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Chapter 8
Business Cycles:
An Introduction
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• To understand the characteristics of
business cycles
• To examine the economic data that underlie
the business cycle
• To understand how the two schools of
thought, Keynesian and classical economics,
view the role of governments in the
business cycle
• To develop a theory of business cycles and
an economic model to explain those
fluctuations
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Business Cycle Basics
• Arthur Burns and Wesley Mitchell defined
business cycles as fluctuations in
aggregate economic activity in which many
economic activities expand and contract
together in a recurring, but not a periodic,
fashion
• Economic activity typically follows a wavy
line over time with four phases:
–
–
–
–
Trough
Business cycle expansion (boom)
Peak
Business cycle contraction (recession)
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FIGURE 8.1 The Business Cycle
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Box: Dating Business Cycles
• Recessions usually begin with lengthy
periods of falling real GDP, but there are
exceptions:
– In the 2001 recession, GDP never fell more than
one quarter in a row
– In the most recent recession, GDP fell in 2008
even though the National Bureau of Economic
Research (NBER) dates the onset of this recession
as December 2007
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TABLE 8.1 NBER Business Cycle
Dates
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Movement of Business Cycle
Variables
• Many economic activities move together
over the business cycle
• Co-movement of economic variables is
either:
– Procyclical—a variable moves up during
expansions and down during contractions
– Countercylcial—a variable moves down during
expansions and up during contractions
– Acyclical—a variable with ups and downs that
do not coincide with those of the business cycle
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Movement of Business Cycle
Variables (cont’d)
• Timing relative to the business cycle:
– Leading variable—reaches a peak or trough
before the turning points of a business cycle
– Lagging variable—reaches a peak or trough
after the turning points of a business cycle
– Coincident variable—reaches a peak or trough
at the same time of a business cycle
• The Conference Board combines 10 leading
variables into an index of leading
indicators that economists use to forecast
changes in the economy
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Macroeconomics in the News:
Leading Economic Indicators
• There are reasons to question the predictive
power of the Conference Board’s monthly
index of leading indicators in forecasting the
business cycle:
– The Conference Board regularly revises the index
when more accurate data become available
– The Conference Board changes components of
the index over time to improve the index’s
historical record
– The index’s performance using real-time data at
the time is far less accurate than that using
revised data Leading variable
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Macroeconomic Variables and the
Business Cycle
• Real GDP: A broad measure of aggregate
economic activity so that it sometimes
serves as a proxy for the business cycle
• Real consumer spending and investment:
Both are procyclical and coincident, but
investment is more volatile
• Unemployment: The unemployment rate is
countercylical
• Inflation: The inflation rate is procyclical and
lagging the business cycle
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FIGURE 8.2 Real GDP Growth, 19602010
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FIGURE 8.3 Consumer Spending and
Investment Growth, 1960-2010 (a)
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FIGURE 8.3 Consumer Spending and
Investment Growth, 1960-2010 (b)
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FIGURE 8.4 Unemployment Rate,
1960-2010
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FIGURE 8.5 Inflation, 1960-2010
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Macroeconomic Variables and the
Business Cycle (cont’d)
• Financial variables, such as stock and bond
prices, are procyclical and tend to be
leading the business cycle
• The interest rate paid on short-term U.S.
government bonds, known as Treasury bills,
is both procyclical and lagging
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Macroeconomic Variables and the
Business Cycle (cont’d)
• The spread (difference in interest rates)
between long-term and short-term
government bonds is leading and
procyclical, and it is a good predictor of
recessions
• The spread between interest rates on
corporate bonds and government bonds is
countercyclical as companies are more
likely to run out of money in recessions and
thus have to pay higher interest rates for
corporate bonds
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FIGURE 8.6 Stock Prices, 1960-2010
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FIGURE 8.7 Interest Rates on U.S.
