Macroeconomic Analysis I

Topic 7

BUSINESS CYCLES

(Abel, Bernanke & Croushore: Chap 8)

 Learning Objectives

o Define and describe the business cycle

o Describe the behavior of variables over the course of the business cycles

o Use the aggregate demand and aggregate supply to describe the impact of
various shocks on business cycles

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 What Is a Business Cycle?

o U.S. research on cycles began in 1920 at the National Bureau of Economic

Research (NBER)

NBER maintains the business cycle chronology—a detailed history of

business cycles

NBER sponsors business cycle studies

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 What Is a Business Cycle?
o Burns and Mitchell (Measuring Business Cycles, 1946) makes five main
points about business cycles:

1. Business cycles are fluctuations of aggregate economic activity, not a

specific variable
2. There are expansions and contractions
3. Economic variables show comovement - regular and predictable
patterns of behavior over the course of the business cycle
4. The business cycle is recurrent, but not periodic
5. The business cycle is persistent
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 What Is a Business Cycle?

• Expansions and contractions

• Aggregate economic activity declines in a contraction or
recession until it reaches a trough (Fig. 8.1)

5
 Figure 8.1: A business cycle

peak

:
to

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 What Is a Business Cycle?

• Expansions and contractions

• 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
• Turning points are officially designated by the NBER Business
Cycle Dating Committee

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 What Is a Business Cycle?

• The 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

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 What Is a Business Cycle?

• The 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

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Table 8.1: NBER Business Cycle Turning Points and
Durations of Post-1854 Business Cycles

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 The American Business Cycle: The Historical Record

o Have American business cycles become less severe?

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

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 Business Cycle Facts

o All business cycles have features in common

o Two main characteristics of the cyclical behavior of macroeconomic

variables: direction and timing

What direction does a variable move relative to aggregate economic

activity?
Procyclical – in the same direction
Countercyclical – in the opposite direction
Acyclical – no clear pattern

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 Business Cycle Facts

o All business cycles have features in common

o Two main characteristics of the cyclical behavior of macroeconomic

variables: direction and timing

What is the timing of a variable’s movements relative to aggregate

economic activity?
Leading – in advance
Coincident – at the same time
Lagging – after

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 Business Cycle Facts
Cyclical behavior of key macroeconomics variables
o Procyclical
Coincident: Industrial production, Consumption, Business fixed
investment, Employment
Leading: Residential investment, Inventory investment, Average labor
productivity, Money growth, Stock prices
Lagging: Inflation, Nominal interest rates
Timing not designated: Government purchases, Real wage

o Countercyclical: Unemployment

o Acyclical: Real interest rates 14

Figure 8.4 Cyclical behavior of index of industrial production, 1947-2015
( pro cyclical ,
coincident

Variably
reaffirm
,

production
o

0 Ooo
0/9*0 do
oo

15
Source: Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2/series/ INDPRO.
 Figure 8.5 Cyclical behavior of consumption & investment, 1947-2015
coincident Variably
CPW cyclical ,

peak

fortnight D

- m

than
more
fast 3×85 .

\
Consumption of

tend to be
durabiegoods
more

stronglycyclical pro

than a
consumption
of non durable
-

goo_ds.IN#nt&/onsumphM
are

,
more pwcyclica
Volatile

16
Source: U.S. Bureau of Economic Analysis, National Income and Product Account Tables 1.1.3 and 1.1.5, at www.bea.gov.
 Business Cycle Facts

Cyclical behavior of key macroeconomics variables

o Volatility

Durable goods production is more volatile than nondurable goods and

services
Investment spending is more volatile than consumption

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 Figure 8.6 Cyclical behavior of civilian employment, 1955-2015
coincident variable )
( pro cyclical ,

18
Source: Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2/series/ CE16OV.
Figure 8.7 Counter-cyclical behavior of the unemployment rate, 1955-2015
Variable )
(
Strongly counter cyclical
.

