Economics Chapter 11 The Business Cycle and Macroeconomic Policy

Economics

Chapter 11

The Business Cycle and Macroeconomic Policy

The business cycle

When ‘unfortunate incidents’ happened …(e.g. SARS in 2003) Consumption Investment GDP Unemployment Price level

Hong Kong’s economy suffered a downturn. People suffered a lot.

Afterward, many policies helped to build up economy again…(e.g.CEPA) Hong Kong’s economy recovered and expanded

Consumption Investment GDP Unemployment Price level

The business cycle

Every economy experiences up and down cycle.

Business cycle means the recurrent short run fluctuations in real GDP around the long run trend.

Real GDP as a major indicator of economic performance.

The business cycle Short-run cycle Four recurrent phrases of economic cycle:

Recession Trough Recovery, or expansion Peak

Real GDP

Time

The business cycle

1. Recession Sustained decline in economic activities from the peak Slow down or drop in

Consumption Investment Production

Real GDP Unemployment Price level Inflation rate

The business cycle

2. Trough

Economic activities sink to a trough

Real GDP: very low

Consumption, Investment and Production are at the lowest level

Unemployment: very high

Price level is at a low level

The business cycle

3. Recovery / Expansion Continual rise in economic activities from the trough Common interpretation

Early stage: Recovery Later: Boom

Increase in Consumption Investment Production

Real GDP Unemployment Price level Inflation rate

The business cycle

4. Peak

Economic activities are at the peak

Real GDP: very high

Consumption, Investment and Production are at the highest level

Unemployment: very low

Price level is at a high level

The long run trend of GDP

An overall increase in real GDP in the long run

Reasons:

Capital accumulation

Technological progress

Upward trend

Economic indicators at different phases of the business cycle To identify short run economic fluctuations

Real GDP Inflation rate Unemployment rate

Relationship: Real GDP

Inflation rate Unemployment rate

Real GDP Inflation rate Unemployment rate

Economic indicators at different phases of the business cycle

Phase

Indicator

Recession Trough Recovery Peak

Consumption & Investment

Fall from the peak At a low levelRising from a low level

At a high level

Real GDP Falling Lowest Rising Highest

Inflation rateFalling from a high level

At a low levelRising from a low level

At a high level

Unemployment rate

Rising from a low level

At a high levelFalling from a high level

At a low level

Identify a business cycle

Beware of different interpretation of y-axis Real GDP

Actual real GDP figure Must be positive

Growth rate of real GDP Percentage change,

i.e. comparison with real GDP in last term Positive real GDP still rising Downswing in positive side means

real GDP is still rising, but in a lower percentage than that in last term.

Negative real GDP still falling Upswing in negative side means

real GDP is still falling, but in a lower percentage than that in last term.


1. Which phrases do point A, B, C and D show? Point A & B : Recession (Real GDP is falling as compared with previous

term) Point C & D : Recovery (Real GDP is rising as compared with previous term)

2. Does point A illustrate economic recession? Yes. The real GDP is falling at point A.

3. Does point C illustrate economic recovery? Yes. The real GDP is rising at point C.


1. Change in real GDP Rising: Point A & D (with +ve growth rate) Falling: Point B & C (with –ve growth rate)

2. Does point A illustrate economic recession? No. The real GDP is still growing rapidly at point A. ( ∵+ve growth rate)

3. Does point C illustrate economic recovery? No. The real GDP is still falling at point C. ( ∵ -ve growth rate)

Macroeconomic policy

The measures a government adopts to achieve economic objectives.

Monetary policy Expansionary monetary policy Contractionary monetary policy

Fiscal policy (budget) Expansionary fiscal policy (Deficit budget) Contractionary fiscal policy (Surplus budget)

Objectives of macroeconomic policy

1. Maintaining full employment and reducing economic fluctuations

In recession Real GDP Unemployment Living standard

Overheated economy High inflation End up in a recession (from upswing to downturn)

Policies to stable the economy to prevent Recession Economy overheating

Objectives of macroeconomic policy2. Stabilizing the price level

High inflation Living standard People lose confidence in the domestic currency

Specialization & Exchange Cost of production Unfavourable to exchange

Deflation Consumption & Investment Unfavourable to economic development

Unexpected inflation or deflation Unfavouable to social stability

Policies to stable the price level are necessary.

