Chapter 12 The Business Cycle, Inflation, and Deflation

Business Cycle Overview

• Business cycles are difficult to explain, but easy to describe.
• Two main theories used to understand business cycles: mainstream and real business cycle theories.

Mainstream Business Cycle Theory

• Real GDP fluctuates around potential GDP, considering potential GDP grows steadily while aggregate demand varies.
• Potential real GDP starts at $1.4 trillion with full employment.
• Potential real GDP rises to $2.0 trillion, shifting the LAS curve to the right.
• An expansion occurs when aggregate demand increases, usually surpassing potential GDP.
• The AD curve then shifts to AD1.
• The price level is expected to increase to 110, thus the money wage rate is set accordingly.
• The SAS curve shifts to SAS1, the economy remains fully employed at point B.
• The price level increases from 100 to 110, as expected.
• If aggregate demand increases slower than potential GDP, the AD curve shifts to AD2 and the economy moves to point C.
• Real GDP growth slows and inflation is less than expected.
• If aggregate demand increases faster than potential GDP, the AD curve shifts to AD3.
• The economy moves to point D, real GDP grows faster and inflation is higher than expected.
• Continual increases in potential GDP, faster overall increases in aggregate demand, and variations in aggregate demand growth cause economic growth, inflation, and business cycles.

Real Business Cycle Theory

• Random productivity fluctuations are the primary cause of economic fluctuations
• Productivity fluctuations are from changes in technology, international events, climate, or natural disasters .
• RBC theory impulse: productivity growth rate from technological change
• Technological change usually occurs at a steady, moderate pace.
• Occasionally, productivity growth accelerates or decreases, making labor less productive on average.
• Rapid productivity growth leads to expansion, while decreased productivity can trigger a recession.

RBC Mechanism

• Changes in productivity result in two effects that drive expansions or contractions:
  • Investment demand changes.
  • Labor demand changes.
• Decreased productivity reduces investment demand, which reduces demand for loanable funds.
• Results in decline in real interest rates and quantity of loanable funds.
• Decreased productivity lowers the demand for labor.
• The supply of labor decreases as real interest rates fall.
• Employment and real wage rates decrease.
• The decision of when to work involves comparing current vs later earning potential, influenced by real interest rates.
• Intertemporal substitution has a small effect, though RBC theorists believe it is large and the key RBC mechanism.
• The real business cycle concerns real, not nominal or monetary factors.
• Changes in money only affect the price level, not real resources.
• Technological change drives both business cycles and economic growth in RBC theory.

Criticisms and Defense of RBC Theory

• Criticisms:
• The money wage rate is sticky, which conflicts with RBC theory's assumptions.
• Intertemporal substitution is too weak to explain fluctuations in employment with small wage changes.
• Productivity shocks can result from changes in aggregate demand, not just technological change.
• Defenses:
• RBC theory explains macroeconomic facts about the business cycle and economic growth, and is a single explanation for both.
• RBC theory aligns with microeconomic evidence on labor supply, labor demand, investment decisions, and income distribution.

Inflation Cycles

• Inflation occurs in the long run if quantity of money grows faster than Real GDP
• In the short run, inflation can be started by factors, that interact with real GDP
• Two sources of inflation: demand-pull and cost-push

Demand-Pull Inflation

• Inflation starts when aggregate demand increases.
• Can be initiated by: reduced interest rates, increased money supply, government spending, tax cuts, increased exports, or increased investment.
• An increase from full employment shifts AD curves rightward
• As the AD curve shifts, money wage rates increase and SAS curve shifts left
• The price level rises and real GDP falls back to potential GDP
• The inflationary gap emerges as the price level and real GDP increases
• The continuous increase in ad leads to demand pull inflation
• A sustained demand-pull inflation requires an ongoing increase in the money supply.
• Canada experienced a demand-pull inflation in the early 1970s, with double-digit inflation by 1974.

Cost-Push Inflation

• Starts with increasing costs, such as increased money wage rates or raw material
• Cutting of production and raising of oil prices leads to decreased aggregate supply and a shift in the SAS curve leftward
• Real GDP decreases and price level increases as aggregate supply decreases
• The decreasing of aggregate supply leads to aggregate demand response
• The Bank of Canada increases aggregate demand to counter higher unemployment.
• Real GDP increases and the price level further rises.

Aggregate Demand Response

• The initial increase in input costs causes a one-time rise in the price level, which will not cause inflation
• However, aggregate demand must increase for inflation to occur.
• Canada's Central Bank must respond to the unemployment and increase the money supply for increased aggregate demand
• Continuous oil price increase to keep relative price higher will cause a response from the Bank of Canada to increase the quantity of money
• Stagflation combines a rising price level with decreased real GDP.
• Canada experienced cost-push inflation during the 1970s when the Bank responded to rising OPEC oil prices.

Expectation of Inflation

• Expected aggregate demand increase impacts the price level.
• Workers money wage rates increase with the expected rise in price level
• The price level then rises as expected and real GDP remains at potential Real GDP
• To expect inflation, people must forecast it rationally: the best forecast available based on all relevant information.
• A rational expectation is not necessarily accurate, but is the best available.

Inflation and the Business Cycle

• The economy operates at full employment when inflation forecasts are correct.
• The inflation rate will exceed the expected rate, and the economy will act like in a demand-pull inflation if aggregate demand grows faster than expected
• Real GDP falls below potential, inflation slows, and the economy acts like in a cost-push inflation if aggregate demand grows more slowly than expected

Deflation

• Characterized by a consistent decline in the price level
• Causes include persistently slower growth in aggregate demand relative to aggregate supply.
• Quantity Theory and Deflation
• Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate
• Deflation rate = Money growth rate < Real GDP growth rate - rate of velocity change
• For example:
• Japan experienced 0.8% Real GDP growth rate, 2.5% money growth rate, and -3% change in velocity change
• 2.5 + (-3) -0.8 =-1.3% deflation
• Consequences of deflation include redistributing income and wealth, reducing real GDP and employment, and diverting resources away from production.
• Deflation can be ended by increasing the growth rate of money.
• Money growth rate must exceed real GDP growth rate minus the rate of velocity change.

Phillips Curve

• Illustrates the correlation between inflation and unemployment rates.
• There are two types: short-run and a long-run Phillips curve.

Short-Run Phillips Curve

• Represents the tradeoff between inflation and unemployment, assuming constant expected inflation and natural unemployment rates.
• If the actual inflation rate exceeds the expected rate, unemployment decreases.
• Increases in unemployment occur if the actual inflation rate is less than the expected rate.

Long-Run Phillips Curve

• Shows the connection between inflation and unemployment when actual inflation equals expected inflation.
• The curve is vertical at the natural unemployment rate
• Changes in inflation expectations do not affect unemployment.
• The SRPC and LRPC intersect at the expected inflation rate.
• Reduced expected inflation leads SRPC to shift downwards and vice versa.
• Changes in the natural unemployment rate prompt shifts in both the LRPC and SRPC.