Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 27
Business cycles
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The business cycle
short-term fluctuations of total output around its trend path
Trend output grows steadily as productive potential increases.
Actual output fluctuates
around this trend.
A – slump
Actual
output
B – recovery phase
has begun
C
D
E
Trend output
C – Boom
D – recession under way
A
E – slump again
B
Time
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Growth of UK output and
productivity, 1975–2009
Productivity and GDP
6
4
2
0
-2
-4
-6
The growth of output
and productivity
fluctuates in the short
run.
Although not perfectly
regular, there is
evidence of a cycle
of around 5 or 6 years.
Typically, output
fluctuations used to
precede fluctuations
in productivity by
During 1995-2007 it appeared that cycles
about a year, but
had become less pronounced, but the
since the mid 1990s
output
fall of 2009
was the worst
of the
post Supplement
Source:
Economic
Trends
Annual
war period.
this gap has been
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reduced.
The political business cycle
• Some commentators have suggested that there is a
political business cycle,
• whereby governments adopt tight monetary and
fiscal policy soon after an election,
• but then adopt more expansionary policies as the
election approaches to encourage a ‘feel-good’
factor.
• Recent institutional changes to improve policy
credibility – particularly central bank independence
–reduce the scope for political business cycles in the
future.
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Theories of the business cycle
• The multiplier-accelerator theory:
– the multiplier communicates the
effects of changing investment to
aggregate demand
– the accelerator assumes that firms
gauge future demand by reference
to past output growth
• this model can produce fluctuations in
output level in response to a shock.
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The multiplier-accelerator
Period
Yt–1 – Yt – 2
Investment It
Output Yt
t=1
0
10
100
t=2
0
10
120
t=3
20
20
140
t=4
20
20
140
t=5
0
10
120
t=6
–20
0
100
t=7
–20
0
100
t=8
0
10
120
t=9
20
20
140
The multiplier is 2.
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Period 1: Output Y1 = 100.
Investment I1 = 10 - the
investment needed to
offset depreciation.
Period 2: Y2 rises by 20.
Output increases from 100
to 120.
Period 3: I3 increases by 10
(the accelerator) →
increase of 20 (from 120 to
140) in Y3 (the multiplier)
If last period’s income
grew by 2x units, firms
raise current investment
by x units.
The multiplier-accelerator
Period
Yt–1 – Yt – 2
Investment It
Output Yt
t=1
0
10
100
t=2
0
10
120
t=3
20
20
140
t=4
20
20
140
t=5
0
10
120
t=6
–20
0
100
t=7
–20
0
100
t=8
0
10
120
t=9
20
20
140
The multiplier is 2.
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Period 4: I4 remains at 20
since Y3 – Y2 = 20. Thus Y4
remains at 140.
Period 5: I5 falls to 10,
since Y4 – Y3 =0. This fall
of 10 units in investment
leads to a multiplied fall
in Y5 of 20
If last period’s income
grew by 2x units, firms
raise current investment
by x units.
Fluctuations in stock-building
• Stock-building may also be a cause
of fluctuations in output.
• Firms tend to use stocks to smooth
production in the face of fluctuating
demand.
• Output per worker tends to rise in
times of boom, and fall in times of
recession.
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Fluctuations in stock-building
During 2006-07, the level of
stocks fluctuated randomly.
UK stock-building £bn
5
In the first quarter of 2008,
aggregate demand fell and
firms were left with unsold
goods.
4
3
2
1
2009iii
2009i
2008iii
2008i
2007i
2007iii
-2
2006iii
-1
2006i
0
-3
Firms began to cut back
production, reducing stocks
of work in progress.
Once production had fallen
more than demand, stocks
start to increase again.
-4
-5
-6
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Real business cycles
• In this view of the world, fluctuations in
actual output are fluctuations in potential
output
• … so there is no point in trying to stabilize
output over the business cycle.
• Although some swings in potential output
do occur, many short-run fluctuations are
more likely to reflect Keynesian departures
from potential output.
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An interconnected world?
Annual GDP growth (%)
Italy
Japan
France
Germany
UK
USA
6.0
4.0
2.0
-4.0
-6.0
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2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
-2.0
1996
0.0
Output growth has
been similar across
countries since 2000.
The dot.com bust and
the financial crisis were
global events.
Independent central
banks have pursued
rather similar monetary
policies.
These patterns warn us
how interdependent
the leading countries
have become in the
modern world.
Economies are
becoming more open.
An interconnected world? (2)
• Increasingly the business cycle is transmitted from
one country to another. In part by them following
similar policies
• The considerable integration of advanced
economies prompts a further question:
• are the leading emerging market economies,
particularly China and India, on the way towards
similar integration with the their longer-established
partners?
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An interconnected world? (3)
Prior to the crisis, Asian
economies had been
growing much more
quickly as they caught
up with the OECD.
Annual real output growth (%)
USA EU Emerging Asia
8
6
4
2
0
-2
2007
2008
2009
2010
-4
-6
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The cyclical pattern in
response to the global
crisis was very similar to
OECD countries, albeit
from a higher baseline
rate of growth.
Some maths: A simple cycle
C = A +cY-1
I = a [Y-1-Y -2]
Y = C+I
Y = A +cY-1 + a [Y-1-Y -2 ]
(1)
Using y to denote Y-Y*, the deviation of
output from its long run level, we can subtract
Y* from both sides of equation (1) to yield:
y = cy-1 + a [y-1-y -2 ]
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(2)
Some maths: A simple cycle (2)
y = cy-1 + a [y-1-y -2 ]
(2)
Depending on the values of c and a,
equation (2) can yield constant cycles,
damped cycles that gradually get smaller
and smaller, or explosive cycles that get
larger and larger.
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