Understand the four phases of the business cycle and explain the primary characteristics of recessions and expansions using leading, coincident and lagging indicators Use potential output and the output gap to analyze an economy's position in the business cycle. Understand the aggregate demand and aggregate supply curves, and factors causing their shift

1. AD, AS and the business cycle
Chapter 24
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2. Learning Objectives
1. Understand the four phases of the business cycle and
explain the primary characteristics of recessions and
expansions using leading, coincident and lagging
indicators
2. Use potential output and the output gap to analyze an
economy's position in the business cycle.
3. Understand the aggregate demand and aggregate
supply curves, and factors causing their shift
2
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3. Media Headlines
US
• “Home Sales and Prices Continue
to Plummet”
• “As Jobs Vanish, Motel Rooms
Become Home”
• “Global Stock Markets Plummet”
• “Energy Prices Surge, and Stocks
Fall Again”
• “Steep Slide in Economy as Unsold
Goods Pile Up”
• “Fed Plans to Inject Another $1
Trillion to Aid Economy”
• “World Bank Says Global Economy
Will Shrink in ‘09”
• US economy has passed through
its worst recession in 25 years
UAE: Activity (board)
• Go online on the website
of any UAE-related local
newspaper, and write
some economic
headlines similar to the
headlines related to the
US and UK
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3

4. Business cycle
(economic cycle or boom-bust cycle)
4
• Business Cycles are short-term fluctuations in real GDP
• Four main stages which affect the whole economy and decisions
• The solid line shows the growth rate that the economy shall follow, but the
economy actually recorded performance presented by the dotted line

5. How draw the business cycle:
Real GDP Growth, 1999 – 2014
5
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6. The four stages of the business cycle
• A recession (or contraction) is a period during which real GDP
falls for two or more consecutive quarters
– A variety of economic data are examined
– A depression is a particularly severe recession
– During recession, households and businesses are pessimistic
• An expansion is a period in which the economy is growing at a rate
significantly above normal
– A boom is a strong and long lasting expansion
– During expansion, households and businesses are optimistic
• A peak is the end of a expansion is the beginning of a recession
– High point of the business cycle
– It is the end of optimism and the beginning of pessimism
• A trough is the end of a recession and beginning of expansion
– Low point of the business cycle
– It is the end of pessimism and the beginning of optimism
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7. Activity
• The term business cycle refers to __________.
A. Fluctuations in aggregate economic activity over time
B. Ups and downs in the production of goods
C. Increasing unemployment
D. Declining savings
• The turning points of the business cycle are _________
A. The expansion and peak
B. Peak and contraction
C. Contraction and trough
D. Peak and trough
• _____ refers to the top or the highest point of the business cycle
A. Expansion
B. Peak
C. Expansion and peak
D. None f the above
• The trough of a business cycle occur when ______ hits its lowest point
A. The money supply
B. He employment level
C. Inflation in the economy
D. Aggregate economy activity
• There is an end of pessimism and the beginning of optimism at ______
A. Expansion
B. Peak
C. Trough
D. depression
21-7
• ______ is the severe form of recession with the lowest level of
economic activity
A. Upswing
B. Depression
C. Downsizing
D. Peak
• Which of the following is not the characteristics of business
cycle?
A. They are recurrent
B. They are not a regular intervals
C. They have uniform causes
D. All of the above
• The great depression of ______ caused enormous misery and
human sufferings
A. 1929-33
B. 1919-23
C. 1940-53
D. 1950-63
• Industries that are most badly affected by business cycles are the
__________.
A. Durables goods and services sector
B. Non-durable goods and services
C. Capital goods and non-durable goods sectors
D. Capital goods and durable goods sectors
• During a recession, which of the following is likely to occur?
A. an increase in real wages
B. an increase in production
C. and increase in the GDP growth rate
D. an increase in the unemployment rate

8. Types of economic indicators:
leading, coincident and lagging
8
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Types of indicators in the
economy
Leading indicators are
forward-looking in that they
provide a signal before a
change in the real GDP
Coincident indicators
move with Real GDP
Lagging indicators
move after the
change in real GDP
has happened
1. Bank Credit growth
2. Durable goods consumption
1. Real GDP
2. Unemployment rate
1. Manufacturing production
2. Inflation

