Chapter 8: Chapter 8 Business Cycles


Real Output of the U.S. economy: Real Output of the U.S. economy


The U.S. Unemployment Rate: The U.S. Unemployment Rate


Introduction: Introduction Since the Industrial Revolution, the economies of the US, like many other countries, have grown tremendously. Over the past 130 years, the annual real output of the US has increased by more than 100 times. The long-term economic expansion has been periodically interrupted by temporary declines in economic activities and then followed by recovery. These fluctuations are more obvious when we look at the unemployment rates.


Introduction: Introduction Aggregate Economic Activities Time Long-run Economic Growth Business Cycles


Introduction: Introduction The observed changes in aggregate economic activity can be decomposed into two parts: Long-run economic growth: the changes in economic performance over a long period of time, say between 1870 and 2007. Business cycles: temporary decline in economic activities followed by recovery.


What is a business cycle ? : What is a business cycle ? Business cycles are defined broadly as fluctuations of aggregate economic activity (not just real GDP). Other important indicators of economic activity include employment, aggregate investment, inflation rate etc. These variables often move together in a similar pattern as real output. The tendency of many economic variables to move together over the business cycle is called comovement.


What is a business cycle ?: What is a business cycle ?


What is a business cycle ?: What is a business cycle ? The period of time during which aggregate economic activity is falling is a contraction or recession. If the recession is particularly severe, it becomes a depression. During a recession, many sectors of the economy experience declining sales and production, and workers are laid off or forced to work only part-time.


What is a business cycle ?: What is a business cycle ? After reaching the low point of the contraction (the trough), aggregate economic activity begins to increase. The period of time during which aggregate economic activity grows is an expansion or a boom. The high point of the expansion is called a peak. A complete cycle is measured from peak to peak or trough to trough.


What is a business cycle ?: What is a business cycle ? Business cycles are recurrent but not periodic. These cycles are not periodic in the sense that they do not occur at regular, predictable intervals of time (in fact no one knows for sure when they will happen) they do not last for a fixed or predetermined length of time (once a cycle begins no one knows for sure when it will end).


What is a business cycle ?: What is a business cycle ? The duration of a complete business cycle can vary greatly, from about a year to more than a decade. Usually a downturn (from a peak to a trough) happens within a rather short period of time. But it may take years for the economy to recover from it and reach another peak. Business cycles are often asymmetric: the contraction period is short and sudden, the expansion period is long and slow.


Business Cycle Facts: Business Cycle Facts Business cycles are all alike in the sense that they share some common features. Similar cyclical behavior of economic variables are observed in every cycle. In particular, covemovements among economic variables is one common feature of business cycles. These comovements are what we call business cycle facts.


Business Cycle Facts: Business Cycle Facts Macroeconomists often use the cyclical behavior of real GDP as the benchmark, and compare this with the cyclical behavior of other economic variables (such as employment, consumption, investment, real wage etc.). 2 common criteria for comparisons: The direction in which a variable moves (up or down, increase or decrease) when real GDP increase. Whether the peak (or trough) of the variable happens before, after or at the same time as the peak (or trough) of the real GDP.


Cyclical Behavior of Economic Variables: Cyclical Behavior of Economic Variables An economic variable that moves in the same direction as real GDP is called procyclical. An economic variable that moves in the opposite direction to real GDP is called countercyclical. Variables that do not display a clear pattern over the business cycle is called acyclical.


Procyclical Variable: Procyclical Variable Time Real GDP Procyclical variable


Countercyclical Variable: Countercyclical Variable Time Real GDP Countercyclical variable


Acyclical Variable: Acyclical Variable Time Real GDP Acyclical variable


Cyclical Behavior of Economic Variables: Cyclical Behavior of Economic Variables An economic variable is a leading variable if it tends to move in advance of real GDP. This means the peaks and troughs in a leading variable occur before the corresponding peaks and troughs in real GDP. If an economic variable consistently leads the business cycle, then it can be used to forecast the future course of the economy.


Leading Variable: Leading Variable Time Real GDP Leading variable


Cyclical Behavior of Economic Variables: Cyclical Behavior of Economic Variables A coincident variable is one whose peaks and troughs occur at about the same time as the corresponding peaks and troughs in real GDP. A lagging variable is one whose peaks and troughs tend to occur later than the corresponding peaks and troughs in real GDP.


