MACROECONOMICS
AND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition
Business Cycles
1
PowerPoint by Beth Ingram
University of Iowa
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.
14-2
Key Concepts
 Business Cycle characterization
 Recessions and Depressions
 Frisch-Slutsky Paradigm
 Real Business Cycle Theory
 Keynesian Theory
14-3
Business Cycle
 Deviation from trend growth (i.e. fluctuations
in GDP around its trend)
Business Cycle
10500.0
8500.0
7500.0
6500.0
5500.0
4500.0
3500.0
2500.0
Potential Real GDP
Actual Real GDP
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
Jan-73
Jan-71
Jan-69
Jan-67
Jan-65
Jan-63
Jan-61
Jan-59
Jan-57
Jan-55
Jan-53
Jan-51
1500.0
Jan-49
Billions of 2000 Dollars
9500.0
14-4
Business Cycle
 Trend GDP: for a given level of capital, labor, and
technology a certain amount of GDP can be
sustainably produced
 Above trend: labor and/or capital being more
intensively used…unsustainable


labor must eventually rest or be paid premium (e.g.
overtime)
capital wears out and breaks down
 Below trend: labor and/or capital not being fully
used.

eventually employ more capital and/or labor
14-5
Business Cycle
 Output Gap: difference between actual and
potential (trend) GDP



Positive output gap: excess demand =>
upward price pressures
Negative output gap: excess supply (capacity)
=> downward price pressure
Note: you can have negative output gap and
positive growth => “growth recession”
n8
Ja 0
nJa 81
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Ja 2
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Ja 3
n8
Ja 4
n8
Ja 5
n8
Ja 6
n8
Ja 7
n8
Ja 8
n8
Ja 9
n9
Ja 0
nJa 91
n9
Ja 2
n9
Ja 3
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Ja 4
n9
Ja 5
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Ja 6
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Ja 7
n9
Ja 8
n9
Ja 9
n0
Ja 0
nJa 01
n0
Ja 2
n0
Ja 3
n04
Ja
Percent Deviation from Potential Growth
14-6
Business Cycle
U.S. Output Gap
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
-8.00%
-10.00%
14-7
Stages of the Business Cycle
14-8
Stages of the Business Cycle
 There are expansions and contractions
 Aggregate economic activity declines in a contraction or
recession until it reaches a trough

Informal recession definition: 2 consecutive quarters or
negative GDP growth
 Then activity increases in an expansion or boom until it
reaches a peak
 A particularly severe recession is called a depression
 The sequence from one peak to the next, or from one
trough to the next, is a business cycle
 Peaks and troughs are turning points
Popular saying: “Recession is when someone you know
becomes unemployed; a depression is when you
become unemployed.”
350
300
250
Billions of 1972 Dollars
14-9
Business Cycle Example
The U.S. Great Depression
500
450
400
200
150
100
2
94
-1
ar
M 941
-1
ar
M 940
-1
ar
M 939
-1
ar
M 938
-1
ar
M 937
-1
ar
M 936
-1
ar
M 935
-1
ar
M 934
-1
ar
M 933
-1
ar
M 932
-1
ar
M 931
-1
ar
M 930
-1
ar
M 9 29
-1
ar
M 9 28
-1
ar
M 9 27
-1
ar
M 9 26
-1
ar
M 9 25
-1
ar
M 9 24
-1
ar
M 9 23
-1
ar
M 9 22
-1
ar
M
Linear (1922-1929 Trend)
Real GDP
14-10
Business Cycle Example
Economic Activity
United States
United Kingdom
Germany
France
Italy
Japan
Spain
Canada
Netherlands
Switzerland
Sweden
Australia
Denmark
Norway
Finland
Portugal
Share of World
GDP
(1931, Percent)
42.4
13.1
9.5
7.9
5.4
5.1
4.2
2.5
2.1
2
1.6
1.4
1.1
0.9
0.5
0.4
Peak
1929
1930
1928
1932
1928
1930
1929
1929
1930
1930
1930
1926
1930
1930
1928
1935
Trough
1933
1931
1932
1935
1933
1933
1931
1933
1934
1932
1933
1931
1932
1931
1931
1936
GDP Loss
(Percent)
-29.4
-0.5
-26.3
-10.4
-13.7
-14.9
-6.3
-29.7
-14.2
-6.5
-12.1
-24.9
-4.4
-8.0
-7.2
-0.7
14-11
Co-movement Across World
Real GDP
7
5
4
3
2
1
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
0
19
Annual Percent Growth
6
Advanced economies
Other emerging market and developing countries
World (All WEO countries)
14-12
The Changing U.S. Business Cycle?
14-13
Business Cycle Paradigm
Impulse/Shock
Propagation
Business Cycle
14-14
Business Cycle Paradigm
Shocks
 monetary and fiscal shocks
 consumption and investment shocks
 technology shocks
 external shocks: (1) exchange rate shock
(2) terms of trade shocks
 financial system shock
14-15
Fluctuations
 Increase in aggregate demand


Increase in C, I, G, NX
Increases prices and output
 Increase in aggregate supply


Increase in labor, capital, TFP
Decreases prices and increases output
14-16
Aggregate Demand Aggregate Supply Model
 Aggregate Demand Curve
 Inverse relationship between price level and real
output: downward slopping
 Real Balance Effect
 Interest Rate Effect
 Exchange Rate Effect
 Short Run Aggregate Supply Curve
 Positive relationship between price level and real
output: upward slopping
 sticky input prices, sticky output prices, misperceptions
 Long Run Aggregate Supply Curve
 Real output independent of price level: vertical
 Fundamentals—resources, productivity, trade—only
matter
14-17
Real Business Cycle Theory
 Both growth and business cycles are caused
by aggregate supply shocks
 Business cycles are outcome of optimizing
market mechanism

aggregate demand is endogenous
 No role for government in changing the
nature of business cycles
14-18
Keynesian View
 Prices and wages may be sticky … may not
adjust to equilibrate markets
 Conduct countercyclical aggregate demand
management


Business cycle largely the result of
destabilizing movement in aggregate demand
New Keynesians also acknowledge aggregate
supply shocks matter
 Government must step in to shore up
aggregate demand … policy can alter the
business cycle.