9. Three main symptoms of
Business Cycles: recession
• Cyclical unemployment rises sharply during
recessions
– Real wages grow more slowly for those employed
– Promotions and bonuses are often deferred
– New labour market entrants have difficulty finding work
• Less bank credit
• Production of durable goods is more volatile than
services and non-durable goods:
(Decrease of demand on capital goods, and decrease in the production of capital goods)
– Cars, houses, capital equipment less stable
• Inflation generally decreases during recession
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10. Fluctuations in US Real GDP,
1929-2016
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11. Recessions and expansions are irregular in
their length and severity (recession since
1929)
Peak
(m/y)
Trough
(m/y)
Months Unemployment Rate (high)
Change in
real GDP
Next Expansion
8/29 3/33 43 24.9% –26.3% 50 months
5/37 5/38 13 19.0 –3.3 80
2/45 10/45 8 3.9 –11.6 37
11/48 10/49 11 5.9 –0.5 45
7/53 5/54 10 5.5 –0.6 39
8/57 4/58 8 6.8 –0.7 24
4/60 2/61 10 6.7 2.6 106
12/69 11/70 11 5.9 0.2 36
11/73 3/75 16 8.5 –0.7 58
1/80 7/80 6 7.6 –0.2 12
7/81 11/82 16 9.7 –1.9 92
7/90 3/91 8 7.5 –0.1 120
3/01 11/01 8 6.0 1.0 73
12/07 6/09 18 9.6 -3.1
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12. Activity
• Expansion phase refers to all but
one of the following
characteristics:
A. Increase in national output
B. Increasing in consumer
spending
C. Excess production capacity of
industries
D. Expansion of bank credit
• There is a large scale of
involuntary unemployment in the
________ phase of the business
cycle
A. Expansion
B. Peak
C. Contraction
D. None of the above
• (involuntary) Unemployment is at t
lowest level in the ________
phase of the business cycle
A. Expansion
B. Contraction
C. ‘trough
D. Depression
• Fall in the levels of investment, fall
in production, fell in employment,
fall in stock prices, …., are all
found during ______ phase of
business cycle
A. Expansion
B. Boom
C. Peak
D. contraction
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12

13. Output Gaps
• Potential output (Y*) is the maximum sustainable amount of
output that an economy can produce
– Full-employment output (all capital and labour resources are
employed)
• Actual output grows at a variable rate (of technical innovation,
capital formation, weather conditions, etc.
– Actual output does not always equal potential output
• The output gap is the difference between actual output and its
potential output,
– Recessionary gap is a negative output gap; Y* > Y
• It means output and employment are less than their sustainable
level
– Expansionary gap is a positive output gap; Y* < Y
• Expansionary gaps lead to inflation 13

14. Activity
• When actual output equals potential output there is ____ output gap and the rate of inflation will
tend to __________.
A. an expansionary; increase
B. an expansionary; decrease
C. no; remain the same
D. a recessionary; increase
• When actual output is less than potential output, there is ____ output gap and the rate of inflation
will tend to ___________.
A. an expansionary; increase
B. an expansionary; decrease
C. a recessionary; decrease
D. a recessionary; increase
• When actual output exceeds potential output there is ____ output gap and the rate of inflation
will tend to
• ____.
A. an expansionary; increase
B. an expansionary; decrease
C. no; remain the same
D. a recessionary; increase
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14

15. The Aggregate Demand Curve
• The aggregate demand curve (AD) shows the
amount of output that “consumers, firms,
government, and foreign or overseas sector” want to
buy at each price level
– Slopes downwards
– A higher inflation rate (Price)
reduces expenditure which
reduces output (Y).
Y = AD = C + I + G + NX
24-15
Output (Y)
AD
Inflation
rate
𝜋
(Prices
)

16. Shifts in the Aggregate Demand
Curve
• A shift of the aggregate demand curve is
called a change in aggregate demand
– Shift to the right or shift to the left.
• At the given price level (or inflation rate),
something causes output
to rise or fall
• Two main causes:
– Demand shocks
– Stabilization policies
24-16
Output (Y)
AD AD'
Inflation
rate
𝜋
(Prices
)
AD’'

17. Demand shocks
• Demand shocks are changes in spending
not caused by a change in output or a
change in Prices (or inflation rate).
• Consumer spending: TWO factors:
– Consumer confidence (expectations about the future of
the economy: pessimism and optimism)
– Consumer wealth
• Investment spending by firms: a factor:
– Business confidence (expectations about the future of the
economy: pessimism and optimism)
24-17

18. Activity
• Firms suddenly becoming pessimistic
about future business prospects as a
demand shock will _________.
A. Increase the aggregate demand
B. Decrease the aggregate demand
C. Increase the aggregate supply
D. Decrease the aggregate supply
• If concerns about future weakness in the
economy cause businesses to reduce
their spending on new capital, then the
______ shifts _____.
A. aggregate demand curve; right
B. aggregate demand curve; left
C. aggregate supply curve; left
D. aggregate supply curve; right
• For a given inflation rate, if bright
prospects for the future of the economy
cause businesses to increase spending
on new capital, then the ______ shifts
_____.
A. aggregate demand curve; right
B. aggregate demand curve; left
C. aggregate supply curve; left
D. aggregate supply curve; right
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21-18

