352 Chapter 8: Business Cycles

Two Business Cycles in Great Depression

1. A contraction from August 1929 to March 1933, followed by an expansion that peaked in May 1937 (Roosevelt instituted New Deal which led to expansions) 2. A contraction from May 1937 to June 1938 By May 1937, output/real GDP had nearly returned to its 1929 peak, but the unemployment rate was high (14%) → people eligible to work grew over time and increases in productivity allowed employment to grow more slowly than output In 1939 the unemployment rate was over 17% Great Depression ended with the start of WWII Wartime production brought the unemployment rate below 2% Real GDP almost doubled between 1939 and 1944!

Barsky and Miron's findings

1. Expenditure on durable goods vary most over the seasonal cycle and expenditures on services vary least 2. Government spending is seasonally procyclical 3. Employment is seasonally procyclical, unemployment rate is seasonally-countercyclical 4. Average labor productivity is seasonally procyclical and the real wage hardly varies over the seasonal cycle 5. Nominal money stock is seasonally procyclical Seasonal fluctuations of inventory investment, price level, nominal interest rate are much smaller than their fluctuations over the business cycle Seasonal cycle illustrates three potential source of aggregate economic fluctuations Changes in consumer demand (christmas time) Changes in productivity (construction workers become less productivity in winter weather in first quarter) Changes in labor supply (people take summer vacations in third quarter)

Average Labor Productivity and Real Wage

ALP: output per unit of labor input → tends to be procyclical (in booms workers produce more output during each hour of work than they do in recessions) Real wage: compensation received by workers per unit of time measured in real purchasing power terms A main determinant of the amount of labor supplied by workers/demanded by firms → mildly procyclical but there's controversy over this

Expansions and Contractions, what is a business cycle?

After a trough, 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 Contraction or recession: economic activity is falling Depression: when recession's particularly severe Expansion or boom: aggregate economic activity grows Trough: low point Peak: high point --> Peaks and troughs are known as turning points --> Turning points are officially designated by the NBER Business Cycle Dating Committee (a group of small economists) Business cycle: sequence of decline followed by recovery, measured from peak to peak or trough to trough is a business cycle

Aggregate supply

Aggregate supply curve shows how much output producers are willing to supply at any given price level The short-run aggregate supply curve is horizontal; prices are fixed in the short run, tendency of a producer to set a price for some time and then supply whatever is demanded at that price The long-run aggregate supply curve is vertical at the full-employment level of output, all firms will adjust their prices as necessary so as to be able to produce their normal level of output (if demand of ice cream is so high employer can't produce enough in allotted time, they might increase prices so demand is lower, owner will keep raising price as long as quantity demanded exceeds normal production capacity -In long run when prices fully adjust, aggregate quantity of output supplied will equal full-employment level of output (Y) -LRAS is vertical because price level doesn't affect employment levels, since LRAS = full-employment output

Aggregate Demand Shock

An aggregate demand shock is a change that shifts the aggregate demand curve Example: a negative aggregate demand shock (customers became pessimistic about future and reduced current consumption spending) The aggregate demand curve shifts down and to the left Short-run equilibrium occurs where the aggregate demand curve intersects the short-run aggregate supply curve; output falls, price level is unchanged Long-run equilibrium occurs where the aggregate demand curve intersects the long-run aggregate supply curve; output returns to its original level, price level has fallen (look at graph below) Economy will not stay at point F forever (new intersection point between AD and SRAS) because firms won't be content to keep producing below their normal capacity → will respond to lower demand by adjusting prices downward New long-run equilibrium at point H

What is a business cycle?

Burns and Mitchell (Measuring Business Cycles, 1946) makes five main points about business cycles: Business cycles are fluctuations of aggregate economic activity, not a specific variable There are expansions and contractions Economic variables show comovement—they have regular and predictable patterns of behavior over the course of the business cycle The business cycle is recurrent, but not periodic The business cycle is persistent

The business cycle is recurrent, but not periodic The business cycle is persistent

Business cycle is recurrent but not periodic Recurrent means the pattern of contraction- trough-expansion-peak occurs again and again Not being periodic means that it doesn't occur at regular, predictable intervals Business cycle is persistent Declines are followed by further declines; growth is followed by more growth Because of persistence, forecasting turning points is quite important

Aggregate Economic Activity

Business cycles defined broadly as fluctuations of "aggregate economic activity" rather than as fluctuations in a single, specific economic variable such as real GDP

How long does it take to get to the long run?

