1. Chapter 27 Business cycles
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2. ©McGraw-Hill Companies, 2010
The business cycle short-term fluctuations of total output around its trend path
Trend output grows steadily as productive potential increases.
Trend output
Actual output fluctuates
around this trend.
Actual
output
Output
A – slump A
B – recovery phase
has begun B
C – Boom C
D – recession under way D
E – slump again E
Time
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3. Growth of UK output and productivity, 1975–2009-6 -4 -2 2 4 6
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
The growth of output and productivity fluctuates in the short run.
Productivity and GDP
Although not perfectly regular, there is evidence of a cycle of around 5 or 6 years.
Typically, output fluctuations used to precede fluctuations in productivity by about a year, but since the mid 1990s this gap has been reduced.
During it appeared that cycles had become less pronounced, but the output fall of 2009 was the worst of the post war period.
Source: Economic Trends Annual Supplement
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4. The political business cycle
Some commentators have suggested that there is a political business cycle,
whereby governments adopt tight monetary and fiscal policy soon after an election,
but then adopt more expansionary policies as the election approaches to encourage a ‘feel-good’ factor.
Recent institutional changes to improve policy credibility – particularly central bank independence –reduce the scope for political business cycles in the future.
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5. Theories of the business cycle
The multiplier-accelerator theory:
the multiplier communicates the effects of changing investment to aggregate demand
the accelerator assumes that firms gauge future demand by reference to past output growth
this model can produce fluctuations in output level in response to a shock.
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6. The multiplier-accelerator
Invest-
ment It
Period
Yt–1 – Yt – 2
Output Yt
Period 1: Output Y1 = 100. Investment I1 = 10 - the investment needed to offset depreciation.
Period 2: Y2 rises by 20. Output increases from 100 to 120.
Period 3: I3 increases by 10 (the accelerator) → increase of 20 (from 120 to 140) in Y3 (the multiplier)
If last period’s income grew by 2x units, firms raise current investment by x units.
The multiplier is 2.
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7. The multiplier-accelerator
Invest-
ment It
Period
Yt–1 – Yt – 2
Output Yt
Period 4: I4 remains at 20 since Y3 – Y2 = 20. Thus Y4 remains at 140.
Period 5: I5 falls to 10, since Y4 – Y3 =0. This fall of 10 units in investment leads to a multiplied fall in Y5 of 20
If last period’s income grew by 2x units, firms raise current investment by x units.
The multiplier is 2.
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8. Fluctuations in stock-building
Stock-building may also be a cause of fluctuations in output.
Firms tend to use stocks to smooth production in the face of fluctuating demand.
Output per worker tends to rise in times of boom, and fall in times of recession.
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9. Fluctuations in stock-building
UK stock-building £bn -6 -5 -4 -3 -2 -1 1 2 3 4 5
2006i
2006iii
2007i
2007iii
2008i
2008iii
2009i
2009iii
During , the level of stocks fluctuated randomly.
In the first quarter of 2008, aggregate demand fell and firms were left with unsold goods.
Firms began to cut back production, reducing stocks of work in progress.
Once production had fallen more than demand, stocks start to increase again.
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10. ©McGraw-Hill Companies, 2010
Real business cycles
In this view of the world, fluctuations in actual output are fluctuations in potential output
… so there is no point in trying to stabilize output over the business cycle.
Although some swings in potential output do occur, many short-run fluctuations are more likely to reflect Keynesian departures from potential output.
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11. An interconnected world?
Annual GDP growth (%)
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Italy
Japan
France
Germany UK
USA
Output growth has been similar across countries since The dot.com bust and the financial crisis were global events.
Independent central banks have pursued rather similar monetary policies.
These patterns warn us how interdependent the leading countries have become in the modern world. Economies are becoming more open.
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12. An interconnected world? (2)
Increasingly the business cycle is transmitted from one country to another. In part by them following similar policies
The considerable integration of advanced economies prompts a further question:
are the leading emerging market economies, particularly China and India, on the way towards similar integration with the their longer-established partners?
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13. An interconnected world? (3)
Prior to the crisis, Asian economies had been growing much more quickly as they caught up with the OECD.
Annual real output growth (%) -6 -4 -2 2 4 6 8
2007
2008
2009
2010
USA EU Emerging Asia
The cyclical pattern in response to the global crisis was very similar to OECD countries, albeit from a higher baseline rate of growth.
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14. Some maths: A simple cycle
C = A +cY-1
I = a [Y-1-Y -2]
Y = C+I
Y = A +cY-1 + a [Y-1-Y -2 ] (1)
Using y to denote Y-Y*, the deviation of output from its long run level, we can subtract Y* from both sides of equation (1) to yield:
y = cy-1 + a [y-1-y -2 ] (2)
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15. Some maths: A simple cycle (2)
y = cy-1 + a [y-1-y -2 ] (2)
Depending on the values of c and a, equation (2) can yield constant cycles, damped cycles that gradually get smaller and smaller, or explosive cycles that get larger and larger.
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