95. The Business Cycle

The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP.

• A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a below-full employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve.

• An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve.

• A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP.

• The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

96.THE KEYNESIAN THEORY OF BUSINESS CYCLE

One of the most thought-provoking theories of the business cycle proposed in recent years is that of John Maynard Keynes (1883- ), one of the foremost contemporary English economists. In his book The General Theory of Employment Interest and Money (1936), he goes far beyond the bounds of the classical ideas of the business cycle, and frequently offers unorthodox ex­planations and proposals. He challenges the generally accepted view that the way to end depressions is to cut expenses, especially wages, and by so doing encourage full employment and revival. In individual plants a reduction of wages may make it possible to expand production and increase employment. A general wage cut, however, would simply reduce consumption and accentuate the depression. In Mr. Keynes' opinion, satisfactory business condi­tions depend upon maintaining full employment. His argument, therefore, attempts to show why full employment is not achieved and why declining business activity appears as a consequence. The goal of the business man is profit. He operates his business at a level which will yield in his opinion the maximum return. In making his decision on this point he considers three variable factors: (1) the "propensity" of the population to consume; (2) the prospective return of new capital investment; and (3) the rate of interest. 97.THE NEW KEYNESIAN THEORY OF BUSINES CYCLE

The label “new Keynesian” describes those economists who, in the 1980s, responded to this new classical critique with adjustments to the original Keynesian tenets.

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust. New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with “sticky” wages and prices.(WHAT`S STICKY WAGES?It is an economic theory that states that wage rates are said to be "sticky" when they do not respond quickly to changes in demand or supply. An example would be employment contracts. If an economy is in recession or expansion, and the prices are either rising or falling, the wages of contract-bound employees do not change with economic changes.)New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and whymonetary policy has such a strong influence on economic activity