Classical theory: prices adjust rapidly (recession caused by aggregate supply shocks) Economy gets to its long-run equilibrium quickly (few months or less) So recessions are short-lived No need for government intervention Keynesian theory: prices (and wages) adjust slowly (recession caused by both aggregate supply/demand shocks) Adjustment may take several years So the government can fight recessions by taking action to shift the aggregate demand curve → increase purchases of goods/services (Gov purchases go up, AD shifts up to right back to AD1)

Aggregate Supply Shock

Classicals view aggregate supply shocks as the main cause of fluctuations in output (since aggregate demand shocks don't cause sustained fluctuations in output - prices/wages adjust quickly to maintain same level of output while Keynsians believe return of economy to long-run equilibrium may be slow)) An aggregate supply shock is a shift of the long run aggregate supply curve Position of LRAS curve depends on full-employment level of output, Y, so aggregate supply shocks can be thought of as factors that lead to changes in Y Factors that cause aggregate supply shocks are things like changes in productivity or labor supply Example: a negative aggregate supply shock (severe drought that greatly reduces crop yields) -Aggregate supply shock reduces full-employment output, causing long-run aggregate supply curve to shift left -New equilibrium has lower output and higher price level -So recession (adverse supply shock) is accompanied by higher price level --> Classical view: economy moves quickly from point E to point F and remains at point F (new LRAS) --> Keynesians also recognize the importance of supply shocks; their views are discussed further in Chapter 11, Keynesians agree that an adverse supply shock will reduce output and increase price level in long run

Post-WWII Business Cycles

Congress passed Employment Act of 1946 to avoid relapse into depression (required government to fight recessions/depressions) From 1945 to 1970 there were five mild contractions A very long expansion (106 months, from February 1961 to December 1969 - correlation between economic expansion and war) made some economists think the business cycle was dead But the OPEC oil shock of 1973 caused a sharp recession, with real GDP declining 3%, the unemployment rate rising to 9%, and inflation rising to over 10% → oil prices had quadrupled in 1973 causing recession, inflation shot up (though it had fallen during previous recessions) The 1981-1982 recession was also severe, with the unemployment rate over 11%, but inflation declining from 11% to less than 4% The 1990-1991 and 2001 recessions were mild and short, but the recoveries were slow and erratic

Money Growth and Inflation

Cyclical behavior is controversial as well Money growth can be acyclical (no obvious pattern) or procyclical - money growth can fall just before the onset of a recession *****Inflation is procyclical with some lag (inflation builds during economic expansion and peaks slightly after business cycle peaks and then falls until some time after the business cycle trough is reached)

Problems with Leading Indicators

Data on components of index are available promptly, but often revised later when more complete data becomes available, so the index may give misleading signals → revisions change value of the index and may even reverse a signal of a future recession The index has given a number of false warnings The index provides little information on the timing of the recession or its severity Structural changes in the economy necessitate periodic revision of the index

Expenditure

Durability is key to determining sensitivity of expenditure to business cycle Consumption expenditure on durable goods are more strongly procyclical while consumption expenditures on durable goods or consumption of services (still not as procyclical as investment expenditures) Consumption/investment are generally coincident **********Inventory/residential investment is procyclical and leading however (suppliers will predict demand) while business fixed investment is coincident Government purchases of goods/services are procyclical

Business Cycle Facts: Have American business cycles become less severe?

Economists believed that business cycles weren't as bad after World War II as they were before - business cycles generally have become less severe -The average contraction before 1929 lasted 21 months compared to 11 months after 1945 -The average expansion before 1929 lasted 25 months compared to 50 months after 1945 Romer's 1986 article sparked a strong debate, as it argued that pre-1929 data was not measured well, and that business cycles weren't that bad before 1929 New research has focused on the reasons for the decline in the volatility of U.S. output -Stock and Watson's research showed that the decline came from a sharp drop in volatility around 1984 for many economic variables; dubbed the Great Moderation -A plot of real GDP growth (text Figure 8.2) shows that the quarterly growth rate of GDP was more stable after 1984 After showing that many theories for the reduced volatility in output were not convincing, Stock and Watson found no factors that were convincing The reduction in output's volatility remains unexplained —some unknown form of good luck in terms of smaller shocks to the economy → not just due to one thing Other economic variables including inflation, residential investment, output of durable goods, output of structures appear to fluctuate less in the past 30 years than they did in the preceding 40 It is not yet clear if the Great Recession implies that the Great Moderation has ended, though the decline in volatility in 2014 suggests that perhaps the Great Moderation is continuing

The Long Boom

Extended period of economic growth beginning in 1982 and ending with recession of 2001 From 1982 to 2001, only one brief recession (not very severe), July 1990 to March 1991, not very severe Volatility of many macroeconomic variables declined sharply So, Long Boom was the first part of the period known as the Great Moderation (period of reduced volatility) Volatility: how often money is turned over Volatility declining: people don't spend as much

