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Business cycles

Explain the difference between the short and long run in macroeconomics.

Understand what happens during a business cycle.

Explain how economists think about business cycles.

Use the AD & AS model to explain the business cycle.

Derive the formula for the expenditure multiplier.

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Learning Objectives
After studying this chapter, you should be able to:
9.1
9.2
9.3
9.4
9.A

Is the housing cycle the business cycle?

What caused the recession of 2007-2009, the worst recession (hopefully) of our lifetimes?

Short answer: the bursting of an epic housing bubble.

Ed Leamer (UCLA): Fluctuations in spending on new residential housing are the main reason for the business cycle.

Certainly, not all economists agree.

But housing definitely plays an important role in business cycles, beyond its (at best) 6% share of GDP.

Why? Spending on housing fluctuates a lot, and prices of houses are inflexible downwards.

Business cycles were not always a focus of macroeconomics.

Emphasis started after Great Depression of the 1930s.

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Economies around the world experience a business cycle.

Does the business cycle impose significant costs on the economy?

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Key Issue and Question

Issue:

Question:

Explain the difference between the short run and the long run in macroeconomics.

9.1

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Learning Objective

The short run and the long run in macroeconomics

We will start off with some definitions:

Potential GDP The level of real GDP attained when firms are producing at capacity and labor is fully employed.

Business cycle Alternating periods of expansion and recession.

Expansion The period of a business cycle during which real GDP and employment are increasing.

Recession The period of a business cycle during which real GDP and employment are decreasing.

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The short run and the long run in macroeconomics

Two Facts about the business cycle:

Unemployment rises—and employment falls—during a recession and unemployment falls—and employment rises—during an expansion.

Real GDP declines during a recession, and real GDP rises during an expansion.

Market clearing is often assumed for simplification, so prices rise to eliminate shortages and fall to eliminate surpluses.

However, prices do not continually adjust and all markets are not cleared all the time.

Unemployment and production below capacity do not affect long-run output but play an important role in short run output.

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The Keynesian approach

Keynesian economics The perspective that business cycles represent disequilibrium or nonmarket-clearing behavior.

Keynes argued in The General Theory of Employment, Interest, and Money that high levels of unemployment and low levels of output represented a disequilibrium.

Cyclical employment in the Keynesian view is involuntary unemployment, and the decline in output occurs even though firms would like to produce more at prevailing prices.

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The Classical approach

Classical economics The perspective that business cycles can be explained using equilibrium analysis.

The classical view is that the labor market and goods markets are in equilibrium during recessions.

Due to voluntary decisions of households to supply less labor.

Firms voluntarily supply fewer goods and produce less.

The majority of economists believe the basic Keynesian view is correct.

Different explanations persist.

New classical macroeconomists still believe the equilibrium or classical view is correct.

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Macroeconomic shocks and price flexibility

Macroeconomic shock An unexpected exogenous event that has a significant effect on an important sector of the economy or on the economy as a whole.

Classical and Keynesian economists see cycles as responses of firms and households to macroeconomic shocks.

Collapse of the housing bubble, IT innovation, or increases in oil prices might be considered shocks.

more quickly.

During 2004-2006 residential construction was more than 6% of GDP.

By 2009, about 2.5% of GDP was residential construction.

About a $470-billion-dollar annual shift.

More than 2 million workers would need to change industries.

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Stickiness of prices in the short run

In microeconomic analysis, we see markets adjusting to changes in demand and supply through changes in prices.

In the short run, prices and wages may not adjust quickly to a macroeconomic shock.

In the short run, nominal prices and nominal wages are “sticky”, while in the long run, nominal prices and nominal wages are flexible.

Keynesian economists initially focused on nominal wage stickiness, because that is what Keynes emphasized in The General Theory.

In recent years, new Keynesian economists have shifted focus to nominal price stickiness.

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Why are prices sticky in the short run?

Two factors cause price stickiness:

Most firms are in imperfectly competitive markets with some control over their own price.

Menu costs involved in changing prices.

Menu costs The costs to firms of changing prices.

Firms lower prices following declines in demand if benefit is greater than the cost.

