The business cycle

“A wavelike movement in the overall level of business activity”

The Business Cycle

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.

Time

Real G

DP

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

2 phases of the 1954-58 cycleR

eal G

DP

Year/MonthMay ‘54

Aug. ‘57

Apr. ‘58

expansion contraction

TroughTrough

Peak

Trend line

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

Nonfarm payrolls in the U.S., 1990-91

Year/month

91/791/591/391/190/1190/990/790/590/390/1

Non

farm

payro

lls (

thou

san

ds)

120000

119750

119500

119250

119000

118750

118500

118250

118000

117750

117500

117250117000

Peak

Trough

www.bls.gov

A “full” business cycle consists of two “half-cycles”—an 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

Trough Peak TroughExpansion in

MonthsContraction

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

Statistic

Depression(1929.4 to

1933.1)Six Severe Recessions1

Four Mild Recessions

2

Ave. Duration(Months)

43 12 10

% Decline Real GDP

-32.6 -3.3 -1.7

% Decline Industrial

Production-53.4 -13.1 -7.8

% Decline Nonfarm

Employment-31.6 -3.8 -1.7

Duration and Depth of Selected Business Cycles Contractions Source: Zarnowitz (1985)

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

Econ

omic

Activ

ity

Stage I Stage II Stage III

Trough Trough

Peak

1 year 1 year2 years

The “typical” business cycle

ComponentPercent ChangeDuring

Recession1

Percent Change

First Year

Percent Change

Second 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 Fixed

Investment

-8.04 4.10 9.17

Percent Change in Components of GDP Over the Business Cycle

1Based on the 1957-58, 1960-61, 1973-75, 1980, and 1981-82 recessions.

Source: Oyen (1991).

ComponentPercent ChangeDuring

Recession1

Percent Change

First Year

Percent Change

Second 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

Percent Change in Components of GDP Over the Business Cycle (Part 2)

1Based on the 1957-58, 1960-61, 1973-75, 1980, and 1981-82 recessions.

2Excludes transfer payments

Source: Oyen (1991).

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.

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.

Change in the quantity of real GDP (Y) supplied

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

Potential GDP

10.0

110

AS

As price level increase, AS increases

As price level increase, AS increases

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

The Labor MarketLet

•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.

(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 15.25

3 187 52 $0.25 13.00

4 222 36 $0.25 9.00

5 238 16 $0.25 4.00

Plato’s Vineyard

0

Plato’s LD

Number of workers

w/p

$17.50

$15.25

1 2

I couldn’t afford to pay more than $15.25 for the second worker

Diminishing Returns

Rea

l Hou

rly

Wag

e =

w/p

Number of Workers

100 million = Full Employment

0

Excess Demandfor Labor

LD

LS

10

15

$20

E

BA

JH

The Labor Market

Excess Supplyfor Labor

Potential GDP Corresponds to Labor Market Equilibrium

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

Potential GDP

10.0

Note that potential GDP does not change when the price level changes

$10 trillion of real GDP can be produced when the economy is at full employment

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

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

Shifts of AS

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

Potential GDP

10.0

110

AS1

AS0

AS1 to AS0

•Falling wages or benefits costs.

•Falling prices of other inputs (e.g., diesel fuel, rubber, copper, wood).

Potential GDP can change too

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

Potential GDP

10.0 11.0

Potential GDP can rise as a result of

•Growth of the labor force

•Capital accumulation including human capital

•Improve technology

The aggregate demand (AD) curve

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

AD

The AD curve shows what spending units plan to spend at various price levels, holding all other influences on buying plans constant.

Why is the AD curve downward-sloping?

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

AD

120

110

Y1 Y2

A

B

•Change in the real interest rate

•Change in the relative prices of exports and imports

•Change in the buying power of money

Changes (shifts) of (AD) curve

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

AD0

AD1

AD2

•AD0 to AD1 is an increase in AD

•AD0 to AD2 is a decrease in AD

Why 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

The Aggregate demand (AD Multiplier)

Price level (GDP deflator)

Real GDP (trillions of 1996 dollars)

0

AD1

AD0

AD0 +I

110

Increase in IInduced increase in C

10.0 10.4 11.0

Increase in investment induces increase in C via the effect on income

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.

10.0 10.09.5 10.5

Potential GDP

Potential GDP

AD1

AD2

AD0

AS AS

Price level

Price level

RealGDP

RealGDP

0 0

105

115

AB

CC

AD2

10.59.5

DE

115

105

AD3

AD4

Expansion Contraction

An aggregate demand (AD) cycle

Year

Real GDP

A

B

C

D

E

Peak

TroughTrough

Full employment

10.5

10.0

9.5

1 2 3 4 5

Stagflation is a combination of

recession (falling real GDP) and inflation.

Now we will show how stagflation could be

produced by a supply shock

Inflation-Unemployment pairs for the U.S., 1960-89

Unemployment Rate

109876543

Inflati

on

Rate

16

14

12

10

8

6

4

2

0

8988

87

86

8584

83

82

81

80

79

78

7776

75

74

73

72

71

7069

68

6766

65

646362

6160

www.bls.gov

Price per barrel of 320 crude oil

Date Price ($)Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84

April 1979 14.55June 1979 18.00

Nov 1979 24.00

Aug. 1980 30.00Oct. 1981 34.00

Source: Petroleum Economist

Stagflation due to oil price shock

10.09.75

AS0

AD

AS1

110

115

Real GDP0

Price Level