International Aspects of Business

Generally, most cyclical behavior of key economic variables in other economies are similar to US The cyclical behavior of key economic variables in other countries is similar to that in the United States Major industrial countries frequently have recessions and expansions at about the same time Fig. 8.13 illustrates common cycles for Japan, Canada, the United States, France, Germany, and the United Kingdom In addition, each economy faces small fluctuations that aren't shared with other countries

Seasonal cycle/business cycle

If the seasonal cycle is like the business cycle, and the seasonal cycle represents desirable responses to various factors (Christmas, the weather) for which government intervention is inappropriate, should government intervention be used to smooth out the business cycle? Some economists challenge the need for the Fed to change the money supply over the seasons ⇒ classical economists (no gov. intervention) If the Fed did not increase the money supply in the fall, for example, the seasonal demand for currency due to holiday shopping would cause interest rates to rise → natural response Some economists see the rise in interest rates as a natural phenomenon that the Fed should not prevent - But the case for seasonal monetary policy is based on preventing bank panics (as occurred frequently from 1890 to 1910) and reducing transactions costs (which arise because people expend effort to reduce money balances when interest rates rise) Not as true today (we have new technology for payments)

Long-run equilibrium

Long-run equilibrium: the aggregate demand curve intersects the long-run aggregate supply curve Factors that shift long-run aggregate supply (productivity, labor supply) Technology Supply of labor/capital → affect amount of output that economy can produce

In touch with data and research: the seasonal cycle and the business cycle

Output varies over the seasons: highest in the fourth quarter (oct-dec), lowest in the first quarter (jan-march) First quarter recession is short, output rises almost 4% in second quarter (april-june) Most economic data are seasonally adjusted to remove regular seasonal movements Seasonal adjustment allows users of economic data to ignore seasonal changes and focus on business cycle fluctuations and longer-term movements in data Barsky and Miron's 1989 study shows that the movements of variables across the seasons are similar to the movements of variables over the business cycle --> They argue that practice of seasonally adjusting macroeconomic data may throw away information that could help economists better understand the business cycle

Employment/Unemployment

Recession: employment grows slowly or falls, workers laid off, jobs become more difficult to find Employment is procyclical (more people have jobs in booms than in recessions), coincident with the cycle Unemployment is countercyclical: rises sharply in contractions and falling slowly in expansions

The American Business Cycle: The Historical Record Pre WWI

Recessions were common from 1865 to 1917 This period between the Civil War and WWI was one of rapid economic growth in US, but still had recessions

Problems with Leading Indicators: research

Research by Diebold and Rudebusch showed that the index does not help forecast industrial production in real time In real time, the index sometimes gave no warning of recessions/did not improve forecasts of industrial production Because recessions may be caused by sudden shocks, the search for a good index of leading indicators may be fruitless

Should we even care about the business cycle?

Robert lucas (U of Chicago) → no In Models of Business Cycles, Lucas says: Cost of business cycle instability since World War II is very low The cost is one-fifth the cost of having an inflation rate of 10% So if faced with the choice of eliminating all recessions and having a 10% inflation rate, or having recessions the size we've had since 1945 and having no inflation at all, Lucas argues we should take the latter He suggests that we should move toward a microeconomic view of the business cycle

Short-run equilibrium

Short-run equilibrium: the aggregate demand curve intersects the short-run aggregate supply curve Factors that shift short-run aggregate supply Expected inflation → higher expected inflation leads to an upward and leftward shift in short-run AS Price shock → supply restriction or workers pushing for higher wages lead to an upward and leftward shift in AS Persistent output gap → upward and left shift in short-run AS curve

Production

Since level of production is basic indicator of aggregate economic activity, peaks/troughs in production tend to occur at same time as peaks/troughs in aggregate economic activity Production is coincident and procyclical

Financial Variables

Stock prices are procyclical (rise in good economic times) and leading (stock prices fall in advance of a recession) ******Nominal interest rates are procyclical and lagging (bank will adjust interest rates after they see a pattern in economy) Real interest rate (adjusts for inflation) doesn't have obvious cyclical pattern (individual business cycles have different causes which have different effects on the real interest rates) --> acyclical

Comovement

Tendency of economic variables to move together in a predictable way over the business cycle (expansions or contractions occur at about the same time - output/employment in most industries tend to fall in recessions and rise in expansions) Prices, productivity, investment, government purchases have regular/predictable patterns of behavior

The Great Recession

The longest and deepest recession since the Great Depression began in December 2007 -Began with a housing crisis -Followed by a financial crisis that rivaled that of the Great Depression --> Numerous financial institutions failed or required government assistance to save them -Unemployment rose above 10% for the first time since 1982 -Fed reduced interest rates to near zero -Sluggish economic growth even after the recession ended in 2009

