Chapter 15
Business Cycles
© 2003 South-Western College Publishing
The Business Cycle
The rise and fall of economic activity
relative to the economy’s long-term
growth trend
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Types and Lengths of Cycles
Minor cycles
relatively mild intensity, noticeable but not severe
short
numerous
Major cycles
wide fluctuations, serious contractions or
depressions
widespread unemployment
lower output
low profits or net losses
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Other Types of Cycles
 Long-wave
building cycles
 Commodity price fluctuations
 Stock market price fluctuations
4
Duration of Business Cycles
since WWII
Number
Average duration
Longest cycle
Shortest cycle
Average expansion
Shortest expansion
Longest expansion*
Average recession
Shortest recession
Longest Recession
*as of February, 2000
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56 months
120 months (1991-2001)
28 months (1980-1982)
57 months
12 months (1980-1981)
120 months (1991 - 2001)
11 months
6 months (1980)
17 months (1981-1982)
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Phases of the Business Cycle
Real GDP
Peak: highest level of
economic activity in a
particular cycle
Contraction:
noticeable drop in the
level of business
activity
Expansion: rising level
of economic activity
Trough: lowest level of
business activity in a
particular cycle
Time
6
Phases and Measurement of
Cycles
Trend
Directional movement of the economy over an
extended time, usually 20-30 years
Seasonal Variations
Recurring fluctuations in activity in a given period,
usually 1 year
Random Fluctuations
Changes in activity caused by unexpected events
Cyclical Fluctuations
Changes in activity that occur regardless of trend,
seasonal variations, or random forces
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Patterns of Cycles
Two kinds of elements or forces bring about
business cycles
Internal: elements within the very sphere of
business activity itself: production, income,
demand, credit, interest rates, inventories
External: elements outside the normal scope of
business activity: population growth, wars, basic
changes in nation’s currency, national economic
policies, natural disasters
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Trough
 Output
Pessimism
HIGH
 Employment
 Income
 Price
LOW
 Costs
 Profits
 Investment
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Expansion
 External
factors
 Cost-price relationship
 Replacement of depleted inventories
 Low interest rates
 Investment increases
 Demand increases
 Employment and income increase
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Peak
 Output
 Employment
 Income
 Price
HIGH
Optimism
 Profits
 Investment
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Contraction

Output, employment, income at peak
 Consumer demand tapers off
 Prices level out, inventories increase
 Costs increase, profit margins diminish
 Demand slackens, firms reduce excess
inventories
 Output is cut, and so are income and
employment
 Investments discouraged & outlook
pessimistic
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Business Cycle Indicators
Leading Indicators
Group of 11 indexes whose upward and downward
turning points generally precede the peaks and
troughs in general business activity
Roughly Coincident Indicators
Group of 4 indexes whose turning points usually
correspond to the peaks and troughs of general
business activity
Lagging Indicators
Group of 7 indexes whose turning points occur after
the turning points for the general level of business
activity have been reached
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Leading Indicators

Average work week for production workers in
manufacturing
 Rate of layoffs in manufacturing
 New orders for consumer goods and materials
 New business formations
 Contracts and orders for plant an equipment
 Vendor performance, measured as a % of
companies reporting slower deliveries from
suppliers
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Leading Indicators (cont.)

Number of new building permits issued for
private housing units
 Net change in inventories
 Change in sensitive prices
 Change in total liquid assets
 Changes in money supply
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Coincident Indicators
 Number of
employees on nonagricultural
payrolls
 Personal income less transfer payments
 Industrial production
 Manufacturing and trade sales volume
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Lagging Indicators

Average duration of employment
 Change in labor cost per unit of output
 Average prime rate charged by banks
 Commercial and industrial loans outstanding
 Ratio of consumer installment loans
outstanding to personal income
 Change in the CPI for services
 Ratio of manufacturing and trade inventories
to sales
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Real or Physical Causes of the
Business Cycle
Innovation theory
Business cycles are caused by breakthroughs
in the form of new products, new methods,
new machines, or new techniques
Agricultural theories
Business cycles relate the general level of
business activity to the weather
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Psychological Causes of the
Business Cycle
Psychological theory
When investors and consumers react according to
some belief about future conditions, their actions
tend to transform their outlook into reality
Rational expectations theory
Suggests that individuals and businesses act or react
according to what they think is going to happen in
the future, after considering all available
information
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Monetary, Spending & Saving
Causes of the Business Cycle
Monetary theory
Business cycle is caused by the free and easy
expansion of the money supply
Spending and saving causes
Underconsumption theories: cycles are caused
by the failure to spend all national income, resulting
in unsold goods, reduced total production, and
consequent reductions in employment and income
Underinvestment theories: recessions occur
because of inadequate investment in the economy
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1991-2001 Business Cycle
Longest cyclical expansion in U.S. history &
subsequent recession one of the mildest
Causes of expansion
Usual ingredients for cyclical recovery
Monetary and fiscal policies conducive to economic
growth
Rapid introductions of new applications of
innovations in communication and computer
technology, including Internet
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1991-2001 Business Cycle
Productivity gains
Low energy costs
Causes of contraction
September 11th and its impact on travel related
industries
Collapse of several major companies such as Enron,
WorldCom, etc.
Declines in equity markets and their impact on
personal wealth
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