Many economists believe:

“Sticky” wages and prices are not fully flexible in the short run, but do adjust completely in the long run.

Sticky wages and prices refer to nominal wage and prices.

Nominal price and wage rigidity or nominal price and wage stickiness.

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How long are prices and wages sticky?

Cost of raising prices can be thought of as the cost of determining how a firm responds to a macroeconomic shock.

Firms need to spend time changing prices or reprinting catalogs.

Customers may be angered by price increases.

Long-term contracts make it difficult for firms to raise prices.

Most firms in the U.S. and W. Europe change prices once or twice per year.

Service sector changes prices less frequently.

Firms more likely to change prices as a result of shocks to their sector than shocks to the aggregate economy.

Long-term labor contracts explain sticky wages.

Difficult to renegotiate.

Implicit contracts are not formal.

Employers raise wages less in expansions and cut wages less in recessions.

Employers may retain their best workers with efficiency wages.

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The curious case of the 5-cent bottle of Coke

Prices for many firms typically fully adjust within a year or two.

From 1886 to 1955 Coca-Cola maintained a price of $0.05 per 6.5 oz. bottle.

The Great Depression, Prohibition, two World Wars, and severe recessions occurred.

Price of sugar tripled.

Structure and technology changed in industry.

Daniel Levy and Andrew T. Young argue three factors account for price rigidity.

From 1899 to 1921, Coca-Cola was contracted to sell syrup at $0.92 per gallon. After 1921, the syrup price fluctuated.

Technology of vending machines could only accept a single coin.

Firm felt it was important that consumers could buy a Coke with a single coin.

Ultimately, by late 1950s, Coke dropped its 5-cent strategy.

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Making the Connection

Explain what happens during a business cycle.

9.2

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Learning Objective

What happens during a business cycle?

During a business cycle, macroeconomic shocks push real GDP away from potential GDP.

Economists examine three large shocks that occurred during 2007–2009.

Financial crisis.

Housing bubble collapse.

Large increase in the price of imported oil.

Actual GDP pushed away from potential GDP.

Growth of real GDP fell from 1.7% in Q4 of 2007 to –8.9% in Q4 2008.

Shocks were global in nature.

Euro countries witnessed declines from 1.6% growth in Q4 2007 to –6.8% in Q4 2008.

Declining real GDP is accompanied by falling employment.

The long-term unemployed can experience severe hardship, bankruptcies, and economic decline.

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An idealized and an actual business cycle

In panel (a), we see an idealized business cycle. The economy moves from expansion to recession and back to expansion.

Real GDP rises during expansions and contracts during recessions.

Panel (b) examines the 2007-2009 recession period in the U.S.

Real GDP has not returned to potential well into expansion.

The business cycle

Figure 9.1

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Fluctuations in real GDP over time

Annual percentage changes in real GDP were more severe before 1950 than after.

Eight years with 3% or greater declines before 1950, and none after.

“Great Moderation” period after early 1980s witnessed two mild recessions.

Fluctuations in real GDP, 1901-2011

Figure 9.2

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The changing severity of the U.S. business cycle

Great Moderation business cycle contractions were shorter and milder than those before the mid-1980s.

Expansion length increased, while recession length decreased after 1950.

Expansions were more than six times as long as recessions after 1950.

2007-2009 recession was 18 months long, the longest since the Great Depression.

Until 2007, the business cycle had become milder. (Note: WWI and WWII omitted)

Table 9.1

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Possible expansions for more stable macroeconomy

Increasing importance of services, and declining importance of goods.

Sectoral shifts

The establishment of unemployment insurance and other government transfer programs that provide funds to unemployed.

Safety nets did not exist before the Great Depression.

Active federal government policies to stabilize the economy.

Public opinion favored government intervention after Great Depression.

The increased stability of the financial system.

Great Depression associated with financial system instability.

Reduction in wealth and difficulty obtaining credit.

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How do we know the economy is in expansion/recession?

The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) determines the official beginning and end of recessions.

Significant decline in economic activity spread across the economy.

Lasting more than a few months.

Visible in production, employment, real income, and other indicators.

Recessions begin at peak in economic activity and end at trough.

Between trough and peak economy is expanding.

