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Chapter 8 Business Cycles
Goals of Chapter 8
A. Define and describe the business cycle (Sec. 8.1)
B. Summarize the history of the American business cycle (Sec. 8.2)
C. Describe the behavior of various variables over the course of the business cycle (Sec. 8.3)
D. Use aggregate demand and aggregate supply to describe the impact on business cycles of
various shocks (Sec. 8.4)
I.
What Is a Business Cycle? (Sec. 8.1)
A. U.S. research on cycles began in 1920 at the National Bureau of Economic Research (NBER)
1. NBER maintains the business cycle chronology—a detailed history of business cycles
2. NBER sponsors business cycle studies
B. Burns and Mitchell (Measuring Business Cycles, 1946) make five main points about
business cycles:
1. Business cycles are fluctuations of aggregate economic activity, not a specific variable
2. There are expansions and contractions
a. Aggregate economic activity declines in a contraction or recession until it reaches a
trough (Figure 8.1)
Figure 8.1
b. Then activity increases in an expansion or boom until it reaches a peak
c. A particularly severe recession is called a depression
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d. The sequence from one peak to the next, or from one trough to the next, is a business cycle
e. Peaks and troughs are turning points
f. Turning points are officially designated by the NBER Business Cycle Dating Committee
3. Economic variables show comovement—they have regular and predictable patterns of
behavior over the course of the business cycle
4. The business cycle is recurrent, but not periodic
a. Recurrent means the pattern of contraction–trough–expansion–peak occurs again and again
b. Not being periodic means that it doesn’t occur at regular, predictable intervals
5. The business cycle is persistent
a. Declines are followed by further declines; growth is followed by more growth
b. Because of persistence, forecasting turning points is quite important
III. Business Cycle Facts (Sec. 8.3)
A. All business cycles have features in common
B. The cyclical behavior of economic variables—direction and timing
1. What direction does a variable move relative to aggregate economic activity?
a. Procyclical: in the same direction
b. Countercyclical: in the opposite direction
c. Acyclical: with no clear pattern
2. What is the timing of a variable’s movements relative to aggregate economic activity?
a. Leading: in advance
b. Coincident: at the same time
c. Lagging: after
C. Cyclical behavior of key macroeconomic variables (text Figures 8.4 to 8.12)
1. Procyclical
a. Coincident: industrial production, consumption, business fixed investment, and employment
b. Leading: residential investment, inventory investment, average labor productivity, money
growth, and stock prices
c. Lagging: inflation, nominal interest rates
d. Timing not designated: government purchases, real wage
2. Countercyclical: unemployment (timing is unclassified)
3. Acyclical: real interest rates (timing is not designated)
4. Volatility: durable goods production is more volatile than nondurable goods and services;
investment spending is more volatile than consumption
5. Application: The Job Finding Rate and the Job Loss Rate
a. The probability that someone finds or loses a job in a given month changes over time
b. The job finding rate is the probability that someone who is unemployed will find a job
during the month, but that probability declines in recessions and increases in expansions
(text Figure 8.8)
c. The job loss rate is the probability that someone who is employed one month will become
unemployed the next month (text Figure 8.9); it declines in expansions and rises in
recessions
d. An example (text Table 10.2) shows that small changes in the job loss rate may lead to
larger changes in the unemployment rate than larger changes in the job finding rate
e. But since the job loss rate applies to many more people, job loss is the main force in
increased unemployment rates during recessions
D. International aspects of the business cycle
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1. The cyclical behavior of key economic variables in other countries is similar to that in the
United States
2. Major industrial countries frequently have recessions and expansions at about the same time
3. Text Figure 8.13 illustrates common cycles for Japan, Canada, the United States, France,
Germany, and the United Kingdom
4. In addition, each economy faces small fluctuations that aren’t shared with other countries
E.
In touch with data and research—coincident and leading indexes
1. Coincident indexes are designed to help figure out the current state of the economy, while
leading indicators are designed to help predict peaks and troughs
2. The first index was developed by Mitchell and Burns of the NBER in the 1930s
3. The CFNAI is a coincident index produced by the Federal Reserve Bank of Chicago based on
85 macroeconomic variables; it is a coincident index that turns significantly negative in
recessions (text Figure 8.14)
4. The ADS Business Conditions Index is a coincident index based on variables of different
frequencies (text Figure 8.15)
5. The CFNAI and ADS index perform similarly; the ADS is available more frequently but
doesn’t have a long track record
6. The Conference Board produces an index of leading economic indicators; a decline in the
index for two or three months in a row warns of recession danger
7. Problems with the leading indicators
a. Data are available promptly, but often revised later, so the index may give
misleading signals
b. The index has given a number of false warnings
c. The index provides little information on the timing of the recession or its severity
d. Structural changes in the economy necessitate periodic revision of the index
8. Research by Diebold and Rudebusch showed that the index does not help forecast industrial
production in real time
9. In real time, the index sometimes gave no warning of recessions
a. The index gave no advance warning of the recession that began in December 1970
b. The index was late in calling the recession that began in November 1973; the index did
not turn down two months in a row until September 1974
10. After the fact, the index of leading indicators is revised and appears to have predicted the
recessions well
11. Stock and Watson attempted to improve the index by creating some new indexes based on
newer statistical methods, but the results were disappointing as the new index failed to
predict the recessions that began in 1990 and 2001
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12. Because recessions may be caused by sudden shocks, the search for a good index of leading
indicators may be fruitless
F.
