The equilibrium level of output is labeled as Y*. Note that Y* is well to the left of Yf. We use Yf to indicate full employment, which is consistent with an unemployment rate where those who desire to work have jobs. Full employment is an indicator that an economy is reaching full capacity utilization, or potential output.

After taking office in January 1993, President Clinton passed a budget that significantly reduced the fiscal budget deficit. Responding to indications that budget deficits were under control, financial markets gave President Clinton a windfall, as long-term interest rates rapidly declined by nearly 2% in early 1993.

The Fed gives a rough estimate that for every 0.10% decrease in long-term interest rates, economic activity increases by $10 billion. Because the economy is much more responsive to changes in long-term rates than it is to short-term rates, the decline in long-term interest rates during 1993 gave the U.S. economy a $200 billion boost to GDP.

In 2001, the Fed went through a series of rate cuts that lowered the key interest rate that it controls from 6.5% to 1.75% by early 2002. Never before had the Fed decreased a key interest rate so quickly.

 

 

 

Figure 7-8 shows the stimulus that falling long-term interest rates gave to economic growth in 1993. The growth rate of the U.S. economy picked up substantially, resulting in a significant rightward shift in aggregate demand from ADo to AD1.

In addition to the shift in aggregate demand, aggregate supply also moved outward from ASo to AS1 due to the continuous expansion in the productive capacity of the economy. As the graph shows, the expansion in aggregate demand exceeded the growth in aggregate supply. Output increased from Yo to Y1 and prices remained constant. In reality, the rate of increase in prices remains constant. This implies that the inflation rate also did not change. If we look at prices on the vertical axis as representing changes in the inflation rate, then the increase in aggregate demand has no impact on the rate of inflation.

It is important to distinguish the reasons for the shift in aggregate demand in contrast to changes in aggregate supply. The general rule to follow for this course is the key influence on the business cycle is changes in aggregate demand. Increases in aggregate demand raise economic output, GDP, and growth, and lower unemployment. Contractions of aggregate demand have the opposite effect. Aggregate demand is effective in changing economic growth only when aggregate demand is shifting along the relatively flat part of aggregate supply. When aggregate demand shifts along the vertical range of aggregate supply, changes in prices (inflation rates) are the only economic consequences.

For the most part, changes in aggregate supply are independent of the business cycle. We can assume that the increase in aggregate supply is relatively constant over time, reflecting changes in our economy's productive capacity and potential output.

The growth of potential output is reflected in the outward expansion of the production possibilities frontier. As you may recall, important factors causing growth in the production possibilities frontier are increases in resources (e.g., the labor supply) and changes in technology. It is evident that changes in the labor force are pretty much independent of the business cycle. How many parents, when considering the conception process, discuss the likelihood of a recession in twenty-two or so years just when the unknown child graduates from college and enters the labor force? Certainly during recessions, some people will stay in school or return to school, but for the most part the pool of labor struggles with diminished opportunities. Changes in technology take time to research, develop, and implement, and progress is pretty much independent of the business cycle.

The rate of technological progress does vary. It is possible that the annual increase in worker productivity is rising due to the computer revolution that you, many businesses, and governments are participating in. This is certainly an issue worth considering for the long-run expansion of a nation's potential output. Improvements in the pace of worker productivity will increase the growth rate of aggregate supply, but gradually, independent of the business cycle. For our purposes, we will assume that the rate of aggregate supply growth remains constant over time (at the present time for the U.S. economy it is estimated to be between 3% annually in real terms).

The Fed Takes Away the Punch Bowl

 

 

 


With the catalyst created by falling long-term interest rates, economic growth accelerated throughout 1993 and into 1994, reaching a frothy 6% annual rate by the fourth quarter of 1993. Figure 7-9 shows the situation as the U.S. economy entered 1994.

The growth rate of aggregate demand (from AD1 to AD2) was much faster than the intrinsic rate of growth of aggregate supply (AS1 to AS2), which was roughly 2.5% annually in the mid-1990s. As the economy expanded, the slack present in 1992 and 1993 was absorbed and capacity utilization was rapidly approaching the Fed's warning track of about 84%. Aggregate demand was reaching the vertical portion of the aggregate supply curve. As our economy reached potential output, warning signals were triggered. If aggregate demand continued to grow faster than aggregate supply, the inflation rate would soon accelerate upward.

