The business cycle

Chapter 31 The business cycle David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 31.1 Actual output Actual output fluctuates around this trend. The business cycle: short-term fluctuations of total output around its trend path Time Trend output Trend output grows steadily as productive potential increases. A A – slump E E – slump again B B – recovery phase has begun C C – Boom D D – recession under way 31.2 UK: growth of real GDP -4 -2 0 2 4 6 8 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 % ch an ge p .a. Source: Economic Trends Annual Supplement 31.3 The political business cycle  Some commentators have suggested that there is a political business cycle  whereby governments adopt tight monetary and fiscal policy soon after an election  but then adopt more expansionary policies as the election approaches to encourage a ‘feel-good’ factor 31.4 Theories of the business cycle  The multiplier-accelerator theory: – the multiplier communicates the effects of changing investment to aggregate demand – the accelerator assumes that firms gauge future demand by reference to past output growth  this model can produce fluctuations in output level in response to a shock 31.5 Fluctuations in stock-building  Stockbuilding may also be a cause of fluctuations in output  Firms tend to use stocks to smooth production in the face of fluctuating demand  Output per worker tends to rise in times of boom, and fall in times of recession. 31.6 Real business cycles  In this view of the world, fluctuations in actual output are fluctuations in potential output  … so there is no point in trying to stabilize output over the business cycle.  Although some swings in potential output do occur, many short-run fluctuations are more likely to reflect Keynesian departures from potential output. 31.7 Is there an international business cycle? Growth in GDP, selected countries -4 -2 0 2 4 6 8 10 12 14 16 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97 % p. a. USA UK France Italy Source: International Financial Statistics 31.8 Chapter 32 Macroeconomics: where do we stand? David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 32.10 Macroeconomics in perspective  There is a spectrum of views about the macroeconomy – especially with regard to – market clearing – expectations formation – speed of adjustment 32.11 Market clearing  The question of whether all markets clear is critical in macroeconomics  In a Classical view of the world, all markets clear – so the economy is at full employment and at potential output.  In a Keynesian world, markets do not clear (especially the labour market) – and there is more scope for the government to influence the macroeconomy. 32.12 Expectations formation  Beliefs about the future shape today’s decisions – but how do people form expectations about the future?  Exogenous expectations – not explained within the model  Extrapolative expectations – assumes that the future will be similar to the recent past  Rational expectations – assumes that on average people guess the future correctly 32.13 Points along the macro spectrum  New Classical macroeconomics – instantaneous market clearing – rational expectations  Gradualist monetarists – full employment will be restored within a few years – the main effect of higher money is higher prices  Moderate Keynesians – economy will eventually get back to full employment – but wage and price adjustment is fairly sluggish  Extreme Keynesians – markets fail to clear in the short run – and fail to clear even in the long run 32.14 A stylized view of the competing views Market clearing Expectations Long run/ short run Full employment Hysteresis Policy conclusion New Classical Gradualist monetarist Moderate Keynesian Extreme Keynesian Very fast Rational – adjust quickly Not much difference Always close No problem Demand management useless; need supply-side Quite fast Adjust more slowly Long run more important Never too far away No problem Supply-side more important; avoid wild swings in demand Quite slow Could be fast or slow to adjust Don’t neglect short run Could be far away Might be big problem Demand management important too Very slow Adjust slowly Short run v. important Could stay away Not a big problem Demand management is what counts 31.15 Chapter 33 International trade and commercial policy David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 33.17 Exports as % of GDP 0 20 40 60 80 % Be lgi um N'l an ds UK Fra nc e Ita ly US A Ja pa n 1967 1998 33.18 Destination of world exports, 1996 EU 38% Asia 28% Middle East 3% Latin America 5% North America 17% Africa 2% Other 7% Source: Direction of Trade Statistics 33.19 The composition of world exports 0% 20% 40% 60% 80% 100% 1955 1995 Food, ag Fuels Other primary Manufactures 33.20 Some important issues  Raw materials prices – Less-developed countries (LDCs) have claimed exploitation by industrial countries  e.g. by buying raw materials cheaply & selling manufactures dear  Manufactured exports from LDCs – some LDCs have had success in exporting manufactures – leading to complaints that jobs are under threat in the industrial countries  Trade disputes between industrial countries – In some countries , established producers of certain goods are being undercut by efficient modern producers – especially from Japan & East Asia – should such exports be restricted? 33.21 Comparative advantage  Trade offers benefits when there are international differences in the opportunity cost of goods.  Opportunity cost of a good – the quantity of other goods sacrificed to make one more unit of that good  The law of comparative advantage – states that countries should specialize in producing and exporting the goods that they produce at a lower relative cost than other countries. 33.22 The source of comparative advantage  An important difference between countries is in factor endowments  which will be reflected in different relative factor prices – e.g. if the UK has relatively abundant capital but relatively scarce labour as compared with India, – then the UK would tend to specialize in capital-intensive goods, – and India would tend to specialize in labour-intensive products  Comparative advantage may also reflect a relative advantage in technology 33.23 Gainers and losers  Countries may gain from specialization and trade – but not all countries may gain equally  Commercial policy – is government policy that influences international trade through taxes or subsidies  e.g. tariffs – or through direct restrictions on imports and exports. 33.24 The effect of a tariff DD SS Quantity DD and SS show the domestic demand and supply for a good. Pw If the world price is Pw, and there is free trade, Qs domestic firms supply Qs Qd domestic demand is Qd A tariff can stimulate domestic supply and restrict imports Pw+ T At a domestic price Pw + T, where T is the size of the tariff Qs' Qd' Domestic demand falls to Qd', domestic supply rises to Qs' and the difference is imported. and imports fall. 33.25 The government raises revenue – i.e. there is a transfer to the government There is a social cost from production inefficiency, given that the good could be imported at Pw. There is also a loss of consumer surplus. and there is a transfer in the form of extra profits to producers The welfare costs of a tariff DD SS Quantity Pw Qs Qd Pw+ T Qs' Qd' The tariff leads both to transfers and net social losses. 33.26 Tariffs  The deadweight burden of a tariff suggests that society suffers from this method of restricting trade.  This is the case for free trade.  Tariffs have fallen substantially under the GATT – General Agreement on Tariffs and Trade 33.27 The case for tariffs – good arguments  Optimal tariff – a first-best argument – only valid where the importing country is large enough to affect the world price  This policy fulfils the principle of targeting – which says that the most efficient way to attain a given objective is to use a policy that influences that activity directly. – Policies that attain the objective, but also influence other activities are second-best, because they distort those other activities. 33.28 The case for tariffs – second-best arguments  Way of life – an attempt to preserve ‘traditional’ ways – a production subsidy would be better  Suppressing luxuries – an attempt to curb consumption patterns of the rich in a poor society – better achieved by a consumption tax  Infant industries – an attempt to nurture new activities via learning by doing – a temporary production subsidy probably better  Revenue – tariffs raise government revenue – but there are better ways  Cheap foreign labour – a non-argument – denies benefits of comparative advantage 33.29 Other commercial policies  Although tariff rates have fallen under GATT, there has been a proliferation of other trade restrictions – quotas – non-tariff barriers  administrative regulations that discriminate against foreign goods – export subsidies 33.30 Social costs arise from production inefficiency and consumer surplus. An export subsidy DD S Quantity P ri c e Pw World price Under free trade, with the world price at Pw, Qd consumers demand Qd Qs production is Qs exports are GE. G E Subsidy With a subsidy, producers supply Qd' to the domestic market and produce Qs'. Pw+ s Qd' Q`s' Exports are now AB. A B