Macro Economics - Business Cycles

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Business Cycles

Business Cycles
► The value of real GDP over time shows periodic

fluctuations in its movement
► The business cycle refers to the periodic fluctuations

of economic activity about its long term growth trend
► The Business cycle is the more or less regular pattern

of expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth.
 At cyclical peak, economic activity is high relative to
trend

 At a cyclical trough, the low point in economic activity is reached.

The business cycle
Potential output

Real GDP

3
3
2

2
4

41

1

O
fig

Time

Trend output
4
Actual output
4

Business Cycles
► The trend path of output is the smooth path of long-

run output once its short-term fluctuations are
averaged out
► Fluctuations about the trend in real GDP.
► Potential output is the output (GDP) produced if all

the factors of production are fully employed

Business Cycles
► Economic Recession: “a period of significant decline in

total output, income, employment, and trade lasting
from six months to a year, and marked by widespread
contractions in many sectors of the economy” (NBER)
“Two consecutive quarters of declining real GDP”
- Informal definition.
► Economic Depression: is a prolonged period of severe

economic contraction/recession

Deep recession is known as Depression

Expansion and Contraction:
The Business Cycle


An expansion, or boom, is the
period in the business cycle
from a trough up to a peak,
during which output and
employment rise.

 A contraction, recession, or
slump is the period in the
business cycle from a peak down
to a trough, during which output
and employment fall. (At least two
quarters of falling real GDP)

Depression: a prolonged period of severe economic contraction

Features of Business Cycles
Variable

Recovery/
Expansion

Peak

Recession

Trough

Industrial
Production

Increase

Rapid increase Decline

Rapid decline

Prices

- do -

- do -

- do -

- do -

Cost

- do -

- do -

Gradual
decline

-do- but slower
than prices

Investment

Increase

High

Falls slowly

Falls rapidly

Employment

Gradual
increase

Rapid increase Falls

Rapid falls

Bank credit

Liberal

Very liberal

Falls

Rapid falls

Speculation

Gradual
increase

Very high

Minimum

Hardly any

Theories of Business Cycles


Various alternative theories by economists



Most prominent one is the theory based on the interaction
of accelerator and multiplier (originally developed by
Samuelson)



Multiplier theory: Given increase in investment will result in a multiple increase in income/output



Accelerator principal: An increase in income/output will
result in fresh investment



Real output cannot grow after the full employment level
output



This will act as a break on fresh investment, causing a decline in output in the next stage

Indicators of Business Cycles
There are variables other than real GDP that influence
the business cycle. They are classified into three:
(1) Leading Indicators: generally change before real GDP
changes

Can be used to forecast future output
Caution: short-run movements in the indicators can be
very misleading
(2) Coincident Indicators: tend to change at the same
time as real output changes

eg: as real output increases employment and sales rise
Ref: MB p.136

Indicators of Business Cycles
(3) Lagging Indicators: do not change until after the
value of real GDP has changed
eg: as output increases, jobs are created, more
workers are hired, and as a result unemployment falls
inflation rate of services tends to change after real
GDP changes

All these three groups of indicators are used together to
identify the peaks and troughs in business cycles.

Ref: MB p.136

Indicators of Business Cycle
Leading Indicators...
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