Figure 7-9 above shows the rate of growth in aggregate demand exceeding the growth rate of aggregate supply. As aggregate demand shifts outward along the flat part of aggregate supply, excess capacity is soaked up, idled machinery is put back into use and unemployed workers are hired. The growth rate of aggregate demand exceeds the rate at which productive capacity is added to the economy. Inflationary thoughts send chills down the hardy spines of economic policymakers.

In the graph, prices increase by a modest amount from P1 to P2. Since the actual rate of inflation remained constant during this time, we can consider the price increase shown in the graph a representation of inflationary pressures that were building at the time due to the elimination of economic slack. Whether it represents actual or anticipated inflation, the price increase leads (will lead) to higher inflation unless the growth rate of aggregate demand is reduced.

As 1994 began, the economic party was in full swing for businesses and investors. Labor enjoyed lower unemployment rates, yet wage gains were stifled for many. Fortunately, inflation was increasing at an annual rate below 3%, so despite almost stagnant incomes, workers were not losing the purchasing power that high inflation often erodes. The Fed feared than if aggregate demand continued to grow at the pace of late 1993 and early 1994, inflation would soon result as economic bottlenecks increased. Thus the Fed initiated a series of interest rate hikes to slow the growth rate of aggregate demand.

The Goldilocks Economy

This section begins with the story of Goldilocks and the three bears, a book most of us pick up on a regular basis. As you may recall, momma bear liked her porridge on the cool side, papa bear wanted his porridge piping hot. Baby bear liked it, not too hot nor too cool, but just right.

We can think of the conduct of economic policy by the Federal Reserve in the same way. If the economy gets too hot, higher inflation is the result. Too cool, and jobs are lost, perhaps even a recession. Just right implies that the economy is at full employment and inflation is not a problem. This is the characterization of the US economy during the second half of the 1990s. In this case, the growth rate or speed limit of the economy is determined by the annual supply side growth rate (e.g. 3%) and aggregate demand growth is adjusted by the Federal Reserve to keep pace.

Assuming that the economy is at full employment, if aggregate demand growth starts to exceed the growth rate of aggregate supply, inflationary pressures start to build (inflation rates may even have already picked up), the economy is “too hot” and the Fed puts the brakes on by rising interested rates to slow down the pace of aggregate demand growth. In contrast, if aggregate demand growth starts to lag behind the growth rate of aggregate supply, the economy is cooling off and the Fed want to pick up the pace by reducing interest rates. Things are “just right” when the annual growth rate of aggregate demand is about equal to the annual supply side growth rate (assuming full employment and low inflation).

The key point to remember is that the determinant of long run growth is the annual expansion of aggregate supply (shown earlier in the course by the production possibilities frontier). Once full employment is reached, aggregate demand (GDP) cannot grow appreciably faster than aggregate supply without causing higher inflation rates.

If the annual pace of aggregate supply picks up, for example from 3% to 4% annually, then this also allows for non-inflationary growth of aggregate demand to increase from 3% to 4% per year.

If the annual pace of aggregate supply drops, for example from 3% to 2% annually, then aggregate demand must decrease from 3% to 2% per year or inflation will be the consequence.

 

 

 


Figure 7-10 shows the mythical soft landing that the Fed was trying to achieve in the mid-1990s. The goal was to have the growth rates of aggregate demand and aggregate supply in harmony, a situation known as noninflationary growth. Once aggregate demand reaches the area of potential output (the steep part of the aggregate supply curve), the Fed will fine-tune the growth rate of aggregate demand to equal the growth rate of potential output or aggregate supply. Graphically, the shift from AD2 to AD3 will match the shift from AS2 to AS3.


