1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 8 Business Cycles: An Introduction

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-2 Preview To understand the characteristics of business cycles To examine the economic data that underlie the business cycle To understand how the two schools of thought, Keynesian and classical economics, view the role of governments in the business cycle To develop a theory of business cycles and an economic model to explain those fluctuations

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-3 Business Cycle Basics Arthur Burns and Wesley Mitchell defined business cycles as fluctuations in aggregate economic activity in which many economic activities expand and contract together in a recurring, but not a periodic, fashion Economic activity typically follows a wavy line over time with four phases: –Trough –Business cycle expansion (boom) –Peak –Business cycle contraction (recession)

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-4 FIGURE 8.1 The Business Cycle

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-5 Box: Dating Business Cycles Recessions usually begin with lengthy periods of falling real GDP, but there are exceptions: –In the 2001 recession, GDP never fell more than one quarter in a row –In the most recent recession, GDP fell in 2008 even though the National Bureau of Economic Research (NBER) dates the onset of this recession as December 2007

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-6 TABLE 8.1 NBER Business Cycle Dates

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-7 Movement of Business Cycle Variables Many economic activities move together over the business cycle Co-movement of economic variables is either: –Procyclical—a variable moves up during expansions and down during contractions –Countercylcial—a variable moves down during expansions and up during contractions –Acyclical—a variable with ups and downs that do not coincide with those of the business cycle

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-8 Movement of Business Cycle Variables (cont’d) Timing relative to the business cycle: –Leading variable—reaches a peak or trough before the turning points of a business cycle –Lagging variable—reaches a peak or trough after the turning points of a business cycle –Coincident variable—reaches a peak or trough at the same time of a business cycle The Conference Board combines 10 leading variables into an index of leading indicators that economists use to forecast changes in the economy

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-9 Macroeconomics in the News: Leading Economic Indicators There are reasons to question the predictive power of the Conference Board’s monthly index of leading indicators in forecasting the business cycle: –The Conference Board regularly revises the index when more accurate data become available –The Conference Board changes components of the index over time to improve the index’s historical record –The index’s performance using real-time data at the time is far less accurate than that using revised data Leading variable

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-10 Macroeconomic Variables and the Business Cycle Real GDP: A broad measure of aggregate economic activity so that it sometimes serves as a proxy for the business cycle Real consumer spending and investment: Both are procyclical and coincident, but investment is more volatile Unemployment: The unemployment rate is countercylical Inflation: The inflation rate is procyclical and lagging the business cycle

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-11 FIGURE 8.2 Real GDP Growth, 1960- 2010

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-12 FIGURE 8.3 Consumer Spending and Investment Growth, 1960-2010 (a)

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-13 FIGURE 8.3 Consumer Spending and Investment Growth, 1960-2010 (b)

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-14 FIGURE 8.4 Unemployment Rate, 1960-2010

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-15 FIGURE 8.5 Inflation, 1960-2010

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-16 Macroeconomic Variables and the Business Cycle (cont’d) Financial variables, such as stock and bond prices, are procyclical and tend to be leading the business cycle The interest rate paid on short-term U.S. government bonds, known as Treasury bills, is both procyclical and lagging

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-17 Macroeconomic Variables and the Business Cycle (cont’d) The spread (difference in interest rates) between long-term and short-term government bonds is leading and procyclical, and it is a good predictor of recessions The spread between interest rates on corporate bonds and government bonds is countercyclical as companies are more likely to run out of money in recessions and thus have to pay higher interest rates for corporate bonds

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-18 FIGURE 8.6 Stock Prices, 1960-2010

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-19 FIGURE 8.7 Interest Rates on U.S. Treasury Bills, 1960-2010

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-20 FIGURE 8.8 Credit Spreads and Spreads Between Long and Short-Term Bonds, 1960-2010 (a)

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-21 FIGURE 8.8 Credit Spreads and Spreads Between Long and Short-Term Bonds, 1960-2010 (b)