Business Cycle Facts (1): Business Cycle Facts (1)


Business Cycle Facts (2): Business Cycle Facts (2)


Consumption & Investment: Consumption & Investment


Consumption & Investment: Consumption & Investment P: peak of the business cycle T: trough of the business cycle Investment is strongly procyclical and coincident with the business cycle. Consumption expenditures on durable goods (such as cars, TVs) is more strongly procyclical than consumption expenditures on non-durable goods (such as food, clothing) or services (such as education).


Employment: Employment


Unemployment: Unemployment


Employment & Unemployment: Employment & Unemployment Business cycles are strongly felt in the labor market. In a recession, employment grows slowly or falls, many workers are laid off and jobs become more difficult to find. Employment is procyclical. The civilian unemployment rate is strongly countercyclical, rising sharply in contractions but falling more slowly in expansions (asymmetry).


Business Cycle Theory: Business Cycle Theory How do we explain these comovements of economic variables ? What causes business cycles ? Many theories of business cycle have been proposed in macroeconomics, the one that we consider is called the real business cycle (RBC) theory. [Chapter 10 Section 10.1, p.360-364.]


Real Business Cycle Theory: Real Business Cycle Theory The RBC theory is first developed by Nobel laureates Edward Prescott and Finn Kydland. This theory argues that productivity shocks to the economy are the primary cause of business cycles. Productivity shocks are disturbances that affect the production function, the size of the labor force, and the spending and saving decisions of consumers. They are also referred to as real shocks or supply shocks.


Real Business Cycle Theory: Real Business Cycle Theory According to the RBC economists, The economy is continuously buffeted by productivity shocks. These shocks may take the form of changes in the availability or prices of raw materials or energy, unusually good or unusually bad weather, the development of new products or production methods etc. Economic booms (recessions) result from positive (negative) productivity shocks.


Temporary Decrease in A: Temporary Decrease in A Labor Output Labor MPN


Temporary Decrease in A: Temporary Decrease in A Labor Real Wage ND1 NS w1* N2* After the shock E w2* N1* ND2


Temporary Decrease in A: Temporary Decrease in A N1* Y1* = 1000 Real output Employment Production Function (with K being held constant) N2* Y2* = 800


Temporary Decrease in A: Temporary Decrease in A FE1 Real Output Real Interest Rate Y1* = 1000 LM1 IS r* = 5% Step 2: When price adjustment is completed. E FE2 Y2* = 800 F 6% LM2 A


Explanations: Explanations Recall that in Chapter 9, we use the IS-LM-FE diagram to determine how a temporary negative productivity shock affects real output, real interest rate and price level. A temporary decrease in productivity (A) lowers the marginal product of worker and hence lowers the firm’s labor demand. In the labor market, this shifts the ND curve down and to the left. The equilibrium level of real wage and employment decrease as a result. The full-employment level of output (Y*) also decreases.


Explanations: Explanations Hence a negative productivity shock leads to a reduction in output (a recession). When real output or current income decreases, people will consume less. So consumption should decrease as well. In the IS-LM-FE diagram, the reduction in current income shifts the FE line to the left. Real interest rate increases as a result. Since investment is negatively related to real interest rate. Investment should be reduced by this.


Explanations: Explanations In order to achieve general equilibrium, the general price level has to increase. This shifts the LM curve up and to the left so that eventually it will pass through the new equilibrium point. The increase in price level means that there is inflation.


To Summarize …: To Summarize … The RBC theory predicts that when there is a temporary negative productivity shock: Full-employment level of output ↓ (recession) Real wage ↓ Employment ↓ Consumption ↓ Investment ↓ Real interest rate ↑ Price level ↑ (inflation)


To Summarize …: To Summarize … The RBC theory correctly predicts that real wage, employment, consumption, investment are procyclical. It predicts that the real interest rate should be countercyclical but data suggest that it should be acyclical. It also predicts that there should be inflation during periods of recession which is not consistent with the business cycle facts.


To Summarize …: To Summarize … Unemployment is ignored in a typical RBC model, so it cannot make any predictions on the cyclical behavior of unemployment.