What to teach the undergraduates about business cycles

Let me promote this to “highlighted” status, and flag it: it is time I once again tried to think hard about just what the “macro” weeks of introductory economics are for:

Time to Start Teaching the Undergraduates About Business Cycles: How to begin? What is the vision I went them to take away and remember?

How about this:

For some reason–it can be any of a large number of reasons, this time it is the blowback from excessive leverage and irrational exuberance, but it can be for any of a large number of reasons–the people in the economy decide that they are spending too much on currently-produced goods and services. They decide that they want to spend less and so build up their holdings of financial assets. People cut back on their spending on currently-produced goods and services, planning to use the margin they will create between income and spending to build up their holdings of financial assets.

The problem is that one person’s spending is another person’s production, and that one person’s production is another person’s income. Businesses see demand for what they produce fall off. They see their inventories of unsold goods rise. Businesses thus lay workers off in order to avoid making even more stuff that they cannot sell: production falls.

And as production falls businesses stop paying the workers they have laid off: incomes fall.

People spend what they had planned on currently-produced goods and services. But they find that their incomes are less than they had thought they would be. Thus the margin they had hoped to create between their incomes and their spending does not exist. People find that they have not managed to carry out their plans to build up their holdings of financial assets. But they still want to. So people try to cut back on their spending on currently produce goods and services yet again to build up their holdings of financial assets. And the process repeats. Spending, production, and incomes fall again.

Why don’t spending and production and incomes and production fall to zero in this downward spiral?
Because at some point incomes drop so low that people give up on the idea of building up their stocks of financial assets.
They still would like to build up their stocks of financial assets–if their incomes were normal. But keeping their standard of living from falling too much becomes a higher priority.

The economy settles down at a spot where spending on currently-produced goods and services once again equals production and income. It finds itself at a short-run macroeconomic equilibrium where inventories are neither rising and causing businesses to fire more workers or falling and causing businesses to hire more workers. This equilibrium, however, has a lot of unemployment: a lot of unemployed workers looking for jobs, and few vacancies looking for workers.

How bad do things get as a result of this collective decision to try to build up stocks of financial assets?

For that we need to build an economic model. And we need to build different economic model then the production function base growth economic model we been dealing with over the past two weeks…