eco 561 week 5

The Business Cycle

The long-run trend of the U.S. economy is one of economic growth. But growth has been interrupted by periods of economic instability usually associated with business cycles. Business cycles are alternating rises and declines in the level of economic activity, sometime over several years. Individual cycles (one “up” followed by one “down”) vary substantially in duration and intensity.

Origin of the Idea

O 26.1

Business cycles

Phases of the Business Cycle

Figure 26.1 shows the four phases of a generalized business cycle:

At a peak, such as the middle peak shown in Figure 26.1, business activity has reached a temporary maximum. Here the economy is near or at full employment and the level of real output is at or very close to the economy’s capacity. The price level is likely to rise during this phase.
Figure 26.1 The business cycle.

The Business Cycle

The long-run trend of the U.S. economy is one of economic growth. But growth has been interrupted by periods of economic instability usually associated with business cycles. Business cycles are alternating rises and declines in the level of economic activity, sometime over several years. Individual cycles (one “up” followed by one “down”) vary substantially in duration and intensity.

Origin of the Idea

O 26.1

Business cycles

Phases of the Business Cycle

Figure 26.1 shows the four phases of a generalized business cycle:

At a peak, such as the middle peak shown in Figure 26.1, business activity has reached a temporary maximum. Here the economy is near or at full employment and the level of real output is at or very close to the economy’s capacity. The price level is likely to rise during this phase.
Economists distinguish four phases of the business cycle; the duration and strength of each phase may vary.

A recession is a period of decline in total output, income, and employment. This downturn, which lasts 6 months or more, is marked by the widespread contraction of business activity in many sectors of the economy. Along with declines in real GDP, significant increases in unemployment occur. Table 26.1 documents the 9 recessions in the United States since 1950.
In the trough of the recession or depression, output and employment “bottom out” at their lowest levels. The trough phase may be either short-lived or quite long.
A recession is usually followed by a recovery and expansion, a period in which real GDP, income, and employment rise. At some point, the economy again approaches full employment. If spending then expands more rapidly than does production capacity, prices of nearly all goods and services will rise. In other words, inflation will occur.
Table 26.1 U.S. Recessions since 1950

Although business cycles all pass through the same phases, they vary greatly in duration and intensity. Many economists prefer to talk of business “fluctuations” rather than cycles because cycles imply regularity while fluctuations do not. The Great Depression of the 1930s resulted in a 27 percent decline in real GDP over a 3-year period in the United States and seriously impaired business activity for a decade. By comparison, the more recent U.S. recessions detailed in Table 26.1 were relatively mild in both intensity and duration.

Recessions, of course, occur in other countries, too. At one time or another during the past 10 years, Argentina, Brazil, Colombia, Japan, Indonesia, Mexico, Germany, and South Korea experienced recessions.

Causation: A First Glance

The long-run trend of the U.S. economy is expansion and growth. That is why the business cycles in Figure 26.1 are drawn against a trend of economic growth. A key issue in macroeconomics is why the economy sees business cycle fluctuations rather than slow, smooth growth. In terms of Figure 26.1, why does output move up and down rather than just staying on the smooth growth trend line?

Economists have come up with several theories. But before turning to them, recall that in Chapter 23 we explained that these theories are founded on the idea that fluctuations are driven by shocks—unexpected events that individuals and firms may have trouble adjusting to. Also recall that short-run price stickiness is widely believed to be a major factor preventing the economy from rapidly adjusting to shocks. With prices sticky in the short run, price changes cannot quickly equalize the quantities demanded of goods and services with their respective quantities supplied after a shock has happened. Instead, the economy is forced to respond to shocks in the short run primarily through changes in output and employment rather than through changes in prices.

That being said, economists fall into several different camps when it comes to the types of shocks they believe to be responsible for business cycles. One group, for instance, stresses supply shocks caused by momentous innovations such as the railroad, the automobile, microchips, and the Internet. They believe that major inventions like these have a large impact on investment spending and consumption spending—and therefore on output, employment, and the price level. Because such major inventions occur irregularly and unexpectedly, they contribute to the variability of economic activity.

