Business Cycle Theory

Business Cycle Theory

Length: 1313 words (3.8 double-spaced pages)

Rating: Excellent

Open Document

Essay Preview

More ↓
The Sticky-Wage Model

In this model, economists pursue the sluggish adjustment of nominal wages path to explain why it is that the short-run aggregate supply curve is upward sloping. For sticky nominal wages, an increase in the price level lowers the real wage therefore making labor cheaper for firms. Cheaper labor means that firms will hire more labor, and the increased labor will in turn produce more output. The time period where the nominal wage cannot adjust to the changes in price level and output signifies the positive sloping aggregate supply curve.
•     The nominal wage is set by the workers and the firms based on the target real wage, which may or may not be the labor supply & demand equilibrium, and on price level expectation.

W =      ù       *           Pe
Nominal Wage = Target Real Wage * Expected Price Level

After the nominal wage has been set but before any hiring, firms learn the actual price level (P). From this the real wage is derived

W/P = ù * Pe/P
Real Wage = Target Real Wage * Expected Price Level/Actual Price Level

From the equation,
real wage = target real wage when expected price level = actual price level
real wage > target real wage when expected price level < actual price level
real wage < target real wage when expected price level > actual price level

The bargaining between workers and firms determine the nominal wage rate but not the actual level of employment. This is determined by the firms’ hiring decisions and the labor demand function

L = Ld(W/P)

Output is determined by the production function, Y = F(L). The aggregate supply curve, under the sticky-wage model, summarizes the two functions and the relationship between the price level and output. Any unexpected changes in the price level cause a deviation in the real wage, which in turn, affects the amount of labor and output.
•     The major weakness of the sticky-wage model however, is that in any model with an unchanging labor demand curve, unemployment falls when the real wage falls. Under this model the opposite happens, which means that the real wage should be countercyclical. Economic data over the past decades in the U.S. shows that the real wage in fact tends to rise along with output. This is evidence contrary to Keynes predictions in the General Theory.


The Imperfect-Information Model

Characteristics:
•     Assumes that the market is clear – all wages and prices are free to adjust in order to balance supply and demand – and that differences in the short-run and long-run aggregate supply curves are from misperceptions about prices

How to Cite this Page

MLA Citation:
"Business Cycle Theory." 123HelpMe.com. 12 Dec 2018
    <https://www.123helpme.com/view.asp?id=56755>.

Need Writing Help?

Get feedback on grammar, clarity, concision and logic instantly.

Check your paper »

Austrian Business Cycle Theory in The Great Depression by Mary Ruthbard Essays

- Business cycles are the short-run fluctuations in aggregate economic activity around its Long-run growth path. Austrian business cycle theory is the economic theory started by the Austrian School of economics, concerning how business cycles occur. The theory views business cycles as the reason for excessive growth in bank credit, due to an artificially low market rate of interest. Austrian business cycle theory originated from the work of the Austrian School economists, Ludwig Von Misses and Friedrich Hayek....   [tags: economic theory, bank, credit]

Research Papers
843 words (2.4 pages)

Business Cycle Theory Essay

- The Sticky-Wage Model In this model, economists pursue the sluggish adjustment of nominal wages path to explain why it is that the short-run aggregate supply curve is upward sloping. For sticky nominal wages, an increase in the price level lowers the real wage therefore making labor cheaper for firms. Cheaper labor means that firms will hire more labor, and the increased labor will in turn produce more output. The time period where the nominal wage cannot adjust to the changes in price level and output signifies the positive sloping aggregate supply curve....   [tags: essays research papers]

Free Essays
1313 words (3.8 pages)

Business Cycle Essay

- In everyday society, companies are affected by the economy. The company either suffers or benefits depending on what kind of economy it is. This will depend on what kind of company it is, and what kind of market the business does well in. The Business Cycle is what determines this factor. It is a term used in economics to designate changes in the economy. Timing of the business cycle is not predictable, but its phases seem to be. Many economists site four phases—prosperity, liquidation, depression, and recovery....   [tags: essays research papers]