19. Stabilisation policies
• Stabilization policies are government
policies used to affect aggregate
expenditure or spending
• Fiscal policy
– Change in government spending (G) or taxes (T)
• Monetary policy
– Change in the nominal money supply.
24-19

20. Activity
• The AD curve can be
shifted by:
A. both fiscal and
monetary policy.
B. neither fiscal nor
monetary policy.
C. fiscal policy only.
D. monetary policy only.
• What is monetary
policy?
A. Who designs and
implements the
monetary policy in
the UAE?
B. What is fiscal policy?
C. Who designs and
implements the fiscal
policy in the UAE?
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20

21. • 12. The expansion or
contraction of the
money supply in
order to influence the
cost and the
availability of credit
is _________.
A. Monetary Policy
B. Fiscal Policy
C. Contractionary Policy
D. Expansionary Policy
• __________ refers to
government revenue
and spending
A. Fractional Reserve
Banking
B. Legal Reserves
C. Fiscal
D. Reserve system
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21-21

22. The Aggregate Supply Curve
• The Short Run aggregate supply curve (AS)
shows the relationship between the amount
of output firms want to produce and the
Prices
• Upward sloping
–  Sticky-Wage theory
(Sticky mean hard to change)
–  wage-price spiral: A low (high)
rate of expected inflation tends to
lead to small (large) increases in wages a low (high) rate of
actual inflation. 24-22
Inflation () /
Prices
Output (Y)
Aggregate
Supply (AS)
P2
Y1
B
Y2
P3 C
Y*
P1
A

23. Activity
• The aggregate supply
curve shows the
relationship between the
amount of output firms
want to produce and the
______.
A. nominal interest rate
B. real interest rate
C. unemployment rate
D. inflation rate
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23

24. Shifts in the AS Curve
• A change in aggregate supply is a shift of the
aggregate supply curve
– An increase (decrease) in aggregate supply is a rightward
(leftward) shift of the curve
• THREE main causes:
– changes in available
resources
- Change in technology
– changes in inflation
expectations
24-24
Price
Level
Output Y
AS1
Y*
𝑃1
AS3
AS2

25. Increasing available resources
and technology
• Increasing available resources and technology will
shift the AS curve to the right
• Supply more output without having to increase price
– More resources
Hire more labour, capital
– Technology:
Use existing labour and
machines more efficiently
24-25
Price
Level
Output Y
AS2
Y2
AS1
Y1
𝑃1

26. Inflation Expectations
• If actual inflation exceeds expectations,
expected inflation increases
– AS curve shifts to
the left
– At each level of output,
inflation is higher
24-26
Price
level
(P)
Output (Y)
AS1
Y*
P1
P2
AS2

27. Will aggregate supply increase f
decrease?
A. A significant increase in nominal wages (_________)
B. An increase in physical capital (_________)
C. Ad decrease in cooperate taxes and produces
(_________)
D. An increases I expected inflation (_________)
E. A significant decrease in nominal wages
(_________)
F. An decrease in physical capital (_________)
G. Ad increase in cooperate taxes and produces
(_________)
H. An decreases I expected inflation (_________)
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28. Activity
• Low expected inflation leads to ____ increases in wages and costs and to ____ actual inflation.
A. large; high
B. large; low
C. small; low
D. small; high
• High expected inflation leads to ____ increases in wages and costs and to ____ actual inflation.
A. large; high
B. large; low
C. small; low
D. small; high
• A low rate of expected inflation tends to lead to a ___ rate of actual inflation and a high rate of
expected inflation tends to lead to a ____ rate of actual inflation.
A. high; high
B. high; low
C. low; low
D. low; high
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29. Short-Run Equilibrium
• Short-run equilibrium
occurs when the AD
and AS curves intersect
at a level of output
different from Y*
– Point A in the graph
24-29
Inflation
rate
𝜋
(Prices
)
Output Y
AD
AS
Y1
P1
A

30. • The economy is in short-run
equilibrium:
A. when the AD and AS
curves intersect at
potential output Y*.
B. when the AD and AS
curves intersect at a
level of real GDP that is
above or below Y*.
C. when the AD and AS
curves become vertical.
D. at the peak of the
business cycle.
• When the economy is in
short-run equilibrium,
there will be ______
output gap.
A. no
B. only a recessionary
C. either a recessionary or
an expansionary
D. only an expansionary
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