Delayed: For example, December 2007 business cycle peak announced in December 2008.

Rule of Thumb often quoted but not true: Two consecutive quarters of negative GDP.

Peaks and troughs are announced for specific months, not quarters.

Monthly data on payroll employment, industrial production, real personal income, real manufacturing production, wholesale and retail sales, and monthly estimates of real GDP.

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Measuring business cycles

Output gaps measure how fully the economy is employing its resources.

Output gap The percentage deviation of actual real GDP from potential GDP.

Actual real GDP is composed of potential real GDP and the deviation from potential real GDP.

Since potential GDP grows over time, economists measure fluctuations as percentage deviations of actual real GDP from potential real GDP.

In Q1 2012, real GDP was $13,491 billion and potential GDP was $14,270 billion.

Deviation from potential was -5.5%.

(

If output gap is zero, economy is producing at maximum sustainable level.

If gap is negative, economy producing below potential.

If gap is positive, the economy is producing at an unsustainable level.

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Dating U.S. recessions

You may have heard a recession defined as two consecutive quarters of negative real GDP growth. In fact, though, the NBER does not this rule of thumb in dating recessions.

According to the NBER, the U.S. economy was in a recession from March 2001 to November 2001. The following table shows the growth rate of real GDP for the United States around the time of the recession.

Use the rule of thumb to date the beginning and end of the 2001 recession.

Based on the rule of thumb, did the United States experience a recession in 2001?

Why is there a difference with the NBER dates?

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Solved Problem

Dating U.S. recessions

Step 1 Review the chapter material.

Step 2 Use the rule of thumb to determine if a recession occurred. While the economy slowed down in 2001, the two quarters of negative growth were not adjacent; therefore there was no recession, according to the rule of thumb.

Step 3 Explain why there is a difference between the rule of thumb and NBER dates. The NBER defines a recession as “a significant decline in economic activity… lasting more than a few months.” In determining whether a recession occurred, the NBER looks at many data series, not just real GDP. So it is possible that the NBER can declare a recession, even if the rule of thumb is not satisfied.

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Solved Problem

The U.S. output gap

During a recession, real GDP declines below potential GDP: a negative output gap.

Eventually, as the expansion continues, real GDP will rise above potential GDP: a positive output gap.

Shaded areas on the graph represent recession.

The output gap for the United States, 1949-2012

Figure 9.3

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Costs of the business cycle

Should we care about the business cycle?

After all, while real GDP is sometimes below potential, it is sometimes above potential also.

Effects of economic growth over time are larger than business cycle effects.

But business cycles have large costs on workers and firms.

Recent research suggests the business cycle may actually affect the level of potential GDP also.

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Okun’s Law and unemployment

When real GDP falls below potential GDP during a recession, firms lay off workers—the unemployment rate rises.

This is cyclical unemployment. We can measure how much of unemployment is due to cyclical unemployment by calculating the cyclical unemployment rate:

Cyclical unemployment rate The difference between the actual unemployment rate and the natural unemployment rate.

Okun’s law A statistical relationship discovered by Arthur Okun between the cyclical unemployment rate and the output gap.

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Predicted cyclical unemployment from Okun’s Law

Okun’s law does a good job of expressing how the output gap and cyclical unemploy-ment are related.

Shaded areas represent recessions.

Actual and predicted cyclical unemployment rates, based on Okun’s Law

Figure 9.4

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Did the 2007-2009 recession break Okun’s law?

In early 2009, Christina Romer, who was then chair of the President’s Council of Economic Advisers, and Jared Bernstein, economic adviser to Vice President Joe Biden, predicted that if a stimulus package was passed including higher spending and tax cuts, unemployment would peak at 8% in Q3 2009 and then decline.

The stimulus was passed, and unemployment subsequently was 9.6% in Q3 2009, and rose to 9.9% in Q4 2009, before beginning to fall slowly: 9.6% in Q4 2010, <9.0% in October 2011, 7.8% in September 2012.

Unemployment was significantly higher than predicted from the size of the output gap given Okun’s law.

Okun’s law generally does a good job of predicting changes in the unemployment rate.

Why did it fail this time?

