The business cycle

1
The business cycle
A wavelike movement in the overall level of
business activity
2
The Business Cycle
Real GDP
Time

• The term business cycle is used to describe
  observed fluctuations in key macroeconomic
  measures such as real GDP, personal income,
  profits, or employment.
• A full cycle consists of an expansion and a
  contraction (or recession).
• Business cycles are recurring phenomena however,
  they are irregularly recurring.

3
The Burns and Mitchell (NBER) definition1
Business cycles are a type of fluctuation found
in aggregate economic activity. . . . A cycle
consists of expansions occurring at about the
same time in many activities, followed by
similarly general recessions, contractions, and
revival which merge into the expansion phase of
the next cycle this sequence of change is
recurrent but not periodic in duration cycles
vary from one year to 10 to 12 years.
1Burns, A. and Mitchell, W. Measuring Business
Cycles. New York National Bureau of economic
Research, 1947, p. 3
4
2 phases of the 1954-58 cycle
Peak
Real GDP
Trough
Trough
Trend line
contraction
expansion
Year/Month
May 54
Aug. 57
Apr. 58

1Expansion was at 64 months through August, 1996.
The NBER could date the peak retroactively,
however.
5
Dating business cycles
To date business cycle peaks and troughs,
economists at the NBER look for well-defined
turning points in key coincident indicators
such as industrial production or nonfarm payrolls
6
Peak
Trough
www.bls.gov
7
A full business cycle consists of two
half-cyclesan expansion is one half-cycle and
the (chronologically) adjacent contraction is the
other half cycle. The table on the following
slide gives the record of cyclesin the U.S.
since 1919, as dated by the NBER
8
Trough Peak Trough Expansion in Months Contraction in Months
Mar 1919 Jan 1920 July 1921 10 18
July 1921 May 1923 July 1924 22 14
July 1924 Oct 1926 Nov 1927 27 13
Nov 1927 Aug 1929 Mar 1933 21 43
Mar 1933 May 1937 June 1938 50 13
June 1938 Feb 1945 Oct 1945 80 8
Oct 1945 Nov 1948 Oct 1949 37 11
Oct 1949 July 1952 May 1954 45 10
May 1954 Aug 1957 Apr 1958 39 8
Apr 1958 Apr 1960 Feb 1961 24 10
Feb 1961 Dec 1969 Nov 1970 106 11
Nov 1970 Nov 1973 Mar 1975 36 16
Mar 1975 Jan 1980 July 1980 58 6
July 1980 July 1981 Dec 1982 12 17
Dec 1982 July 1990 Apr 1991 88 9
Apr 1991 March 2001 Nov 2001 120 8
Nov 2001 December 2007 June 2009 83 18
9
Duration and Depth of Selected Business Cycles
Contractions Source Zarnowitz (1985), and
Economagic.com
Statistic Depression(1929.4 to 1933.1) Six Severe Recessions1 Four Mild Recessions2 Current Recession2007.4 -
Ave. Duration(Months) 43 12 10 27
Decline Real GDP -32.6 -3.3 -1.7 - 3.66
Decline Industrial Production -53.4 -13.1 -7.8 -14.81
Decline Nonfarm Employment -31.6 -3.8 -1.7 -5.37
1The dates are 1923.2 to 1924.3 1948.4 to
1949.4 1953.3 to 1954.2 1957.3 to 1958.2
1973.4 to 1975.1 and 1981.3 to 1982.2. 2The
dates are 1926.4 to 1927.4 1960.2 to 1961.1
1969.4 to 1970.4 and 1980.1 to 1980.3
10
Performance of GDP Components, 2007-IV to
2008-III.
Component PercentChange
GDP -3.66
Consumer Durables -1.86
Nonresidential Fixed Investment -12.24
ResidentialInvestment -19.03
GovernmentExpenditure 4.05
Exports -34.4
Imports -12.59
Source Bureau of Economic Analysis
11
The typical business cycle
Peak
Economic Activity
Trough
Trough
Stage I
Stage II
Stage III
1 year
1 year
2 years
12
Percent Change in Components of GDP Over the
Business Cycle
Component Percent ChangeDuring Recession1 Percent ChangeFirst Year Percent ChangeSecond Year
Consumer Durables -8.15 15.96 5.50
Consumer Nondurables -5.50 3.81 3.55
Consumer Services 1.41 4.31 4.59
Business FixedInvestment -8.04 4.10 9.17
1Based on the 1957-58, 1960-61, 1973-75, 1980,
and 1981-82 recessions.
Source Oyen (1991).
13
Percent Change in Components of GDP Over the
Business Cycle (Part 2)
Source Oyen (1991).
Component Percent ChangeDuring Recession1 Percent ChangeFirst Year Percent ChangeSecond Year
Residential Construction -16.30 26.03 5.47
Inventories -153.85 258.91 -38.35
Federal purchases2 1.99 -3.00 1.29
State Local Purchases2 2.64 4.25 2.52
1Based on the 1957-58, 1960-61, 1973-75, 1980,
and 1981-82 recessions. 2Excludes transfer
payments
14
Aggregate Supply
Aggregate supply The relationship between the
quantity of real GDP supplied and the price level
when all other influences on production plans
remain the same.
15
Aggregate Supply Basics

• The quantity of real GDP supplied (Y) depends on
• The quantity of labor employed
• The quantities of capital (including human
  capital) and the technologies they embody
• The quantities of land and natural resources used
• The amount of entrepreneurial talent available.

