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slide 0 Business Cycles Business Cycles – Business cycles are 2-year to 5-year fluctuations around trends in real GDP and other related variables – A recession is a large fall in the growth of real GDP and related variables • A depression is an especially large recession slide 1 Business Cycles slide 2 Real GDP Growth in the United States 10 Percent change from 4 quarters 8 earlier Average growth rate = 3.5% 6 4 2 0 -2 -4 1960 1965 1970 1975 1980 1985 1990 1995 2000 slide 3 Recessions in the U.S. since World War II Year and quarter Number of quarters of peak in RGDP until trough in RGDP Change in RGDP, peak to trough (%) 1948:4 2 -1.7 1953:2 3 -2.7 1957:3 2 -3.7 1960:1 3 -1.6 1970:3 1 -1.1 1973:4 5 -3.4 1980:1 2 -2.2 1981:3 4 -2.9 1990:2 3 -1.5 No simple regular or cyclical pattern: output changes very considerably in size and spacing slide 4 Behavior of the Components of Output in Recessions Component of GDP Consumption Durables Nondurables Services Average Share in GDP (%) Average Share in fall in GDP in recessions relative to normal growth (%) 8.4 25.8 29.5 15.6 11.2 9.1 4.7 10.7 0.7 20.9 11.7 40.6 Net Export -0.4 -12.3 Gov’t Purchases 20.6 3.3 Investment Residential Business Fixed Inventories Fluctuations are distributed very unevenly over the components of output slide 5 Cyclical Behavior of Key Macroeconomic Variables Procyclical variable – An economic variable that moves in the “same” direction as aggregate economic activity industrial production, consumption, investment, employment, real wage, inflation, stock prices Countercyclical variable – An economic variable that moves in the “opposite” direction as aggregate economic activity unemployment slide 6 Cyclical behavior of the index of industrial production slide 7 Cyclical behavior of consumption and investment slide 8 Cyclical behavior of civilian employment slide 9 Cyclical behavior of the unemployment rate slide 10 Cyclical behavior of average labor productivity and the real wage slide 11 Supply shocks A supply shock alters production costs, affects the prices that firms charge. (also called price shocks) Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. (Favorable supply shocks lower costs and prices.) slide 12 CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in 1973 68% in 1974 16% in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. slide 13 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. In absence of further price shocks, prices will fall over time and economy moves back toward full employment. P P2 LRAS B SRAS2 A P1 SRAS1 AD Y2 Y Y slide 14 CASE STUDY: The 1970s oil shocks 70% 12% Predicted effects of the oil price shock: • inflation • output • unemployment 60% …and then a gradual recovery. 10% 50% 10% 40% 8% 30% 20% 6% 0% 1973 4% 1974 1975 1976 1977 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) slide 15 CASE STUDY: The 1970s oil shocks 60% Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 14% 50% 12% 40% 10% 30% 8% 20% 6% 10% 0% 1977 1978 1979 1980 4% 1981 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) slide 16 CASE STUDY: The 1980s oil shocks 40% 1980s: A favorable supply shock-a significant fall in oil prices. As the model would predict, inflation and unemployment fell: 10% 30% 8% 20% 10% 6% 0% -10% 4% -20% -30% 2% -40% -50% 1982 1983 1984 1985 1986 0% 1987 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) slide 17