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Making the Connection

Did the 2007-2009 recession break Okun’s law?

Cyclical unemployment should have been 1% lower than it actually was in mid-2009.

Gap between actual cyclical unemployment and Okun’s law prediction widened to 1.5% in late 2009 and early 2010.

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Making the Connection

Did the 2007-2009 recession break Okun’s law?

What explains the relatively poor performance of Okun’s law over this period?

Some economists point to rising labor productivity.

Firms chose to make the same amount of output with fewer workers.

By the end of Q4 2011, Okun’s law was overestimating cyclical unemployment.

Firms may have originally thought the recession would be even worse, and laid off too many workers.

Some economists argue that changes in the labor market may account for problems with Okun’s law:

Decrease in unionization, increase in temporary employment.

Okun’s law was also relatively inaccurate after 1981-1982 recession.

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Making the Connection

The costs of the business cycle to workers

While cyclical unemployment falls and household incomes rise during expansions, the costs of the business cycle for workers may not average out across the cycle:

Recessions and expansions may not have same magnitude.

Long periods of unemployment cause skills to deteriorate, possibly enough to result in structural unemployment. This could result in hysteresis, a period of increased natural rate of unemployment.

Unemployment and lost income from recessions are concentrated among low-income workers.

Negative effects of recession on workers can last many years; for example, graduating during a recession hurts wage and job prospects for up to 15 years.

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The effect of the business cycle on inflation

As actual GDP increases relative to potential and resources become fully employed, it becomes difficult for firms to find idle labor, capital, and resources.

Prices of inputs rise in expansions; firms pass along cost increases in the form of higher prices, increasing inflation.

High and/or variable inflation makes the economy less efficient, and can discourage capital accumulation.

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Links between business cycles and growth

Business cycles may affect the balanced growth path of real GDP.

If investment rate changes in Solow growth model, the level of real GDP along balanced growth path changes.

Uncertainty of business conditions affects firms’ decisions to invest.

Difficulty knowing if new investments will be profitable.

Difficulty estimating scope of investment.

Garey Ramey and Valerie Ramey found average growth rates of real GDP are lower for countries with more severe business cycles.

Gadi Barlevy estimates eliminating business cycles would result in increased growth rates of 0.4% per year.

Small changes in growth rates become very large differences in the standard of living in the long run.

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Movements of economic variables during business cycle

Real GDP in the current time period is not observable. So how can we make predictions about what will happen over time?

Can look at past behavior of real GDP

Can look at variables that are correlated with real GDP.

Economic variables can be positively or negatively correlated with GDP; these are referred to as procyclical variables and countercyclical variables.

Procyclical variable An economic variable that moves in the same direction as real GDP—increasing during expansions and decreasing during recessions.

Countercyclical variable An economic variable that moves in the opposite direction as real GDP—decreasing during expansions and increasing during recessions.

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Leading indicators

Leading indicators Economic variables that tend to rise and fall in advance of real GDP.

Movements of economic variables relative to real GDP—leading indicators

Table 8.2a

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Coincident and lagging indicators

Coincident indicators Economic variables that tend to rise and fall at the same time as real GDP.

Lagging indicators Economic variables that tend to rise and fall after real GDP.

Movements of economic variables relative to real GDP—coincident and lagging

Table 8.2b

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The global business cycle

The U.S., Japan, and Euro countries are related but not perfectly synchronized.

Synchronization occurs because of trade between countries.

Synchronization may also occur because of global shocks like oil price shocks.

The international business cycle, 1965-2011

Figure 9.5

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Explain how economists think about business cycles.

9.3

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Learning Objective

Shocks and business cycles

Some shocks affect many markets at once.

Organization of Petroleum Exporting Countries (OPEC) instituted an oil embargo in 1973.

Households faced higher gas prices, leading to reduced consumption.

Firms faced higher fuel costs and input costs.

Financial shocks such as the “dot.com bubble” collapse and the 2007-2009 credit crisis led to changes in consumption and investment decisions.

Also natural disasters, like Hurricane Katrina (though it was not severe enough to cause a recession).

Shocks have ripple effects in the economy.

Shocks to stock market values negatively affect wealth.

