Growth of Real GDP and the Business Cycle Lesson 5-1

Real Gross Domestic Product (real GDP) is the total value of all final goods and services produced in a year,adjusted to eliminate the effects of changes in prices. Nominal GDP is the total value of final goods and services produced in a year not adjusted for price changes. GDP is a measure of total national output

The business cycle is the economy’s pattern of expansion and contraction. For a number of years the economy grows, then it stops growing, or even shrinks for a period of time. Why does the Business Cycle occur. The cycles have many causes. In some ways each business cycle is unique. Much of modern economics is devoted to trying to figure out the business cycle and to ameliorate the swings. Why is this important. Last spring, nobody was talking about layoff. Now many companies have announced layoffs of thousands of workers. Why are people losing their jobs.

This downturn started because of a bit to much optimism on the part of some high tech firms. Previously these companies had lost business because they did not have the inventory and production capacity to meet demand. Determined not to make the same mistake, they bulked up on capacity and inventory but this time overestimated the demand. When sales fell short of projections, these companies had to much inventory. They cut production in order to reduce inventory to the desired level. Those sales figures that did not meet estimates and the cuts in production started the snowball rolling.

As you know, this started a stampede out of tech stocks. Panic selling caused the value of many companies to fall 50% to 80%. For example Corning, which in September was selling for over $100 a share, is now selling for $25. Lower valuation means higher borrowing costs. Higher borrowing costs mean cancelled investment projects. Cancelled projects mean less demand for the high tech products that started the decline. Less demand for high tech products starts the downward cycle over again. As you can see, downward momentum grows as one thing feeds upon another. Fortunately, the remainder of the economy appears strong so this downturn should be mild and short, but that may be small consolation to those who are losing their job.

Before we leave this topic, it is important to note the role of the federal government and the Federal Reserve in containing this business downturn. Both entities have been working hard to stop the downturn from snowballing into a major recession. Will they be successful, we don’t know yet. The specific actions taken will be the subject of much of this course.

Business Cycles and the Growth of Real GDP in the United States Exhibit 5-2 shows movements in real GDP in the United States from 1960 to 1998 graphically Real GDP grew at an average annual rate of 3 percent From 1960 to 1998, the U.S. economy experienced six recessions The average expansion has lasted 61 months and the average recession has lasted 11 months The longest expansion was from February 1961 to December 1969 until being surpassed by the expansion that began in March 1991 and has continued since.