Phases of the Business Cycle

Business Cycle Definition: alternating increases and decreases in the level of business activity of varying amplitude and length How do we measure “increases and decreases in business activity?” –Percent change in real GDP!

Business Cycle Why do we say “varying amplitude and length?” –Some downturns are mild and some are severe –Some are short (a few months) and some are long (over a year) Do not confuse with seasonal fluctuations!

The Classical Business Cycle “Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises. A cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle. This sequence of changes is recurrent but not periodic. In duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.” -- Burns and Mitchell, 1946

Recessions and Expansions A recession is the phase of the business cycle marked by pronounced, pervasive and persistent declines in the key measures of aggregate economic activity, i.e., output, employment, income and sales. An expansion is the phase of the business cycle marked by pronounced, pervasive and persistent increases in the key measures of aggregate economic activity, i.e., output, employment, income and sales. Alternating expansions and recessions make up the business cycle.

Note: Shaded areas indicate recessions. Real GDP , in 2000 dollars Note: “Years” is on horizontal axis and “real GDP” is on vertical axis. General trend of economic growth Recession years are shaded blue: note downward slope on graph indicating that GDP is decreasing.

U.S. real gross domestic product per person from 1900 to 2004

Expansion Recession The Phases of the Business Cycle Boom Secular growth trend Downturn Upturn Trough Peak 0 Jan.- Mar Total Output Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Stages of the Business Cycle

Long-Run Economic Growth Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades. A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.

The Conventional Three- Phase Business Cycle 10-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Recession What is a recession? –Generally, 2 or more quarters of declining real GDP –Implication: it’s not officially a called a recession until the economy has already been declining for 6 months!

Who decides when we’re in a recession? –National Bureau of Economic Research traditionally declares recessions Recession dates from peak of business

The Recession as a Vicious Cycle A recession occurs when a decline in some measure of aggregate economic activity sets off cascading declines in the other coincident measures of activity. Thus, when a dip in sales causes a drop in production, triggering declines in employment and income, which in turn feed back into a further fall in sales, a vicious cycle results and a recession ensues. This domino effect of the transmission of economic weakness from sales to output to employment to income, feeding back into further weakness in all of these measures in turn, is what marks a recessionary downturn. This effect spreads from industry to industry, region to region, and indicator to indicator.

The Expansion as a Virtuous Cycle At some point, the vicious cycle is broken and an analogous self-reinforcing virtuous cycle begins, with increases in output, employment, income and sales feeding into each other – the hallmark of a business cycle expansion.

How the Virtuous Cycle Works

Stages of the Business Cycle There are expansions and contractions Aggregate economic activity declines in a contraction or recession until it reaches a trough –Informal recession definition: 2 consecutive quarters or negative GDP growth Then activity increases in an expansion or boom until it reaches a peak A particularly severe recession is called a depression The sequence from one peak to the next, or from one trough to the next, is a business cycle Peaks and troughs are turning points Popular saying: “Recession is when someone you know becomes unemployed; a depression is when you become unemployed.”

Post-World War II Recessions* *The February 1945–October 1945 recession began before the war ended in August Note: These recessions were of varying duration and severity.

Another Look at Expansions and Recessions Can you find a pattern? Neither can economists! That’s why recessions are hard to predict.

Business Cycle Theories Endogenous theories: –Innovation theory: innovation leads to saturation. –Psychological theory: alternating optimism and pessimism –Inventory cycle theory: inventory and demand not in sync –Monetary theory: changes in money supply by Federal Reserve –Underconsumption theory: or overproduction

Business Cycle Theories Exogenous theories: –The external demand shock theory: effect of foreign economies –War theory: war stimulates economy; peace leads to recession –The price shock theory: fluctuations in oil prices

Endogenous Starts from within the model Endo- inside, source Genous- born

Exogenous From outside of the model Exo- outside Genous- born, source

Business Cycle Theories Endogenous theories –Innovation theory –Psychological theory –Inventory cycle theory –Monetary theory –Under-consumption theory Exogenous theories –Sunspot theory –War theory 10-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycle Forecasting The Ten Leading Economic Indicators –1. Average workweek of production workers in manufacturing –2. Average initial weekly claims for state unemployment insurance –3. New orders for consumer goods and materials –4. Vendors performance (companies receiving slower deliveries from suppliers) –5. New orders for capital goods 10-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycle Forecasting (Continued) The Ten Leading Economic Indicators –6. New building permits issued –7. Index of stock prices –8. Money supply –10. Index of consumer expectations 10-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Three Key Aspects of the Economy Economic Growth Inflation Employment

The State of the Art Economic Growth Inflation Employment Long Leading, Weekly Leading, Short Leading & Coincident Services Manufacturing Construction Domestic Foreign Trade Exports Imports Trade Balance Future Inflation Gauge Home Prices Employment Non-Financial Financial Non-Mfg Mfg

Crack of the Bullwhip Around the globe, recession is being transmitted in amplified form to the more export-oriented economies Ruth Mack, a colleague of ECRI founder Dr. Geoffrey H. Moore, uncovered this link in a study of shoe, leather and hides When Mack did her study, shoes were not impulse buys but expensive products that consumers would buy in good times In not so good times, consumers would get their shoes repaired and postpone the purchase, implying that shoe demand was moderately cyclical

Crack of the Bullwhip An increase in inventories of shoes and shoe leather due to a drop in demand resulted in shoemakers reducing production and orders for leather Thus slowdown in shoe demand would result in an actual decline in the demand for leather, which is made from cattle hides This would trigger a sharp plunge in the demand for hides Thus small shifts in demand growth at the consumer level are amplified through the supply chain into big swings in demand as we move up the supply chain away from the consumer This is the BULLWHIP EFFECT because a little flick of the wrist produces a big arc at the end of the whip

Bullwhip Effect Bottom Line Contractions in the global economy are concentrated in the developed countries Economies that are heavily involved in the exports of manufactured goods will be lashed by the Bullwhip Effect and their suppliers – especially the producers of industrial commodities, including oil – will be in even worse predicaments

Keynesian View Prices and wages may be sticky … may not adjust to equilibrate markets Conduct countercyclical aggregate demand management –Business cycle largely the result of destabilizing movement in aggregate demand –New Keynesians also acknowledge aggregate supply shocks matter Government must step in to shore up aggregate demand … policy can alter the business cycle.