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

The Business Cycle þThe term business cycle is used to describe observed fluctuations in key macroeconomic measures such as real GDP, personal income, profits, or employment. þA full cycle consists of an expansion and a contraction (or recession). þBusiness cycles are recurring phenomena; however, they are irregularly recurring. Time Real GDP

The Burns and Mitchell (NBER) definition 1 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. 1 Burns, A. and Mitchell, W. Measuring Business Cycles. New York: National Bureau of economic Research, 1947, p. 3

1 Expansion was at 64 months through August, The NBER could date the peak retroactively, however. 2 phases of the cycle Real GDP Year/Month May ‘54 Aug. ‘57 Apr. ‘58 expansion contraction Trough 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

Peak Trough

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 cycles in the U.S. since 1919, as dated by the NBER

TroughPeakTrough Expansion in Months Contraction in Months Mar 1919Jan 1920July July 1921May 1923July July 1924Oct 1926Nov Nov 1927Aug 1929Mar Mar 1933May 1937June June 1938Feb 1945Oct Oct 1945Nov 1948Oct Oct 1949July 1952May May 1954Aug 1957Apr Apr 1958Apr 1960Feb Feb 1961Dec 1969Nov Nov 1970Nov 1973Mar Mar 1975Jan 1980July July 1980July 1981Dec Dec 1982July 1990Apr Apr 1991March 2001Nov

Statistic Depression ( to ) Six Severe Recessions 1 Four Mild Recessions 2 Ave. Duration (Months) % Decline Real GDP % Decline Industrial Production % Decline Nonfarm Employment Duration and Depth of Selected Business Cycles Contractions Source: Zarnowitz (1985) 1 The dates are to ; to ; to ; to ; to ; and to The dates are to ; to ; to ; and to

Economic Activity Stage IStage IIStage III Trough Peak 1 year 2 years The “typical” business cycle

Component Percent Change During Recession 1 Percent Change First Year Percent Change Second Year Consumer Durables Consumer Nondurables Consumer Services Business Fixed Investment Percent Change in Components of GDP Over the Business Cycle 1 Based on the , , , 1980, and recessions. Source: Oyen (1991).

Component Percent Change During Recession 1 Percent Change First Year Percent Change Second Year Residential Construction Inventories Federal purchases State & Local Purchases Percent Change in Components of GDP Over the Business Cycle (Part 2) 1 Based on the , , , 1980, and recessions. 2 Excludes 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 AS 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 Market Let L S 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). L D 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$0.25$ $ $ $ $ $ Plato’s Vineyard

0 Plato’s L D Number of workers w/p $17.50 $ I couldn’t afford to pay more than $15.25 for the second worker Diminishing Returns

Real Hourly Wage = w/p Number of Workers 100 million = Full Employment 0 Excess Demand for Labor LDLD LSLS $20 E B A J H The Labor Market Excess Supply for 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 AS 1 AS 0 AS 1 to AS 0 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 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 Y1Y1 Y2Y2 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 AD 0 AD 1 AD 2 AD 0 to AD 1 is an increase in AD AD 0 to AD 2 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 AD 1 AD 0 AD 0 +  I 110 Increase in I Induced increase in C 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.

Potential GDP AD 1 AD 2 AD 0 AS Price level Real GDP A B C C AD D E AD 3 AD 4 Expansion Contraction An aggregate demand (AD) cycle

Year Real GDP A B C D E Peak Trough Full employment

Stagflation is a combination of recession (falling real GDP) and inflation. Now we will show how stagflation could be produced by a supply shock

Price per barrel of 32 0 crude oil Source: Petroleum Economist

Stagflation due to oil price shock AS 0 AD AS Real GDP 0 Price Level