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-22 International Business Cycles In a globalized economy, business cycles of many countries are correlated with those of the United States As financial markets throughout the world have become more integrated as well, the financial crisis in the United States during the fall of 2008 led to a global financial crisis and subsequently simultaneous economic contractions around much of the world

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-23 FIGURE 8.9 International Business Cycles, 1960-2010

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-24 A Brief History of U.S. Business Cycles The U.S. economy since 1875 can be divided into several periods: –Pre-World War I period: The U.S. emerged as a global economic power –The Interwar Period with the Great Depression: The “roaring 20s” ended with massive bank failures (when banks could not pay off depositors and other creditors and thus go out of business) that triggered the Great Depression with an unemployment rate as high as 25%

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-25 A Brief History of U.S. Business Cycles (cont’d) –Post-World War II period: High growth, low inflation and mild recessions between 1945 and 1973, followed by a period of the Great Inflation in the 1970s with double-digit inflation rates and the federal funds rate (the interest rate charged on overnight loans between banks) –The “Great Moderation” period: The period between 1984 and 2007 was an era of stability, with low volatility of real GDP and inflation –The Great Recession of 2007-2009: Sparked by defaults on subprime mortgage loans, a financial crisis in 2007 led to the 2007-2009 recession that is comparable to the Great Depression

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-26 FIGURE 8.10 Business Cycles in the United States: A Long-Term Perspective, 1890- 2009 (a)

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-27 FIGURE 8.10 Business Cycles in the United States: A Long-Term Perspective, 1890- 2009 (b)

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-28 FIGURE 8.10 Business Cycles in the United States: A Long-Term Perspective, 1890- 2009 (c)

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-29 Time Horizons in Macroeconomics The study of business cycles focuses on short-run economic fluctuations John Maynard Keynes questioned the classical view that economies moved quickly to their long-run equilibriums Stating that “in the long run, we are all dead”, Keynes argued that the primary focus of macroeconomists should be the short run The followers of Keynes, or Keynesians, also argue that the government should pursue active policies to stabilize economic fluctuations

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-30 The Short Run Versus the Long Run In the long run, prices of goods and services as well as the price of labor (wages) are completely flexible: They adjust all the way to their long-run equilibrium where supply equals demand Classical models make use of a flexible-price framework

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-31 The Short Run Versus the Long Run (cont’d) The flexible-price framework results in the classical dichotomy, in which there is a total separation between real and nominal variables Keynesian models focus on the short run when prices respond slowly to changes in supply and demand—sticky prices

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-32 TABLE 8.2 Long-Run Versus Short- Run Models

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-33 Price Stickiness There are different views of market structure that affect the views on the role of price stickiness Perfect competition versus monopolistic competition –Classical models commonly assume perfect competition in markets where buyers and sellers are price takers –Keynesians focus on the importance of market (monopoly) power in a market with monopolistic competition as firms have the ability to set prices

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-34 Sources of Price Stickiness Menu Costs –Changing prices involves many hidden costs –Collecting information is costly, so firms and households may engage in rational inattention by only making decisions about prices at infrequent intervals –Changing prices frequently may alienate customers Staggered Price Setting –Occurs when competitors adjust prices at different intervals, so that staggered prices slow down price adjustment

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-35 Empirical Evidence on Price Stickiness Empirical evidence indicates substantial price stickiness in markets Example: Alan Blinder found that only 10% of firms changed their prices as often as once a week, and close to 40% changed prices once a year and 10% less than once a year

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 8-36 Road Map For Our Study Of Business Cycles Chapters 9 to 12: Build the aggregate demand- aggregate supply (AD/AS) model with stick prices to discuss business cycle fluctuations Chapters 13 and 14: Discuss macroeconomic policy using the AD/AS model Chapter 15: Use the AD/AS model to examine how financial crises affect the business cycle Chapters 21 and 22: Incorporate the role of expectations in macroeconomic policy and discuss modern business cycle theories