3 pages essay

DESCRIBING THE BUSINESS CYCLE

Todd A. Knoop

Derek Pichler

RE CE SSION

• Recession “A significant decline in economic activity that spreads across the

economy and can last for a few months to a year”

• Recession officially recognized by National Bureau of Economic Research

(NBER) when “Economy has had negative or declining or declining output for

at least six months”

• Growth Recession ”Period of growth that is below trend, or the long run average

of GDP growth, is generally considered as a recession by the public but not

technically considered a recession by economist”

D E P RE SSION

• No formal definition of depression

• Informal definition of depression “Economic output falls by more than 10

percent”

• “Recession is when neighbors lose their job and a depression is when you lose

yours”

D E FINITIONS

• Leading indicator is “a variable that peaks (trough) before GDP peaks (troughs)”

• Lagging indicator is “a variable that peaks after GDP peaks”

• Coincident indicator is “a variable that peaks or troughs at the same time as GDP”

• Procyclical “If its deviations from trend have a positive correlation with deviations in GDP trend”

• Examples: Consumption, Investment, and Employment

• Countercyclical “If its deviations from a trend have a negative correlation with deviations in GDP trend”

• Examples: Unemployment is strongly countercyclical

• Acyclical “No consistent correlation with changes in GDP from trend”

D E TRE ND ING

• Separating cycle from trend, movements consistent with trend must be

subtracted from the collected data

• Example: Assuming trend is constant

• Y = a(1+g)^t

• Y = Trend Level, g = constant growth rate, a = constant, t = time

• Y – Y = Actual GDP – Trend GDP

D E T R E ND ING C O NT .

Assuming that a trend follows a moving average

• Y12 = (Y10 + Y11 + Y12 + Y13 + Y14)

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Issues with moving average trends:

• You cannot calculate trend for the most recent data because you are missing future observations

• You cannot calculate GDP trend in 2014 using the moving average method until 2016 you will not have the data available

B USINE SS CYCLE S A RE NOT CYCLIC A L

• The term business cycle implies that recessions and expansions follow a

regular, predictable pattern. They do not.

• Shortest recession in United States history: 1980 - 6 months

• Followed by shortest expansion: 1981 -12 months

• Longest recession: 1933-1937 - 43 months

• Longest expansion: 1991-2001 - 121 months

• Size of decline in GDP associated with post war business cycles has also varied greatly: Fall of 27% during great recession to only 0.3% during 2001 recession

BUSINE SS CYCLE S A RE NOT SYMME TRIC A L

• In the United States Business Cycles average 39 months; recessions average 18 months

• General rule across countries, recessions tend to be shorter but with sharper changes in

GDP, meanwhile expansions tend to be longer but with more gradual changes in GDP

• Inflation and natural market corrections lead to sharp recessions followed by quantitative

easing and interest rate adjustments by central banks

B USINE SS CYCLE S HAVE CHA NGE D OVE R TIME

• Postwar recession have moderated

• Recessions have gotten smaller and expansions have gotten larger

• Diversification of economy and stabilization policies implemented by federal

reserve

• Technological advances have lead to increased operating and market efficiency

THE GRE AT D E PRE SSION A ND WORLD WA R II

• The Great Depression and the World War II expansion dominate all other

recessions and expansions

• GDP fell by 27% 1929-1933, unemployment rose to peak 25%

• 2008 recession GDP fell 5.1% and unemployment rose to 10%

• GDP rose 64% 1941-1944 during World War II due to increase in government

expenditures and massive mobilization of resources

COMPONE NTS OF GD P

• The components of GDP exhibit behaviors much different than GDP itself

• Consumption (Durable): Volatile

• Investment: Volatile

• Government Purchases: Stable

• Net Exports: Volatile

• Consumption (Non-Durable): Stable

BUSINE SS CYCLE S A ND A COUNTRY'S W E A LTH

• Business Cycles are larger and more frequent in poorer countries than richer

countries. The variability of output in poor countries is twice that of rich

countries

• The variability of output in poor countries is twice that of rich countries

• The ability to increase government spending during downturns is an option

that many poor countries do not have because they have limited access to the

debt capital markets

• Consumption and net exports are more volatile in poor countries

BUSINE SS CYCLE S CORRE LATION TO LA B OR MA RKE T

• A worker is classified as unemployed in the United States “if he or she is currently without work and has been actively looking for work during the previous four weeks”

• Total unemployment is strongly countercyclical and is a lagging indicator of both peaks and troughs. Total unemployment lags peaks in outputs because when the economy first slows down, some workers are still finding jobs so total unemployment lags peak.

• During recessions and expansions; changes in employment appear to be driving a very large share of the share in output

• Real Wages do not behave consistently over business cycles

LA B OR CONT.

• Two variables related to unemployment:

• Duration of unemployment or the average period of unemployment for those

who are currently unemployed

• Second is initial unemployment claims; which are the number of new claims for

unemployment insurance. Leading indicator because firms anticipate changes in

economic conditions and increase layoffs before production fails and decrease

layoffs before conditions improve

MONE Y SUPPLY & INFLATION

• M1(currency and checkable deposits) is strongly procyclical and a leading

indicator of peaks and troughs in the business cycle

• M1 levels determined by Federal Reserve

• Two common measures of inflation

• GDP Deflator “Measures changes in the price of all goods within U.S. borders

and included in GDP”

• GDP deflator is weakly procyclical; falling 6-11% during postwar recession

• Consumer Price Index “Measures changes in the price of consumer goods”

• Consumer Price Index is mildly cyclical; falling 7-11% postwar recessions

FINA NCIA L VA RIA B LE S

• Both short term and long term interest rates are procyclical

• Stock market and corporate profits are procyclical and a leading economic

indicator of peaks and troughs

• 3 month treasury bill has fallen during 10 of 11 postwar recessions

C A PACITY A ND P ROD UCTIVITY

• Capacity utilization is the employment rate of capital

• Procyclical as firms tend to purchase large amounts of capital during

expansionary periods

• Increasing productivity, which is measured as output per worker hour, is the

primary way that economies improve the standard of living for their citizens

• Procyclical as productivity has fallen during 10 of 11 postwar recessions

E XPE CTATIONS

• Publics popular measure of future economic conditions is the consumer

confidence index, which is based on household survey data based on:

• Family’s economic prospects over the next 12 months

• U.S. Economic prospects over the next 12 months

• The U.S. economic prospect over the next 5 years

• Consumer confidence index is strongly procyclical and a leading economic

indicator. It is much more volatile than GDP, meaning the consume confidence

index often provides false signals of business cycle turning points

CONCLUSION

• Goal for economist interested in why business cycles occur and what can be

done about them is straightforward “find a theory that fits the empirical facts

of business cycles as they are understood”

• Is a models ability to match economic data the only measure of its worth? Or

do things like logical structure and consistency with microeconomic theory

matter just as much?

• “It is quite wrong to try founding a theory on observable magnitudes alone. It is a theory which decides what we can observe”