16
Change in the quantity of real GDP (Y) supplied
GDP Deflator is the broad price index
Price level (GDP deflator)
Potential GDP
AS
As price level increase, AS increases
110
As price level decreases, AS decreases
0
Real GDP (trillions of 1996 dollars)
10.0
17
As we move along AS, all other influences on
productions plans remain constant (aside from the
price level).

• These influences include
• The money wage rate
• The money prices of other resources

18
The Labor Market

• Let
• LS denote the supply of labor, which is presumed
  to be a positive function of the real wage, where
  the real wage is equal to the nominal wage
  divided by the price level (w/p).
• LD denote the demand for labor, which is presumed
  to be a negative (or inverse) function of the
  real wage (w/p).

As the real wage increases, the opportunity cost
of leisure rises as well. Hence, people
substitute work for leisure.
19
Platos Vineyard
(1) (2) (3) (4) (5) (3) (4)
Number of Workers Output (Units) Marginal Output (Units) Price per Unit () Value of Marginal Output ()
0 --- 0 0.25 0.00
1 70 70 0.25 17.50
2 135 65 0.25 16.25
3 187 52 0.25 13.00
4 222 36 0.25 9.00
5 238 16 0.25 4.00
20
Diminishing Returns
w/p
I couldnt afford to pay more than 16.25 for the
second worker
Platos LD
17.50
15.25
0
1
2
Number of workers
21
Real Wage w/p
The Labor Market
Excess Supplyfor Labor
LS
20
B
A
15
E
Real Hourly Wage w/p
H
J
10
LD
Excess Demandfor Labor
0
150 billion Full Employment
Hours Worked/Year
22
Real GDP ( Trillions)
Potential GDP is 10 Trillion
10
0
Hours Worked/Year(billions)
150
23
Potential GDP Corresponds to Labor Market
Equilibrium
Price level (GDP deflator)
Potential GDP
10 trillion of real GDP can be produced when the
economy is at full employment
Note that potential GDP does not change when the
price level changes
0
Real GDP (trillions of 1996 dollars)
10.0
24
Why is AS upward-sloping?
Holding the nominal wage (w) constant, the real
wage (w/p) decreases when the price level
increases.
This induces firms to hire more workers.
Real GDP expands
25
Changes of Aggregate Supply

• Aggregate supply can change (shift) due to
• A change in the money wage
• A change in the money prices of other productive
  resources
• A change in potential GDP

26
Shifts of AS
Price level (GDP deflator)
Potential GDP

• AS1 to AS0
• Falling wages or benefits costs.
• Falling prices of other inputs (e.g., diesel
  fuel, rubber, copper, wood).

AS1
AS0
110
0
Real GDP (trillions of 1996 dollars)
10.0
27
Potential GDP can change too
Price level (GDP deflator)

• Potential GDP can rise as a result of
• Growth of the labor force
• Capital accumulation including human capital
• Improved technology

Potential GDP
0
10.0
11.0
Real GDP (trillions of 1996 dollars)
28
The aggregate demand (AD) curve
Price level (GDP deflator)
The AD curve shows what spending units plan to
spend at various price levels, holding all other
influences on buying plans constant.
AD
0
Real GDP (trillions of 1996 dollars)
29
Why is the AD curve downward-sloping?
Price level (GDP deflator)

• Change in the real interest rate
• Change in the relative prices of exports and
  imports
• Change in the buying power of money

A
120
B
110
AD
0
Y1
Y2
Real GDP (trillions of 1996 dollars)
30
Changes (shifts) of (AD) curve
Price level (GDP deflator)

• AD0 to AD1 is an increase in AD
• AD0 to AD2 is a decrease in AD

AD1
AD0
AD2
0
Real GDP (trillions of 1996 dollars)
31
What could cause AD to shift?

• AD will increase if
• Expected future income, profits, or inflation
  increase.
• Government units or the Federal Reserve take
  steps to stimulate planned spending.
• The exchange rate falls or the global economy
  expands

32
The Aggregate demand (AD Multiplier)
Price level (GDP deflator)
Increase in investment induces increase in C via
the effect on income
110
AD1
AD0 ?I
AD0
Increase in I
Induced increase in C
0
10.0
10.4
11.0
Real GDP (trillions of 1996 dollars)
33
Price Level
AS
e
117
e
110
AD
AD
Real GDP
Y
Y
34
The Aggregate Demand (AD) Fluctuations
A business cycle might be explained strictly on
the basis of fluctuations of AD. The next 2
slides show how investment fluctuations can
produce a business cycle.
35
An aggregate demand (AD) cycle
Potential GDP
Price level
Price level
Potential GDP
AS
AS
C
C
115
115
D
B
E
A
AD2
AD2
105
105
AD3
AD1
AD4
AD0
10.0
0
0
10.5
9.5
10.0
9.5
10.5
RealGDP
RealGDP
Expansion
Contraction
36
Real GDP
Peak
C
10.5
B
D
10.0
A
E
9.5
Full employment
Trough
Trough
5
2
3
4
1
Year
37
Stagflation is a combination of recession
(falling real GDP) and inflation. Now we will
show how stagflation could be produced by a
supply shock
38
www.bls.gov
39
Price per barrel of 320 crude oil

• Anchovies
• Grain failures

Source Petroleum Economist
40
Stagflation due to oil price shock
Buffer Stock program
Story of Joseph
Price Level
AS0
AS1
115
110
AD
0
10.0
9.75
Real GDP