19
Source: Federal Reserve Bank of St. Louis FRED databaseat research.stlouisfed.org/fred2/series/ Unrate.
 Figure 8.10 Cyclical behavior of average labor productivity and real wage, 1955Q1-2015Q1
Qaeda €

20
Source: Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2 series OPHNFB (productivity) and COMPRNFB (real wage).
Figure 8.12 Cyclical behavior of the nominal interest rate, 1947–2015
pwcyclical
.
, lagging variable )

21
Source: Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2/series/TB3MS.
 Business Cycle Analysis

International aspects of the business cycle

o The cyclical behavior of key economic variables in other countries is similar

to that in the United States

o Major industrial countries frequently have recessions and expansions at

about the same time

o In addition, each economy faces small fluctuations that are not shared with
other countries

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 Figure 8.13 Industrial production indexes in six major countries, 1960–2014

Source: OECD Main Economic Indicators, August 2012, www.oecd.org/std/oecdmaineconomicindicatorsmei.htm (with scales adjusted for clarity).
Note: The scales for the industrial production indexes differ by country; for example, the figure does not imply that the United Kingdom’s total industrial
production is higher than that of Japan. 23
 Business Cycle Analysis

What explains business cycle fluctuations?

o 2 major components of business cycle theories

A description of shocks
A model of how the economy respond to the shocks

o 2 major business cycle theories

Classical theory
Keynesian theory

o Both theories in the aggregate demand – aggregate supply (AD-AS)

framework
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 Business Cycle Analysis

The Aggregate Demand – Aggregate Supply (AD-AS) Model

o 3 main components plotted in the (P, Y) space:

Aggregate demand (AD) curve

Short-run aggregate supply (SRAS) curve

Long-run aggregate supply (LRAS) curve

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 Business Cycle Analysis

The Aggregate Demand – Aggregate Supply (AD-AS) Model

o Aggregate demand (AD) curve

Shows quantity of goods and services demanded (Y) for any given price
level (P)

Higher P means less aggregate demand (lower Y) ⇒ aggregate demand

curve slopes downward (downward sloping aggregate demand can be
derived from the IS-LM model which will be discussed in the next topic)

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 Business Cycle Analysis

The Aggregate Demand – Aggregate Supply (AD-AS) Model

o Aggregate demand (AD) curve

An increase in aggregate demand for a given P shifts the aggregate

demand curve up and to the right; and vice-versa

Example 1: A rise in the stock market increases consumption, shifting

the aggregate demand curve up and to the right

Example 2: A decline in government purchases shifts the aggregate

demand curve down and to the left

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 Business Cycle Analysis

The Aggregate Demand – Aggregate Supply (AD-AS) Model

o Aggregate supply (AS) curves

The aggregate supply curve shows how much output producers are
willing to supply at any given price level

The short-run aggregate supply (SRAS) curve is horizontal; prices are fixed
in the short run

The long-run aggregate supply (LRAS) curve is vertical at the full-

employment level of output prices fully
are
flexible .

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 Business Cycle Analysis

The Aggregate Demand – Aggregate Supply (AD-AS) Model

o Equilibrium
an
AD

Short-run equilibrium: the aggregate demand curve intersects the short-

run aggregate supply curve

Long-run equilibrium: the aggregate demand curve intersects the long-

run aggregate supply curve

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Figure 8.16 The aggregate demand–aggregate supply model

yingbuontohnlnonmgeshortoun

short run
.

; ,

are fixed
prices

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 Business Cycle Analysis

Aggregate Demand Shocks

o An aggregate demand shock is a change that shifts the aggregate demand curve

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 at ie
Price remains constant R unemployment
creates
supply
excess .

⇒ ⇒
( f)

H§NdYD
short run E →
.

Output falls Ytc 'T→Yz ) dnveltdown

⇒
wages prices Long fall ⇒ F
-

run :
,
prices

Example: A Negative Aggregate Demand Shock

Price falls Ptcp ,
→
B)
Long run :
( f → µ ) ⇒
Y remains (
constant Y=F )

• 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 • < s

• Long-run equilibrium occurs where the

aggregate demand curve intersects the
long-run aggregate supply curve;
output returns to its original level, Unemployment

price level has fallen -

~
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 Business Cycle Analysis
Aggregate Demand Shocks
o How long does it take to get to the long run?
Classical theory
Prices adjust rapidly
So recessions are short-lived
No need for government intervention
Keynesian theory
Prices and wages adjust slowly
Adjustment may take several years
So the government can fight recessions by taking action to shift the
aggregate demand curve
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 Business Cycle Analysis

Aggregate Supply Shocks

o Classical economists view aggregate supply shocks as the main cause of

fluctuations in output

o An aggregate supply shock is a shift of the long-run aggregate supply curve

o Factors that cause aggregate supply shocks are things like changes in productivity
or labor supply

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 Example: A Negative Aggregate Supply Shock
<

• 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 is accompanied by
higher price level
✓
and MY

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