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Lesson 9 : The Business Cycle & Output Gaps

Module 1: Macro Fundamental Analysis

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Video Transcript

so in this video we’re going to compare the classical AS/AD model to the business cycle and when we put these two things side by side the business cycle actually becomes very clear so if we look at the business cycle on the right hand side you can see we have real gdp here on the y-axis and on the x-axis we have time so real gdp tends to increase over time and you can see that changes in the business cycle economic expansions and economic contractions are an oscillation of short-run aggregate supply so actual gdp actual output oscillating across long-run aggregate supply so potential gdp so gdp at sustainable levels but in reality it’s generally speaking unstable it will become extended and then it will become contractionary then it will become extended again and then it will become contractionary again and in periods of economic expansion we will see a decrease in the unemployment rate and in periods of economic contraction we’ll see an increase in the unemployment rate and if we look at long-run aggregate supplies for potential gdp so full employment output and we look at this in relation to what we saw in previous videos on the federal reserve website where they consider full employment at 4.1 percent this would be reflective of 4.1 unemployment in the economy in say the u.s economy in this case and since central banks are committed to the dual mandate of fostering maximum employment and price stability in the event that the economy starts to expand beyond its full potential output level the federal reserve for example in the us would step in and seek to use calling down measures deflationary measures such as raising interest rates to push the economy back towards its natural rate of unemployment so it’s full employment level and conversely if there was an economic contraction and the economy started to perform below its full employment level of output so actual output was less than potential output then the central bank the federal reserve would step in with monetary policy measures such as easing interest rates to push the economy back towards full employment levels of output so let’s go through some examples here then we have the aggregate demand curve shifting to the right output in the short run is greater than long term sustainable levels of output this creates a positive output gap and this causes an economic expansion central banks and governments will seek to step in via monetary and fiscal policy measures to control inflation and cool down the economy although in times of economic expansion this is mainly left to central banks because it’s not politically convenient to start cooling down the economy but fiscal policy measures can be implemented in order to control inflation and return the economy back to sustainable levels of output so what about if the aggregate demand curve shifts to the left output in the short run is less than longer term sustainable levels of output this causes a negative output gap and this results in an economic contraction or a recession this is where monetary authority central banks and in this case governments are very keen to intervene and they will seek to bring in loose monetary policy measures this could include something like the cutting of interest rates or the reducing of taxes what about if we have a shift to the right in the short run aggregate supply curve well in this scenario short run aggregate supply output in the short term is greater than sustainable levels of output in the long run this creates a positive output gap and this would lead to an economic expansion now in this scenario remember that this economic expansion has been caused by a shift in short-run aggregate supply so we do have economic growth but we have very low levels of inflation so in this circumstance there may actually be no real need for a monetary policy response because there is no real urgency to control inflation in this environment and in all likelihood the economy is likely to self-correct through the mechanisms described in previous videos rather than central banks stepping in aggressively and trying to control increases in inflation so whereas with a shift to the right in aggregate demand if you can predict using leading economic indicators that you are at the peak of the business cycle and you’re going to start to see central banks stepping in with tightening monetary policy measures and as a result you’re going to see appreciations in the values of those currencies you can step in and you can take long positions let’s say for argument’s sake in currencies in anticipation of central banks stepping in and increasing interest rates at the top of the business cycle however if you have a positive output gap through shifts in short-run aggregate supply so because the costs of production have decreased then you cannot expect the monetary authorities to step in with the same levels of aggression and they may as i said not even step in at all so it is important to differentiate between what factors are causing positive and negative output gaps in the economy and finally what about if we have a shift to the left in the short run aggregate supply curve here short run aggregate supply so output in the short term is below longer term levels of sustainable output in the economy this creates a negative output gap and at the same time as rising inflation economic growth stagnates or it may even contract well in this situation the economy may enter a period of stagflation and this is a dilemma for policymakers because conventional monetary and fiscal policy tools are counterproductive when dealing with a stagflation scenario because when we have stagflation if there is stagflation in an economy we have very low levels of growth or even growth decreasing and at the same time we have rising inflation so stagnant growth rising inflation stagflation so the dilemma for policymakers becomes if you want to stimulate growth by let’s say cutting interest rates by enacting loose monetary policy conditions you’re going to perpetuate the increase in inflation and this is not something that policymakers want to do in fact they want to control inflation usually within a range of about two percent and conversely if they were to enact tight monetary policy measures to control inflation so to keep inflation down they would harm economic growth even more and they could even see larger contractions in gdp via tighter monetary policy conditions so you can see the dilemma faced by policymakers in that situation now in theory with a shift to the left in short-run aggregate supply the economy should self-heal back to long-term full employment output levels now in reality it may not be that easy and policy makers may be faced with a choice of either trying to stimulate growth or trying to control inflation without aggravating the other too much in terms of the monetary policy decisions and fiscal policy decisions they make or alternatively identifying what caused the shift to the left in short-run aggregate supply and if possible trying to address that issue so if short-run aggregate supply has shifted to the left let’s say because of a major rally in oil prices increasing the cost of production for businesses driving up inflation and causing growth to stagnate if the cause of that were say because of an agreement by opec countries is there a way for an economy such as the u.s for example who may be feeling the effects of that to get those countries to agree to actually increase their oil output in doing so of course increasing the supply of oil and driving the price of oil back down if the causes of the shift to the left in short run aggregate supply can be quickly identified and remedied this can actually keep economic damage at bay and keep inflation at lower levels and stop it from starting to spiral out of control