Objectives of macroeconomic policy3. Narrowing wealth gap

Alleviating poverty (滅貧 ) Maintain social stability Enhance overall economic welfare Method

Collecting tax from high-income groups Providing social welfare to low-income groups

4. Stabilizing exchange rate Enable stable international trade Lower the risk of foreign investment Strengthen people’s confidence in the domestic currency Avoid import inflation

Relationship between money market and aggregate demand

Increase in money demand Real income Md (from Md

1 to Md2)

r (from r1 to r2) Consumption & Investment AD (from AD1 to AD2) In the short run,

Price level (from P1 to P2)

Aggregate output (from YF to Y2)[assume full employment achieve beforehand]

Result Md P and Y

Interest rate (%) Ms

0Quantityof money

Md2

r1

r2

Md1

Price level

Aggregate output

0AD2

SAS

Y2

P2

AD1

YF

P1


Decrease in money demand Real income Md (from Md

1 to Md3)




Result Md P and Y


0Quantityof money

Md3

r1

r3

Md1

Price level

Aggregate output

0

AD3

SAS

Y3

P3

AD1

YF

P1


Increase in money supply Require reserve ratio (RRR) Ms (from Ms

1 to Ms2)




Result Ms P and Y


1

0Quantityof money

Ms2

r1

r2

Md

Price level

Aggregate output

0

AD2

SAS

Y2

P2

AD1

YF

P1

Short run QTM


Decrease in money supply Require reserve ratio (RRR) Ms (from Ms

1 to Ms3)




Result Ms P and Y


1

0Quantityof money

Ms3

r1

r3

Md

Short run QTM

Price level

Aggregate output

0AD3

SAS

Y3

P3

AD1

YF

P1


Conclusion

Money market

Md Ms

Excess money demand Interest rate

Goods market (short run)

AD

Aggregate output Price level

Money market

Md Ms

Excess money supply Interest rate

Goods market (short run)

AD

Aggregate output Price level

Monetary policy

The government’s control of the money supply and interest rate to achieve certain economic objectives.

1. Expansionary monetary policy Ms and r AD

2. Contractionary monetary policy Ms and r AD

Monetary policy

1. Expansionary monetary policy Suppose in economic downturn, Y1 < YF

i.e. the economy cannot achieve full employment Central bank Ms and r Consumption & Investment AD (from AD1 to AD2)

Price level (from P1 to P2) Eliminate deflationary gap

Economic recovery Aggregate output (from Y1 to YF)

Examples: QEII in U.S.A.

Price level

Aggregate output

0

AD2

SAS

YF

P2

AD1

Y1

P1

LAS

Monetary policy

1. Expansionary monetary policy

Policy tools

Issuing banknotes

Open market: Purchasing or redeeming gov’t bonds

Lowering the discount rate

Lowering the required reserve ratio

Monetary policy

2. Contractionary monetary policy Suppose in overheated economy, Y1 > YF

Central bank Ms and r Consumption & Investment AD (from AD1 to AD2)

Price level (from P1 to P2) Eliminate inflationary gap Control / Curb inflation

Cool down overheated economy Aggregate output (from Y1 to YF)

Examples: Macro-economic control in China (宏觀調控 )

Price level

Aggregate output

0AD2

SAS

YF

P2

AD1

Y1

P1

LAS

Monetary policy

2. Contractionary monetary policy

Policy tools

Reducing the quantity of banknotes

Open market: Selling gov’t bonds

Raising the discount rate

Raising the required reserve ratio

HK’s monetary policy

Main objective: Stabilize the (linked) exchange rate The HKMA buys or sells HKD to stabilize the exchange rate

between HKD and USD

Because of the linked exchange rate system MS and r will change according to capital inflow / outflow The HKSAR Gov’t cannot use monetary policy to achieve economic

objective.

Should HK give up using linked exchange rate system?