Research Papers
811 words (2.3 pages)

The Depression, Recession, and Business Cycle Essay

- The phrase “History repeats itself” is a commonly used paradigm when it comes to events that happen in a repetitive notion. The recession that has recently been witnessed by the millions is a great example of history repeating itself. How did it happen, did we know it was going to happen, and was there anything that could have been done to prevent it. There are a multitude of questions that could be asked, with the most important of them all, will it happen again. In just the past two hundred years, the United States has seen “Black Friday” in 1869, “The Great Depression” in 1929, and the most current recession of 2009....   [tags: Economics ]

Research Papers
2042 words (5.8 pages)

Essay IT and the Business Cycle

- IT and the Business Cycle There is a regular business cycle, which lasts for about 9 years. The cycle is characterised by a period of growth, then strong growth and then recession. Unfortunately, the cycle isn't exact and it isn't dependable, or else you could make money out of it, by gambling on it. Sometimes it lasts 7 years, sometimes 10 or 11. In the later stages of the last business cycle some odd things were happening. Growth in the US economy was much higher than anyone expected and unemployment much lower....   [tags: essays research papers]

Free Essays
594 words (1.7 pages)

Organisational Theory (Application of the Organisational Life Cycle Theory)

-   Glanbia is an international nutritional solutions and cheese group. The Company is a global player in the foods ingredients, nutritional and consumer foods industry. It operates in 17 countries and its products are sold in more than 130 countries worldwide. It operates serving business customers and consumers globally. The US and Europe represents companies largest markets. The Company employs 4,900 people across 17 countries. Approximately 48.3% of Glanbia is owned by Glanbia Co-operative Society Limited....   [tags: Isomorphism, Diagnostic Tool]

Research Papers
1668 words (4.8 pages)

Hayeks Contribution to the Business Cycle Essay examples

- Hayeks Contribution to the Business Cycle Friedirch August von Hayek was born in Vienna on May 8, 1899 and died on March 23, 1992, in the city of Freiburg in Breisgan in Germany. Hayek was a central figure in 20th-century economics and he represented the Austrian tradition. After Hayek served military service, he became a student at the University of Vienna where he got his doctorate in law and political science. In 1923-4, Hayek visited New York and then returned to Vienna where he continued his work....   [tags: essays papers]

Research Papers
1864 words (5.3 pages)

Mexico Business Cycle Essay

- Mexico’s Business Cycle The term business cycle or economic cycle refers to the fluctuations of economic activity around its long-term growth trend. It involves shifts over time between periods of relatively rapid growth of output-recovery and prosperity, and periods of relative stagnation or decline- contraction or recession. These fluctuations are often measured using real gdp. Despite being termed cycles, these fluctuations in economic growth and decline do not follow a purely mechanical or predictable periodic pattern....   [tags: Mexico Economics]

Free Essays
1239 words (3.5 pages)

Business Cycles Essay

- Business cycles affect all individuals within the population. Whether as part of the general public, consisting of customers and consumers, or as part of the world of business, from small local companies to large multi-national organisations. Obviously, all governments aim for economic growth within societies, in order to achieve national progression. This can include various factors such as high levels of employment, investment and general business confidence. However, things do not always turn out as planned....   [tags: Economics Business]

Research Papers
1811 words (5.2 pages)

International Product Life Cycle Essay

- INTRODUCTION In this essay will explain and evaluate the stages of the international product life cycle and identify locus of operations and target market at each stage. We also will identify the different dimensions of the international product mix with company illustrations and examine the new product development process and the activities involved at each stage in international markets. Finally we will also will examine the degrees of product newness and address international diffusion processes and providing some examples regarding international product life cycle....   [tags: Dimensions, Development Process]

Research Papers
696 words (2 pages)

