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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT

Business Cycles

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth IngramUniversity of Iowa

2nd edition

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Key Concepts

Business Cycle characterization Recessions and Depressions Frisch-Slutsky Paradigm Real Business Cycle Theory Keynesian Theory

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Business Cycle Deviation from trend growth (i.e. fluctuations

in GDP around its trend)Business Cycle

1500.0

2500.0

3500.0

4500.0

5500.0

6500.0

7500.0

8500.0

9500.0

10500.0

Jan-4

9

Jan-5

1

Jan-5

3

Jan-5

5

Jan-5

7

Jan-5

9

Jan-6

1

Jan-6

3

Jan-6

5

Jan-6

7

Jan-6

9

Jan-7

1

Jan-7

3

Jan-7

5

Jan-7

7

Jan-7

9

Jan-8

1

Jan-8

3

Jan-8

5

Jan-8

7

Jan-8

9

Jan-9

1

Jan-9

3

Jan-9

5

Jan-9

7

Jan-9

9

Jan-0

1

Jan-0

3

Billion

s of

2000 D

olla

rs

Potential Real GDP Actual Real GDP

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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

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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”

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Business Cycle

U.S. Output Gap

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

Jan-

80

Jan-

81

Jan-

82

Jan-

83

Jan-

84

Jan-

85

Jan-

86

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Per

cent D

evia

tion fro

m P

ote

nti

al G

row

th

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Stages of the Business Cycle

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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.”

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Business Cycle Example

The U.S. Great Depression

100

150

200

250

300

350

400

450

500

Mar-1922

Mar-1923

Mar-1924

Mar-1925

Mar-1926

Mar-1927

Mar-1928

Mar-1929

Mar-1930

Mar-1931

Mar-1932

Mar-1933

Mar-1934

Mar-1935

Mar-1936

Mar-1937

Mar-1938

Mar-1939

Mar-1940

Mar-1941

Mar-1942

Billion

s of

197

2 D

olla

rs

Real GDP Linear (1922-1929 Trend)

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Business Cycle Example

Share of World GDP

(1931, Percent) Peak TroughGDP Loss(Percent)

United States 42.4 1929 1933 -29.4United Kingdom 13.1 1930 1931 -0.5Germany 9.5 1928 1932 -26.3France 7.9 1932 1935 -10.4Italy 5.4 1928 1933 -13.7Japan 5.1 1930 1933 -14.9Spain 4.2 1929 1931 -6.3Canada 2.5 1929 1933 -29.7Netherlands 2.1 1930 1934 -14.2Switzerland 2 1930 1932 -6.5Sweden 1.6 1930 1933 -12.1Australia 1.4 1926 1931 -24.9Denmark 1.1 1930 1932 -4.4Norway 0.9 1930 1931 -8.0Finland 0.5 1928 1931 -7.2Portugal 0.4 1935 1936 -0.7

Economic Activity

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Co-movement Across World

Real GDP

0

1

2

3

4

5

6

7

1980 19

8119

8219

8319

8419

8519

8619

8719

8819

8919

90 1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Annua

l Per

cent G

row

th

Advanced economies Other emerging market and developing countries World (All WEO countries)

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The Changing U.S. Business Cycle?

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Business Cycle Paradigm

Impulse/ShockImpulse/Shock PropagationPropagation Business CycleBusiness Cycle

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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

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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

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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

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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

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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.