Figure 7-11 above shows the business cycle that the U.S. economy experienced in the early 1990s. We begin with the mild recession of 1991. This prompted Federal Reserve interest rate cuts, but the large budget deficit resulted in an anemic recovery during 1992. It was only after a significant reduction in the budget deficit in 1993 that long-term interest rates fell noticeably and economy growth accelerated. Rapid growth triggered new inflationary fears as the economy neared full capacity utilization and full-employment, prompting the Fed to raise interest rates throughout 1994. As desired, economic growth tapered off during 1995 and into 1996. Rather than repeating the usual boom-bust cycle of growth followed by a recession, the Fed achieved a soft landing in 1996.

As noted earlier, economic policymakers have three goals:

In other words, the goal is to obtain and then maintain the Goldilocks economy. In this case, the Federal Reserve will both increase and decrease interest rates in an attempt to fine-tune aggregate demand growth so that it is just equal to the growth rate of aggregate supply from one year to the next.

For example, if aggregate supply is growing at 3% per year (equal to 1% growth in the labor force plus 2% growth in worker productivity), then the Federal Reserve would like to maintain aggregate demand growth at an equivalent rate. Figure 7-12 illustrates this point.

Just because a recession ends and the recovery begins, there is no guarantee that the unemployment rate will start to decrease – it may even continue to rise as it did during the recession.

To understand this concept, remember that a country’s supply side growth rate increases independent of the business cycle. For example, in the United States annual supply side growth is about 3% a year, boom or bust.

Regardless of economic conditions on the demand side, people graduate from high school or college and enter the labor force. Not many Americans can or want to postpone their high school or college graduation just because the job market is poor. Additional, the pace of technology is not going to be very sensitive to the business cycle. Most technological improvements are the result of years of research and work.

As with the United States in 2002, assume that the economy is experiencing a relatively weak recovery. If aggregate demand (GDP) growth is positive, but only about 1% or 2% for the year, the recession will have ended, but the pace of aggregate demand growth will be lagging behind the economy’s supply side growth rate (aggregate supply). In this case, the unemployment rate is likely to rise during the weak recovery. The pace of job creation is not keeping up with increases in the labor force and gains in worker productivity. If workers are more productive, fewer workers are needed to produce the same amount of output.

For the unemployment rate to decline during a recovery, the annual rate of aggregate demand must exceed the growth rate of aggregate supply. Only then will new jobs be created leading to a decrease in the unemployment rate.

A Change Takes Place: The 2001 Recession

To summarize, this unit has covered what is a typical business cycle. As the economy continues to grow, inflationary pressures build and if left unchecked, eventually the inflation rate will start to rise. In response to the higher inflation rate, the Federal Reserve puts the brakes on growth by rising interest rates. Historically, the result is a recession that eliminates the problem of inflation, but leads to an increase in the unemployment rate. The Federal Reserve cuts interest rates and economic growth perks up.

In a typical business cycle, the downturn into a recession starts with higher inflation. The inflation is a result of strong demand for goods and services or a supply side shock that increases production costs for firms.

Beginning in the 1990s, the Federal Reserve improved its ability to fine-tune the economy and the Goldilocks economy developed. From 1993 until 2001, the U.S. economy experienced a recond-setting period of uninterrupted economic growth without a hint of a recession. When recession returned to the U.S. economy in 2001, the primary catalyst was not higher inflation but excess capacity in industry. For the first time since the early part of the 20th Century, the U.S. economy experienced an Investment-led recession. As the U.S. economy dropped into the 2001 recession, inflation remained at a low level and the Federal Reserve was rapidly lowering interest rates. However, due to excess industrial capacity, firms did not increase investment as rates fell, instead, they continued to reduce investment in new capital.

For an example of excess capacity, consider an hypotetical auto firm and assume that the firm has four factories that are fully stocked with capital equipment (assembly-line robots, computers, etc.). Due to slowing demand for cars, the firm only has to use three of the factories to satisfy consumer demand and idles the fourth factory. Capacity utilization for the firm is 75%. Lower interest rates will have minimal effect on business investment as firms already have all of the capital that they need to meet consumer demand.

As the Federal Reserve lowered interest rates in 2001, there was little stimulus provided due to the widespread capital overcapacity of U.S. firms. As consumer demand weakened, firms continued to reduce their new capital orders and dropping invesment led the U.S. economy into the 2001 recession. With monetary policy ineffective, it was up to the use of fiscal policy to help restore positive economic growth.