If there’s inflow of capital Demand of HKD increases

HKD rises against USD

The HKMA sells HKD

Monetary base and Ms

Interest rate

Reduce capital inflow

If there’s outflow of capital Supply of HKD increases

HKD falls against USD

The HKMA buys HKD

Monetary base and Ms

Interest rate

Increase capital inflow

Fiscal policy

The government uses its expenditure and taxation to achieve certain economic objectives.

1. Expansionary fiscal policy Usually means “Deficit budget”, i.e. Revenue < Expenditure Government expenditure Tax AD and SAS

2. Contractionary fiscal policy Usually means “Surplus budget”, i.e. Revenue > Expenditure Government expenditure Tax AD and SAS

The effects of fiscal policy on AD1. Expansionary fiscal policy

The government boosts the economy by increasing expenditure or cutting tax.

AD (from AD1 to AD2)

In the short run, Price level (from P1 to P2)

Aggregate output (from Y1 to Y2)

Price level

Aggregate output

0

AD2

SAS

Y2

P2

AD1

Y1

P1

Gov’t Exp.

Transfer payments (e.g.CSSA)

Salaries tax

Disposable income

Investment Profit tax

Consumption AD

The effects of fiscal policy on AD1. Expansionary fiscal policy

Make real GDP return to potential output (YF)

Eliminate a deflationary gap

Suppose economic fluctuation causes the real GDP to deviate from YF

Economy is at point A Output level = Y1 and deflationary gap = YF - Y1

By using expansionary fiscal policy AD (from AD1 to AD2)

Economy is at equilibrium point B Price level (from P1 to P2)

Aggregate output (from Y1 to YF)

Price level

Aggregate output0 YF

P2

LAS

Y1

P1

A

B

SAS

AD1

AD2

The effects of fiscal policy on AD2. Contractionary fiscal policy

The government cools down the economy by reducing expenditure or raising tax.

AD (from AD1 to AD2)

In the short run, Price level (from P1 to P2)

Aggregate output (from Y1 to Y2)

Gov’t Exp.

Transfer payments (e.g. travel subsidy)

Salaries tax

Disposable income

Investment Profit tax

Consumption AD

Price level

Aggregate output

0AD2

SAS

Y2

P2

AD1

Y1

P1

The effects of fiscal policy on AD2. Contractionary fiscal policy

Make real GDP return to potential output (YF)

Eliminate a inflationary gap

Suppose overheated economic activities causes the real GDP to deviate from YF

Economy is at point A Output level = Y1 and inflationary gap = Y1 - YF

By using contractionary fiscal policy AD (from AD1 to AD2)

Economy is at equilibrium point B Price level (from P1 to P2)

Aggregate output (from Y1 to YF)

Price level

Aggregate output

0 YF

P2

LAS

Y1

P1

A

B

SAS

AD1

AD2

The effects of fiscal policy on ASThe supply-side effects of taxation

1. Expansionary fiscal policy Lowering income tax Workers are more willing to work Labour supply SAS SAS curve shifts rightward

(from SAS1 to SAS2)

2. Contractionary fiscal policy Raising income tax Workers will have lower working incentive Labour supply SAS SAS curve shifts leftward (from SAS1 to SAS3)

Price level

Aggregate output

0

SAS2SAS1SAS3

The effects of fiscal policy on ASThe supply-side effects of government expenditure

1. Gov’t expenditure on public health, education, infrastructure……etc.

Accumulate capital Raise productivity SAS and LAS In the short-run, SAS curve shifts rightward

(from SAS1 to SAS2)

2. Gov’t expenditure on unemployment assistance Lower the cost of unemployment Unemployed will have lower incentive to find a job Labour force SAS and LAS In the short-run, SAS curve shifts leftward

(from SAS1 to SAS3)

Combined effects on changes in AD and ASFor expansionary fiscal policy

Income tax AD and AS

Conclusion:

Lowering the income tax, Real GDP must be increased Change of price level is uncertain (depends on the magnitude of the

change in AD and AS)

1. If AD > AS Real GDP Price level

2. If AD < AS Real GDP Price level

3. If AD = AS Real GDP Price level remains unchanged

Check yourself…Fill in the table below.