Related Searches

•     Built by Robert Lucas in the early 1970s.
•     Assumes that each supplier in the economy produces a single good and consumes many goods. Because of imperfect information, changes in overall price level may be confused with changes in relative prices. This confusion has a bearing on decisions about supply quantity and is responsible for the upward sloping aggregate supply curve. If a producer finds that prices are higher than expected, they might conclude that prices of all the goods have increased. In this case they might revise their estimate of general price level but they might not change their production/output. Alternatively, they might think that price of their product has increased so they might increase their production.
•     According to the model, the slope of the aggregate supply curve should depend on the volatility of aggregate demand. This was tested by Robert Lucas and he found that for countries where aggregate demand and prices were most stable, changes in aggregate demand had the biggest effect. As with the sticky-wage model, deviations in output from the natural rate occur when the price level also deviates from the expected level. Specifically, output rises when actual prices are greater than expected prices.


The Sticky Price Model

Characteristics:
•     Emphasizes that firms do not instantly adjust their prices when there are variances in demand. For example, some firms enter contracts with customers, some firms may not want to upset loyal customers with frequent price changes, and the way how some markets are structured make prices sticky.
•     Assumes that there is not perfect competition.
•     A firm’s desired price depends on the overall level of prices and the level of aggregate income. It is denoted as
_
p = P + a(Y – Y) _

Where ‘p’ is desired price, ‘P’ is overall level of prices, (Y – Y) is the level of aggregate output in respect to the natural rate, and ‘a’ is an number greater than zero which measures the sensitivity of the desired price to changes in the level of aggregate output.
•     There are two types of firms: (1) firms with flexible prices, and (2) firms with sticky prices. Those with flexible prices always set their prices according to the above desired equation while those with sticky prices set their prices in advance based on expectations such as economic conditions and what other firms will charge. These sticky-price firms use the formula:

p = Pe + a(Ye – Ye), where ‘e’ represents expected values.

•     With the help of the overall price level, the pricing rules of the flexible and sticky-price firms can be used to derive the aggregate supply equation Y = Y + á(P – Pe), which is the common end result for all three supply models. The overall price level depends on the expected price level and level of output.
•     One significant difference between the sticky-price model and the sticky-wage model is that a sticky-price firm responds to a drop in sales by reducing production and demand for labor – the firm does not move along a fixed labor demand curve.
•     The model also makes predictions about inflation and the short-run supply curve – a higher average inflation rate results in a steeper curve. This prediction is supported by international data; countries with high average inflation have steep short-run aggregate supply curves and low-inflation countries have relatively flat aggregate supply curves.


Mutual Characteristic Of All Three Models
•     The basic short-run aggregate supply equation that all three theories share is
_
Y = Y + á(P – Pe),     á > 0
_
Where Y is output, Y is the natural rate of output, P is the price level, Pe is the expected price level, and á is some number greater than zero which indicates how sensitive output is with regards to changes in the price level. Seeing that 1/ á is the gradient of the aggregate supply curve, if á = 0, then the supply curve is vertical. But as á moves away from zero and becomes very large, the curve grows almost horizontal. This basic common equation says that output will deviate from the natural rate when the price level also deviates from the expected level.
•     Countries with variable aggregate demand have steep aggregate supply curves – if the price level is highly variable then few firms will commit to prices in advance.
•     In all three theories, output rises above the natural rate when the price level exceeds the expected price level, and output falls below the natural rate when the price level is less than the expected price level.


Conclusions & Considerations

Unemployment and inflation are two very important measures of economic performance. Lowering, maintaining, and controlling these rates are targets of economic policymakers. There is short-run tradeoff between inflation and unemployment however, as a lower rate in one measurement means a higher rate in the other. This tradeoff between the two is called the Phillips curve – a reflection of the short-run aggregate supply curve – and is often used to express aggregate supply by economists. The modern form of the curve states that the inflation rate depends on expected inflation, the deviation of unemployment from the natural rate or cyclical unemployment, and supply shocks.

As all three models have weaknesses in their arguments and assumptions, it’s not hard to see why economists disagree on which is the best to explain aggregate supply. However, the theories and information that each model consists of collectively communicate a better understanding of the short-run aggregate supply than any single model could.
Return to 123HelpMe.com