Business Cycles Lecture Notes PDF

Here's the conversion of the provided text into a structured markdown format: # EC108: Macroeconomics ## Lecture 9: Business Cycles **Image Description:** A cartoon strip shows a domestic scene. A washing machine has broken down. A repair man opens the machine. The house owner, an older woman, co...

Here's the conversion of the provided text into a structured markdown format: # EC108: Macroeconomics ## Lecture 9: Business Cycles **Image Description:** A cartoon strip shows a domestic scene. A washing machine has broken down. A repair man opens the machine. The house owner, an older woman, complains about the increased price of the repair. The repair man says it is the state of the economy. The cartoon ends saying 'every time I put on clean clothes I feel like I am dressed crisis'. ### Compulsory Readings (the exam is based on these) * Carlin & Soskice - Chapter 1 (as revision of Term 1) * The Economy, Unit 13: Economic Fluctuations and Unemployment. * Jahan, S. & A. Sahmed Mahmud (2013) What is the output gap? Back to Basics, Finance This term, we will focus on the short-run relationship between three main macroeconomic variables: $output$ (real GDP), $unemployment$ and $inflation$. We observe that year by year these variables fluctuate and we will analyse what causes these fluctuations. Starting with output, you learnt that GDP can be estimated as the total aggregate demand in an economy: $GDP=AD=C+I+G+X-M$ The main component of GDP for most countries is Consumption (see graphs in the slides), but the most volatile is Investment. You studied the GDP components in Term 1, and you can read more about this in sections 13.4 - 13.7 in *The Economy* and Chapter 1 in *Carlin & Soskice*. Investment volatility is considered to be one of the main drivers of the business cycle. Business cycles is the ‘ups and downs of the economy'. More formally, is the alternating periods of faster and slower growth rates. We can distinguish four stages of the business cycle: expansion, peak, recession & trough (Section 13.1 of *The Economy*). During economic downturns, an economy's output (GDP) declines, while during booms it increases. We are concerned is how close GDP is to the economy's *long-term potential output*. *Potential output* is the *maximum** amount of goods and services that the economy can produce operating at the maximum sustainable employment (i.e. when unemployment is equal to its equilibrium level). \*We need to be careful with the word *maximum*: this does not mean that the economy cannot produce more (it can!), it means that this is amount of output produced when all the resources are used efficiently. How can the economy produce more? unemployment can be below equilibrium, so the economy can produce more by utilising more resources. ### EC108: Macroeconomics 1 The man issue we find with potential output is that we don't observe it, so it has to be estimated. There are various ways to estimate potential output. Some may use an estimate of real GDP trend as a good proxy for potential output, but more sophisticated methods are also used. For instance, we saw that the *Institute for Fiscal Studies* (a research institute, based in London) uses a production function to estimate potential output for the UK. A production function gives us the technical relationship between output and inputs used in the production. We can use a production function to attribute how much factors of production (labour, capital, technology) contribute to economic growth. The difference between real GDP and potential output is known as *output gap* (this is commonly expressed in percentage terms). Read Jahan & Sahmed Mahmud (2013) for an explanation of positive and negative output gaps. ### Business cycles, unemployment and inflation Unemployment levels also fluctuate with the business cycle. We can observe that unemployment fluctuates around its long-run equilibrium level. These fluctuations are related to output fluctuations. The relationship between output and unemployment fluctuations is known as *Okun's Law* (read section 13.2 of *The Economy*). Finally, you may be wondering why a positive output gap is not good for an economy - after all, it means that production is above its potential level and unemployment is lower. The reason is that when output is above its potential, firms are producing more to face the high levels of demand. So firms (and workers) operate above their efficient capacity, unemployment is below its equilibrium level so workers demand higher salaries which increases costs for firms and will translate into an increase in prices i.e. higher inflation. Therefore, a positive output gap is related to high inflation (above its target - more on this later). Output gap plays a key role in policy-making. Central banks seek to keep inflation under control using *monetary policy*, and output gap is key in determining inflation pressure in the economy. Governments can also use *fiscal policy* to close the output gap. For this reason, monetary and fiscal policy are also known as *stabilisation policy* or *demand side policies*. Remember, we will focus on short-term fluctuations in this term, so we will say very little about the long-run. Potential output and the equilibrium rate of unemployment are set in the long-run and are not affected by short-term policies. The long-run will be covered in Year 2. If you are interested in reading more about this topic, you can have a look at (these are not part of the syllabus i.e. you don't need these for the exam): * Burns A. F. & W. C. Mitchell (1946), *Measuring business cycles*, New York, National Bureau of Economic Research * Goodwin, A. & M. Beck (2017) *The UK Economic Outlook*. Institute for Fiscal Studies. * Schulz (2019) *Recent trends to the UK economy*. Institute for Fiscal Studies.