MACROECONOMICS

AND THE GLOBAL BUSINESS ENVIRONMENT

2nd edition

Business Cycles

1
PowerPoint by Beth Ingram
University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.
14-2

Key Concepts
 Business Cycle characterization
 Recessions and Depressions
 Frisch-Slutsky Paradigm
 Real Business Cycle Theory
 Keynesian Theory
14-3

Business Cycle
 Deviation from trend growth (i.e. fluctuations
in GDP around its trend)
Business Cycle

10500.0

9500.0
Billions of 2000 Dollars

8500.0

7500.0

6500.0

5500.0

4500.0

3500.0

2500.0

1500.0
Jan-49

Jan-73

Jan-77
Jan-53

Jan-57

Jan-63

Jan-67

Jan-71

Jan-75

Jan-83

Jan-87

Jan-93

Jan-97

Jan-03
Jan-51

Jan-61

Jan-79
Jan-81

Jan-91

Jan-01
Jan-55

Jan-65

Jan-85

Jan-95
Jan-59

Jan-69

Jan-89

Jan-99
Potential Real GDP Actual Real GDP
14-4

Business Cycle
 Trend GDP: for a given level of capital, labor, and
technology a certain amount of GDP can be
sustainably produced
 Above trend: labor and/or capital being more
intensively used…unsustainable
 labor must eventually rest or be paid premium (e.g.
overtime)
 capital wears out and breaks down
 Below trend: labor and/or capital not being fully
used.
 eventually employ more capital and/or labor
14-5

Business Cycle
 Output Gap: difference between actual and
potential (trend) GDP
 Positive output gap: excess demand =>
upward price pressures
 Negative output gap: excess supply (capacity)
=> downward price pressure
 Note: you can have negative output gap and
positive growth => “growth recession”
 14-6

Percent Deviation from Potential Growth

Ja
n-
8

-8.00%
-6.00%

-10.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
Ja 0
n-
Ja 81
n-
8
Ja 2
n-
8
Ja 3
n-
8
Ja 4
n-
8
Ja 5
n-
8
Ja 6
n-
8
Ja 7
n-
8
Ja 8
n-
8
Ja 9
n-
9
Business Cycle

Ja 0
n-
Ja 91
n-
9
Ja 2
n-
9
U.S. Output Gap

Ja 3
n-
9
Ja 4
n-
9
Ja 5
n-
9
Ja 6
n-
9
Ja 7
n-
9
Ja 8
n-
9
Ja 9
n-
0
Ja 0
n-
Ja 01
n-
0
Ja 2
n-
0
Ja 3
n-
04
14-7

Stages of the Business Cycle

14-8

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.”
14-9

Business Cycle Example

The U.S. Great Depression
500

450

400
Billions of 1972 Dollars

350

300

250

200

150

100
M M M M M M M M M M M M M M M M M M M M M
ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar
-1 - - - - - - - - - - - - - - - - - - - -
92 192 192 192 192 192 192 192 193 193 193 193 193 193 193 193 193 193 194 194 194
2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2

Real GDP Linear (1922-1929 Trend)

14-10

Business Cycle Example

Economic Activity
Share of World
GDP GDP Loss
(1931, Percent) Peak Trough (Percent)
United States 42.4 1929 1933 -29.4
United Kingdom 13.1 1930 1931 -0.5
Germany 9.5 1928 1932 -26.3
France 7.9 1932 1935 -10.4
Italy 5.4 1928 1933 -13.7
Japan 5.1 1930 1933 -14.9
Spain 4.2 1929 1931 -6.3
Canada 2.5 1929 1933 -29.7
Netherlands 2.1 1930 1934 -14.2
Switzerland 2 1930 1932 -6.5
Sweden 1.6 1930 1933 -12.1
Australia 1.4 1926 1931 -24.9
Denmark 1.1 1930 1932 -4.4
Norway 0.9 1930 1931 -8.0
Finland 0.5 1928 1931 -7.2
Portugal 0.4 1935 1936 -0.7
14-11

Co-movement Across World

Real GDP
7

5
Annual Percent Growth

03
04
02
00

01

05
84

93
94
82
80

81

87
85

92
90

91

97
88

95
83

86

89

98
96

99
19
19

20
19
19

19
19
19

19

19

20
19

19

20
19
19
19

20

20
19

19

19
19
19
19

20
Advanced economies Other emerging market and developing countries World (All WEO countries)
14-12

The Changing U.S. Business Cycle?

14-13

Business Cycle Paradigm

Impulse/Shock Propagation Business Cycle

14-14

Business Cycle Paradigm

Shocks
 monetary and fiscal shocks
 consumption and investment shocks
 technology shocks
 external shocks: (1) exchange rate shock
(2) terms of trade shocks
 financial system shock
14-15

Fluctuations
 Increase in aggregate demand
 Increase in C, I, G, NX
 Increases prices and output
 Increase in aggregate supply
 Increase in labor, capital, TFP
 Decreases prices and increases output
14-16

Aggregate Demand Aggregate Supply Model

 Aggregate Demand Curve
 Inverse relationship between price level and real
output: downward slopping
 Real Balance Effect

 Interest Rate Effect

 Exchange Rate Effect

 Short Run Aggregate Supply Curve

 Positive relationship between price level and real
output: upward slopping
 sticky input prices, sticky output prices, misperceptions
 Long Run Aggregate Supply Curve
 Real output independent of price level: vertical
 Fundamentals—resources, productivity, trade—only
matter
14-17

Real Business Cycle Theory

 Both growth and business cycles are caused
by aggregate supply shocks
 Business cycles are outcome of optimizing
market mechanism
 aggregate demand is endogenous
 No role for government in changing the
nature of business cycles
14-18

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.