Aggregate demand

The model will be developed in ch 9-11 The model has 3 main components; all plotted in (P,Y) space Aggregate demand curve: C+I+G+NX Short-run aggregate supply curve Long-run aggregate supply curve Shows quantity of goods/services demanded (Y) for any price level (P) Higher P means less Aggregate Demand (lower Y), so aggregate demand curve slopes downward → means that when general price level is higher people demand fewer goods/services (not just prices of goods, but also increase in price of income of people who produce/sell these goods) → reason is discussed in chapter 9, doesn't mean higher prices directly = people can't afford to buy as much Movement along the curve with change in price → look on graph An increase in aggregate demand for any given P shifts the aggregate demand curve up and to the right or down and to the left Example: rise in stock market increases C, shifted AD curve up and to the right Example: development of more efficient capital goods will increase firms' demand for new capital goods, shifting AD to right Example: a decline in government purchases shifts aggregate demand curve down and to the left AD = C+I+G+NX

Application: The Job Finding Rate and Job Loss Rate

The probability that someone finds or loses a job in a given month changes over time The job finding rate is the probability that someone who is unemployed will find a job during the month, but that probability declines in recessions and increases in expansions The job loss rate is the probability that someone who is employed one month will become unemployed the next month (increases during recessions and decreases in expansions) An example (text Table 8.2) shows that small changes in the job loss rate may lead to larger changes in the unemployment rate than larger changes in the job finding rate → effect on job finding rate is greater than on job loss rate -Job finding rate declines substantially more than the job loss rate rises during recessions -Since the job loss rate applies to many more people, job loss is the main force in increased unemployment rates during recessions

The cyclical behavior of economic variables— direction

What direction does an economic variable move relative to aggregate economic activity? Procyclical: in the same direction Countercyclical: in the opposite direction Acyclical: with no clear pattern

Business Cycle Analysis: A Preview

What explains business cycle fluctuations? 2 major components of business cycle theories A description of the shocks (oil prices, war, weather, new inventions) A model of how the economy responds to shocks 2 major business cycle theories Classical theory Keynesian theory Study both theories in aggregate demand- aggregate supply (AD-AS) framework

The cyclical behavior of economic variables— timing

What is the timing of a variable's movements relative to aggregate economic activity? Leading: economic variable moves in advance of aggregate economic activity (peaks/troughs in leading variable occur before corresponding peaks/troughs in business cycle) - residential investment, inventory investment, average labor productivity, money growth, stock prices, inflation Coincident: variable moves at the same time - industrial production, consumption, business fixed investment, employment Lagging: peaks/troughs occur later than corresponding peaks/troughs in business cycle -inflation, nominal interest rates Timing not designated: government purchases, real wage -Some economic variables consistently lead business cycle suggests they might be used to forecast future course of economy

Great Depression and WWII

Worst economic contraction (economy falls) in the history of US Great depression: people buy stock on credit cards and were unable to pay back credit, stock market crashed, people also say it was due to the activities of the Federal Reserve ⇒ Y = C + I + G + NX (C, I, G, NX go down) -Stock market crashes, wealth effect (not as much to spend) -Consumption goes down, production is cut, unemployment rises -Federal reserve went into contractionary monetary policy Real GDP fell nearly 30% from the peak in August 1929 to the trough in March 1933 The unemployment rate rose from 3% to nearly 25% → much more significant than the 2007-2009 recession Thousands of banks failed/went out of business, the stock market collapsed, many farmers went bankrupt b/c of forced low crop prices and drought (our accounts weren't insured by federal reserve), and international trade was halted --> People withdrew money from banks, borrowers unable to pay loans forced to default

What if economic growth is "too rapid"?

refers to a situation in which aggregate demand has shifted to the right in short run: intersects SRAS1 at level of output that's greater than full-employment level of output (Y1 shifts to Y2 and price stays the same) --> associated with inflation because in the long run price will increase and SRAS curve will shift up to intersect with LRAS and AD curve (output Y2 goes back to Y1 and price will increase) this situation increases output int he short-run and increases inflation in the long-run

A surprising discovery by Barsky and Miron

there is little production smoothing Economic theory suggests that even if demand changes over the seasons, production needn't Firms could instead produce steadily through the year, building up inventories of goods in the first three quarters of the year and selling them off in the fourth quarter But Barsky and Miron find that this doesn't happen; production and sales tend to move together

In touch with data and research—coincident and leading indexes

→ leading indicators are guidance towards a recession Coincident indexes are designed to help figure out the current state of the economy: index designed to have peaks and troughs that occur about the same time as corresponding peaks/troughs in aggregate economic activity Index: single number that combines data on a variety of economic variables Leading indexes are designed to help predict peaks and troughs: designed to have peaks/troughs before corresponding peaks/troughs in aggregate economic activity The first index was developed by Mitchell and Burns of the NBER in the 1930s The Conference Board produces an index of leading economic indicators A decline in the index for two or three months in a row warns of recession danger