If nominal prices and wages are flexible, markets absorb shocks.

If nominal wages and prices are sticky, quantities in individual markets respond to shocks, reverberating through economy.

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Multiplier effects

The effects of shocks are amplified through multiplier effects:

Multiplier Effect A series of induced increases (or decreases) in consumption spending that results from an initial increase (or decrease) in autonomous expenditure; this effect amplifies the effect of economic shocks on real GDP.

Autonomous expenditures refers to to spending that does not depend on income:

Government purchases or taxes

Consumer spending related to consumer confidence

Investment spending about confidence in profitability

Idea of multiplier effect: $1 in consumption becomes $1 in income; some percentage of that income is saved, and the rest is spent, becoming additional income, etc.

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Multiplier effect in action

Suppose households save 10% of income, spending the rest.

Some shock causes spending to increase by $1 billion.

That $1 billion goes as income; then 90% of it ($900 million) is spent again, becoming income once more.

Then 90% of that $900 million is spent ($810 million), …

Overall, the $1 billion in increased spending will result in $10 billion in increased consumption. (Note: this effect is proved in the appendix to this chapter.)

For this effect, the source of the shock doesn’t matter.

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Shock

Spending response by households and firms

Multiplier effect

Change in real GDP

How big is the multiplier?

The multiplier measures how large of a change in real GDP we get, when a shock occurs.

Multiplier The change in equilibrium GDP divided by the change in autonomous expenditure.

Multipliers are not really as large as 10, partly because of the effects of taxes and expenditures on imports. The table shows the effect of a 1-percentage-point increase (shock) to autonomous expenditures, relative to potential GDP:

Multiplier estimate for the United States

Table 9.3

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An example of a shock with multiplier effects

We can illustrate the multiplier effect by looking at the effects of the bursting of the housing bubble during the 2000s.

Estimated decline in real estate value of $2,330 billion from Q1 2007 to Q1 2008.

$1 change in real estate wealth, changes consumption by $0.07.

Initial change in total consumption: -$2,330 billion x 0.07 = -$163 billion

2008 potential GDP was $13,423 billion. So this was a shock of size:

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The bursting of the housing bubble

According to the table from earlier, a -1.2% shock to real GDP should reduce expenditures in the first year by:

Real GDP was 0.7% above its potential level in 2007, so ceteris paribus, we would expect real GDP to fall below potential in 2008.

As time goes on, we expect the effect of the reduction in housing wealth to fade. Per the table:

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Use the aggregate demand and aggregate supply model to explain the business cycle.

9.4

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Learning Objective

A simple of model of the business cycle: AD & AS

We will develop more detailed models in the following chapters; but the aggregate demand and aggregate supply model, or AD-AS model, can help us understand some key facts about the business cycle.

The aggregate demand-aggregate supply model

Figure 9.6

Three components:

Aggregate demand (AD) curve: Shows the relationship between aggregate price level and total domestic expenditure.

Short-run aggregate supply (SRAS) curve: Shows the relationship between aggregate price level and firms’ intended production.

Long-run aggregate supply (LRAS) curve: Shows the long-run equilibrium (potential, full employment) level of GDP.

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Why does aggregate demand slope downward?

The AD curve resembles a regular demand curve; but it does not slope downward for the same reasons. It slopes downward because of:

The wealth effect: As the price level increases, the real value of household wealth declines, reducing consumption.

The interest rate effect: At higher price levels, the demand for money increases, causing an increase in the interest rate. At higher interest rates, firms and households invest less.

The international trade effect: High price levels in the U.S. relative to foreign countries make our exports expensive, and our imports cheap. So net exports fall. Also, higher interest rates might increase demand for the $U.S., again causing a decline in net exports.

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The aggregate supply curves

The short-run aggregate supply curve describes firms’ production decisions when the price level is constant.

It is horizontal, implying firms supply whatever level of output is demanded.

In the long run, prices will adjust to relatively high or low level of demand.

The long-run aggregate supply curve shows that, when prices are perfectly flexible (i.e. in the long run), firms will produce at the level of potential GDP.

Since we have two different aggregate supply curves, we have two different equilibria: a short-run equilibrium, and a long-run equilibrium.