Another school of thought sees shocks to productivity as the major cause of business cycles. When productivity unexpectedly increases, the economy booms; when productivity unexpectedly falls, the economy goes into a recession. Others view the business cycle as a purely monetary phenomenon. They say that when a country’s central bank shocks the economy by creating more money than people were expecting, an inflationary boom occurs. By contrast, printing less money than people were expecting triggers a decline in output and employment and, eventually, in the price level. Still others say that business cycles result from unexpected financial bubbles and bursts, which spill over through optimism or pessimism to affect the production of goods and services. And, finally, unexpected political events like wars or the 9/11 terrorist attacks also constitute major economic shocks to which the economy must adjust.

But whatever they see as the underlying forces driving economic shocks, most economists agree that the immediate cause of the large majority of cyclical changes in the levels of real output and employment is unexpected changes in the level of total spending. If total spending unexpectedly sinks and firms cannot lower prices, firms will find themselves selling fewer units of output (since with prices fixed, a decreased amount of spending implies fewer items purchased). Slower sales will cause firms to cut back on production. As they do, GDP will fall. And since fewer workers will be needed to produce less output, employment also will fall. The economy will contract and enter a recession.

By contrast, if the level of spending unexpectedly rises, output, employment, and incomes will rise. This is true because, with prices sticky, the increased spending will mean that consumers will be buying a larger volume of goods and services (since, with prices fixed, more spending means more items purchased). Firms will respond by increasing output. This will increase GDP. And because they will need to hire more workers to produce the larger volume of output, employment also will increase. The economy will boom and enjoy an expansion. Eventually, as time passes and prices become more flexible, prices are also likely to rise as a result of the increased spending.

Cyclical Impact: Durables and Nondurables

Although the business cycle is felt everywhere in the economy, it affects different segments in different ways and to different degrees.

Firms and industries producing capital goods (for example, housing, commercial buildings, heavy equipment, and farm implements) and consumer durables (for example, automobiles, personal computers, and refrigerators) are affected most by the business cycle. Within limits, firms can postpone the purchase of capital goods. For instance, when the economy goes into recession, producers frequently delay the purchase of new equipment and the construction of new plants. The business outlook simply does not warrant increases in the stock of capital goods. In good times, capital goods are usually replaced before they depreciate completely. But when recession strikes, firms patch up their old equipment and make do. As a result, investment in capital goods declines sharply. Firms that have excess plant capacity may not even bother to replace all the capital that is depreciating. For them, net investment may be negative. The pattern is much the same for consumer durables such as automobiles and major appliances. When recession occurs and households must trim their budgets, purchases of these goods are often deferred. Families repair their old cars and appliances rather than buy new ones, and the firms producing these products suffer. (Of course, producers of capital goods and consumer durables also benefit most from expansions.)

In contrast, service industries and industries that produce nondurable consumer goods are somewhat insulated from the most severe effects of recession. People find it difficult to cut back on needed medical and legal services, for example. And a recession actually helps some service firms, such as pawnbrokers and law firms that specialize in bankruptcies. Nor are the purchases of many nondurable goods such as food and clothing easy to postpone. The quantity and quality of purchases of nondurables will decline, but not so much as will purchases of capital goods and consumer durables. ( Key Question 1)

Quick Review 26.1
The typical business cycle goes through four phases: peak, recession, trough, and expansion.
Fluctuations in output and employment are caused by economic shocks combining with sticky prices.
Sources of shocks include unexpected innovations, unexpected changes in productivity, unexpected changes in the money supply, unexpected changes in the level of total spending in the economy, and financial crises.
During a recession, industries that produce capital goods and consumer durables normally suffer greater output and employment declines than do service and nondurable consumer goods industries.