In Touch with Data and Research: The seasonal cycle and the business cycle
1. Output varies over the seasons BUT most economic data are seasonally adjusted to remove
regular seasonal movements
2. However, some seasonal fluctuations are substantial and require interventions by
policymakers. For example, in countries where tourism contributes significantly towards
their GDP (e.g: Egypt or Tunisia)
3. Economists have attempted to study seasonal cycle on the premise that similar variables are
affecting both business and seasonal cycles
4. Seasonal fluctuations also contribute to business cycles and governments should take this
into account so that their spending become procyclical
4. If the seasonal cycle is like the business cycle, and the seasonal cycle represents desirable
responses to various factors (Christmas, the weather) for which government intervention is
inappropriate, should government intervention be used to smooth out the business cycle?
IV. Business Cycle Analysis: A Preview (Sec. 8.4)
A. What explains business cycle fluctuations?
1. 2 major components of business cycle theories
a. A description of the shocks
b. A model of how the economy responds to shocks
2. 2 major business cycle theories
a. classical theory
b. Keynesian theory
3. Study both theories in aggregate demand-aggregate supply (AD-AS) framework
B. Aggregate demand and aggregate supply: a brief introduction
1. The model (along with the building block IS-LM model) will be developed in chapters 9–11
2. The model has 3 main components; all plotted in (P, Y) space
a. aggregate demand curve
b. short-run aggregate supply curve
c. long-run aggregate supply curve
3. Aggregate demand curve
a. Shows quantity of goods and services demanded (Y) for any price level (P)
b. Higher P means less aggregate demand (lower Y), so the aggregate demand curve slopes
downward; reasons why discussed in chapter 9
c. An increase in aggregate demand for a given P shifts the aggregate demand curve up and
to the right; and vice-versa
(1) Example: a rise in the stock market increases consumption, shifting the aggregate
demand curve up and to the right
(2) Example: a decline in government purchases shifts the aggregate demand curve down
and to the left
4. Aggregate supply curve
a. The aggregate supply curve shows how much output producers are willing to supply at
any given price level
b. The short-run aggregate supply curve is horizontal; prices are fixed in the short run
c. The long-run aggregate supply curve is vertical at the full-employment level of output
d. Equilibrium (Figure 8.2; like text Figure 8.16)
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Figure 8.2
(1) Short-run equilibrium: the aggregate demand curve intersects the short-run aggregate
supply curve
(2) Long-run equilibrium: the aggregate demand curve intersects the long-run aggregate
supply curve
C. Aggregate demand shocks
1. An aggregate demand shock is a change that shifts the aggregate demand curve
2. Example: a negative aggregate demand shock (Figure 8.3; like text Figure 8.17)
Figure 8.3
a. The aggregate demand curve shifts down and to the left
b. Short-run equilibrium occurs where the aggregate demand curve intersects the short-run
aggregate supply curve; output falls, price level is unchanged
c. Long-run equilibrium occurs where the aggregate demand curve intersects the long-run
aggregate supply curve; output returns to its original level, price level has fallen
3. How long does it take to get to the long run?
a. Classical theory: prices adjust rapidly
(1) So recessions are short-lived
(2) No need for government intervention
b. Keynesian theory: prices (and wages) adjust slowly
(1) Adjustment may take several years
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(2) So the government can fight recessions by taking action to shift the aggregate
demand curve
D. Aggregate supply shocks
1. Classicals view aggregate supply shocks as the main cause of fluctuations in output
a. An aggregate supply shock is a shift of the long-run aggregate supply curve
b. Factors that cause aggregate supply shocks are things like changes in productivity or
labor supply
2. Example: a negative aggregate supply shock (Figure 8.4, like text Figure 8.18)
Figure 8.4
a. Initial long-run equilibrium at intersection of LRAS1 and AD, with full-employment
output level Y1
b. Aggregate supply shock reduces full-employment output from Y1 to Y2 , causing long-run
aggregate supply curve to shift left from LRAS1 to LRAS2
c. New equilibrium has lower output and higher price level
d. So recession is accompanied by higher price level
3. Keynesians also recognize the importance of supply shocks; their views are discussed further
in chapter 11
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