In the figure from a couple of slides ago, the two equilibria occurred at the same point. But this is not necessarily the case.

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Aggregate supply shocks and the business cycle

An aggregate supply shock is a shock affecting firms’ costs of production.

Example: An increase in oil prices causes many firms’ costs of production to increase.

Negative aggregate supply shock

Figure 9.7

This is a negative aggregate supply shock, and it would cause the SRAS curve to shift up.

(A positive aggregate supply shock results in costs of production falling. The SRAS curve would shift down.)

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Aggregate supply shocks and the business cycle

As a result of the negative aggregate supply shock, the price level rises.

But real GDP decreases below potential GDP.

The cyclical unemployment rate rises, and downward pressure exists on wages.

Negative aggregate supply shock

Figure 9.7

Eventually, wages will fall in order to clear the labor market.

Thus the price level will fall, shifting the SRAS curve back down.

The economy has a automatic mechanism to return real GDP to potential GDP in the long run.

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Aggregate demand shocks and the business cycle

An aggregate demand shock is a shock affecting autonomous expenditure, like firm and household investment or autonomous consumer spending.

Example: Firms become pessimistic about the economy and decrease their investment spending.

Negative aggregate demand shock

Figure 9.8

This is a negative aggregate demand shock, and it would cause the AD curve to shift left.

(A positive aggregate demand shock results in costs of production falling. The AD curve would shift right.)

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Aggregate demand shocks and the business cycle

As a result of the negative aggregate demand shock, the economy is again producing below potential GDP; there is cyclical unemployment.

As with a negative aggregate supply shock, nominal wages will eventually decrease, shifting SRAS down.

Negative aggregate demand shock

Figure 9.8

The new long-run equilibrium is not the same as before. It occurs back at potential GDP, but at a lower price level.

Again, the automatic mechanism restores real GDP to its potential.

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Should policy try to offset shocks?

How long does it take for the automatic mechanism to bring the economy back to potential GDP following a shock?

Most economists (including new Keynesians) believe this happens slowly: nominal wages and prices are sticky in the short run.

They believe it may take several years to return to potential after a negative shock.

If they are right, strengthens the argument for government policy to reduce the severity of the business cycle.

Some economists (including classical economists) believe nominal wages and prices adjust quickly.

They believe fluctuations in real GDP are mostly due to movements in potential GDP.

Therefore little role for government policy.

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How important is housing in the business cycle?

Recall that according to Ed Leamer at UCLA, “housing is the business cycle”.

The graph shows recessions (shaded) and spending on residential construction. Spending on residential construction has declined prior to every recession since 1955.

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Making the Connection

How important is housing in the business cycle?

Also notice that the decline in construction precedes the recession; so it is not caused by the falling incomes that a recession brings.

What causes decline in construction? Generally, higher interest rates, as usually occur late in a business cycle expansion.

But the recent residential housing collapse was particularly prolonged, likely slowing growth in the overall economy.

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Making the Connection

Answering the key question

“Does the business cycle impose significant costs on the economy?”

The business cycle consists of alternating periods of recession and expansion.

According to most economists, it does impose significant costs on the economy.

Lost output and income are one cost.

Another is that workers will lose/have trouble finding jobs.

Economic costs are substantial, and can last for years.

When real GDP rises above potential GDP, there are costs also:

High inflation can impose significant costs on the economy.

Also, there is evidence that countries with severe business cycles grow more slowly over time than countries with mild business cycles.

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Derive the formula for the expenditure multiplier.

9.A

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Learning Objective

Deriving the expenditure multiplier

Total increases in real GDP from increases in autonomous expenditure are found using the formula for an infinite series.

Suppose government purchases rise by $1,000, and households spend $0.90 of each additional dollar of income. The total increase in spending is:

The expression in parentheses is an infinite series, and it equals:

(proof on next slide)

Therefore, total change in real GDP is

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A general multiplier formula

In general, let f be the fraction of income spent during each round through the circular flow (0.9) above. The infinite sum m in the parentheses represents the multiplier:

To solve for m, multiply both sides by f:

Now subtract mf from m:

If , then we get the expected value for the multiplier of .

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