Treasury Bills, 1960-2010
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FIGURE 8.8 Credit Spreads and Spreads
Between Long and Short-Term Bonds,
1960-2010 (a)
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FIGURE 8.8 Credit Spreads and Spreads
Between Long and Short-Term Bonds,
1960-2010 (b)
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International Business Cycles
• In a globalized economy, business cycles of
many countries are correlated with those of
the United States
• As financial markets throughout the world
have become more integrated as well, the
financial crisis in the United States during
the fall of 2008 led to a global financial
crisis and subsequently simultaneous
economic contractions around much of the
world
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FIGURE 8.9 International Business
Cycles, 1960-2010
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A Brief History of U.S. Business
Cycles
• The U.S. economy since 1875 can be
divided into several periods:
– Pre-World War I period: The U.S. emerged as a
global economic power
– The Interwar Period with the Great Depression: The
“roaring 20s” ended with massive bank failures
(when banks could not pay off depositors and other
creditors and thus go out of business) that triggered
the Great Depression with an unemployment rate as
high as 25%
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A Brief History of U.S. Business
Cycles (cont’d)
– Post-World War II period: High growth, low
inflation and mild recessions between 1945 and
1973, followed by a period of the Great
Inflation in the 1970s with double-digit inflation
rates and the federal funds rate (the interest
rate charged on overnight loans between banks)
– The “Great Moderation” period: The period
between 1984 and 2007 was an era of stability,
with low volatility of real GDP and inflation
– The Great Recession of 2007-2009: Sparked by
defaults on subprime mortgage loans, a financial
crisis in 2007 led to the 2007-2009 recession
that is comparable to the Great Depression
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FIGURE 8.10 Business Cycles in the United
States: A Long-Term Perspective, 18902009 (a)
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FIGURE 8.10 Business Cycles in the United
States: A Long-Term Perspective, 18902009 (b)
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FIGURE 8.10 Business Cycles in the United
States: A Long-Term Perspective, 18902009 (c)
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Time Horizons in Macroeconomics
• The study of business cycles focuses on
short-run economic fluctuations
• John Maynard Keynes questioned the
classical view that economies moved quickly
to their long-run equilibriums
• Stating that “in the long run, we are all
dead”, Keynes argued that the primary focus
of macroeconomists should be the short run
• The followers of Keynes, or Keynesians,
also argue that the government should
pursue active policies to stabilize economic
fluctuations
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The Short Run Versus the Long Run
• In the long run, prices of goods and services
as well as the price of labor (wages) are
completely flexible: They adjust all the way
to their long-run equilibrium where supply
equals demand
• Classical models make use of a flexible-price
framework
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The Short Run Versus the Long Run
(cont’d)
• The flexible-price framework results in the
classical dichotomy, in which there is a total
separation between real and nominal
variables
• Keynesian models focus on the short run
when prices respond slowly to changes in
supply and demand—sticky prices
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TABLE 8.2 Long-Run Versus ShortRun Models
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Price Stickiness
• There are different views of market structure
that affect the views on the role of price
stickiness
• Perfect competition versus monopolistic
competition
– Classical models commonly assume perfect
competition in markets where buyers and sellers
are price takers
– Keynesians focus on the importance of market
(monopoly) power in a market with monopolistic
competition as firms have the ability to set prices
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Sources of Price Stickiness
• Menu Costs
– Changing prices involves many hidden costs
– Collecting information is costly, so firms and
households may engage in rational inattention
by only making decisions about prices at
infrequent intervals
– Changing prices frequently may alienate
customers
• Staggered Price Setting
– Occurs when competitors adjust prices at
different intervals, so that staggered prices slow
down price adjustment
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Empirical Evidence on Price
Stickiness
• Empirical evidence indicates substantial
price stickiness in markets
• Example: Alan Blinder found that only 10%
of firms changed their prices as often as
once a week, and close to 40% changed
prices once a year and 10% less than once a
year
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Road Map For Our Study Of Business
Cycles
• Chapters 9 to 12: Build the aggregate demandaggregate supply (AD/AS) model with stick
prices to discuss business cycle fluctuations
• Chapters 13 and 14: Discuss macroeconomic
policy using the AD/AS model
• Chapter 15: Use the AD/AS model to examine
how financial crises affect the business cycle
• Chapters 21 and 22: Incorporate the role of
expectations in macroeconomic policy and
discuss modern business cycle theories
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