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