Raising income tax Lowering income tax

Aggregate demand (AD) Falls Rises

Shifting of AD curve Leftward Rightward

Short run aggregate supply (SAS) Falls Rises

Shifting of SAS curve Leftward Rightward

Aggregate output (Y) Falls Rises

Price level (P) Uncertain Uncertain

Price level[ If AD > AS ] Falls Rises

Limitations of macroeconomic policy

1. Risk of mis-judgement Generally rules:

During recession: Adopt expansionary policy Overheated: Adopt contractionary policy

However, economic situation changes rapidly Enough information to make judgement? Some policies might even make the problem worst. Example

Provision of 85,000 public housing flats→ Tremendous drop in the price of flats → Hinder the economic recovery in the late 20th and early 21st century

Limitations of macroeconomic policy2. Problem of time lag Gov’t needs time to decide…

Whether the economy is in danger of recession or overheating Action to be taken Policy formulation Policy implementation

As time goes by, decisions might not be suitable. Market might resolve the problem itself, and so gov’t decision might worsen the

fluctuation Example: The re-launch of Home Ownership Scheme

→ Price of residential flat is too high now→ Gov’t plans to provide residential flat. Time is needed for planning.→ When the scheme is implemented, market price might drop.→ Increase in flat supply will worsen the market of private flat. → Worsen the economic recession.


2. Problem of time lag

Monetary policy Implemented by the monetary authority Adjust money supply and interest rate at any time Shorter time lag of policy implementation

Fiscal policy Implemented after the approval from the Legislative Council Comprehensive discussion and adjustments Longer time lag of policy implementation


3. Low reversibility of fiscal policy

Monetary policy Implemented by the monetary authority The monetary authority can reverse the policy by changing

money supply and interest rate at any time

Fiscal policy Implemented after the approval from the Legislative Council Right of policy implementation is granted after voting Difficult to reverse after the right is granted


4. Conflicting economic objectives

Unemployment vs. Inflation

E.g. High oil price leads to stagflation If using expansionary policy

Favourable outcome Increase incentive to work Labour supply Aggregate output

Unfavourable outcome Higher production Demand of sources Price of oil Even worsen inflation

If using contractionary policy

Favourable outcome Able to lower the oil price Control inflation

Unfavourable outcome Discourage production Worsen unemployment Aggregate output

Case studyGiven that Country A suffers from recession due to a fall in AD. Before recession: Point A, P1 and Y1

After recession: Point B, P2 and Y2

Choice to make:

(I) Let the economy adjusts Market adjustment: SAS (from SAS1 to SAS2)

Economy goes to point C


Aggregate output goes back to Y1

(II) Adopt expansionary monetary policy Market adjustment: AD (from AD2 to AD1)

Economy goes back to point A

Price level goes back to P1


Conclusion Policy helps stabilize both price level and

aggregate output if the recession is caused by decrease in AD.

Price level

Aggregate output0 Y1

P1

LAS

Y2

P2

C

B

SAS1

AD2

AD1

A

P3

SAS2

Price level

0 Y1

P1

LAS

Y2

P2

B

SAS1

AD2

AD1

A

Case studyGiven that Country B suffers from recession due to a fall in SAS. Before recession: Point Q, P1 and Y1

After recession: Point R, P2 and Y2

Choice to make:

(I) Let the economy adjusts Market adjustment: SAS (from SAS2 to SAS1)

Economy goes back to point Q

Price level goes back to P1


(II) Adopt expansionary monetary policy Market adjustment: AD (from AD1 to AD2)

Economy goes back to point S



Conclusion Policy helps stabilize only aggregate output. It may cause inflation if the recession is caused

by decrease in SAS.

Price level

Aggregate output0 Y1

LAS

Y2

P2

S

R

SAS2

AD1

QP1

SAS1

Price level

0 Y1

P3

LAS

Y2

P2

R

SAS2

AD1

AD2QP1

SAS1

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Economics Chapter 11 The Business Cycle and Macroeconomic Policy