CHAPTER 6

UNDERSTANDING BUSINESS CYCLES

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INTRODUCTION
The study of business cycles is the study of short-term economic
fluctuations.
Factors that may affect business cycles are some of the same factors
that affect economic growth (e.g., labor productivity, money supply,
inflation, and technology).

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OVERVIEW OF THE BUSINESS CYCLE

A business cycle consists of an expansionary period and a contractionary
period.
Characteristics of a business cycle:
- They are typical in economies that rely on business enterprises.
- There are alternating phases of expansion and contraction.
- Phases occur throughout the economy, most often simultaneously.
- Phases reoccur, but vary in duration and intensity.
An expansion occurs after a low point (the trough) and a contraction occurs
after the highest point (the peak).
A contraction
- is also referred to as a recession.
- is referred to as a depression if severe and if aggregate activity declines.

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TYPICAL SCENARIO: RECESSION

Aggregate
demand
declines
Inventories
begin to
accumulate
Companies slow
production
Companies cut
nonessential
expenditures

Lower
GDP
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TYPICAL SCENARIO: EXPANSION

Wages grow and
wages decline

Input prices fall

Consumers and
companies
purchase more
Companies
increase capital
spending

Increase
GDP
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BUSINESS CYCLE SUMMARY

Early Expansion
(Recovery)
Economic activity
changes from decline
to expansion.
Layoffs slow, but new
hiring does not yet
occur and the
unemployment rate
remains high.

Late
Expansion
Accelerating
rate of growth

Peak
Decelerating rate
of growth

Contraction (Recession)
Declines

Unemployment
rate falls to low
levels.

Unemployment
rate continues to
fall.

Unemployment rate rises.

Consumer and
business
spending

Upturn is often most

pronounced in
housing, durable
consumer items, and
orders for light
producer equipment.

Upturn
becomes more
broad based.

Capital spending
expands rapidly,
but the growth rate
of spending starts
to slow down.

Cutbacks appear most in

industrial production,
housing, consumer durable
items, and orders for new
business equipment,
followed by a lag via
cutbacks in other forms of
capital spending.

Inflation

Inflation remains
moderate and may
continue to fall.

Inflation picks
up modestly.

Inflation further
accelerates.

Inflation decelerates but with

a lag.

Characteristic
Economic
activity
Employment

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THEORIES OF BUSINESS CYCLES

Different schools of economic thought are used to explain the causes of
business cycles.
These schools of thought offer different prescriptions with regard to
government actions that may affect the economy.
Schools of thought:
- Neoclassical
- Austrian
- Keynesian
- Monetarists
- New classical
- Real business cycle theory
- Neo-Keynesian

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NEOCLASSICAL AND AUSTRIAN

Neoclassical school of economic thought:
- The invisible hand (that is, free market) will result in a price for every good
for which there is supply and demand.
- Sayss law: All that is produced will sell because supply creates its own
demand.
- This school cannot explain a prolonged depression. Any declines in
aggregate demand would be temporary.
Austrian school of economic thought:
- This school is similar to neoclassical but considers the role of the money
supply and government actions.
- Government intervention may cause a boom-and-bust cycle.

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KEYNESIAN THEORY OF BUSINESS CYCLES

In the event of lower aggregate demand, lower wages result in lower spending,
hence affecting demand further.
Very low interest rates would not stimulate the economy because confidence
would be too low.
Government should intervene in a crisis, running a deficit.
Criticisms of this theory:
- Government debt could get out of control.
- Expansionary policy may cause the economy to grow too fast, resulting in
inflation and other ills.
- It takes time for fiscal policies to work, so they may be ill timed for a shortterm crisis.

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MONETARISTS
Those following the monetarist school of thought object to the Keynesian
approach because Keynesian theory
- does not consider the role of the money supply.
- is not logical in light of utility-maximizing market participants.
- ignores the long-term cost of government intervention.
- does not consider the unpredictability of the timing of fiscal policy changes on
the economy.
Monetarists advocate for a steady increase in the money supply and a limited
role of government.

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NEW CLASSICAL SCHOOL

The new classical school uses the idea that utility-maximizing agents will seek
to maximize profits.
Real business cycle (RBC) theory:
- Business cycles are the result of the efficient operation of the economy in
response to real shocks.
- The RBC theory considers unemployment the result of persons wanting
wages that are too high.
- It is criticized as being an unrealistic assumption.
Neo-Keynesians (new Keynesians):
- Neo-Keynesians assume slow-to-adjust wages and prices.
- Government intervention is needed in the event of disequilibrium.

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UNEMPLOYMENT AND INFLATION

Types of unemployment:
- Unemployed: People who are actively seeking a job but do not have a job.
- Frictionally unemployed are in the process of changing jobs.
- Long-term unemployed have been out of work for a long time, but are still looking.
- Underemployed: Employed people who have the qualifications to work a higherpaying job.
- Discouraged worker: Unemployed person who stopped looking for a job.
- Voluntarily unemployed: Person who is outside of the labor force voluntarily.
Measures describing the labor market:
- Employed: Number of people with a job.
- Labor force: Number of people with a job or actively seeking a job.
- Unemployment rate: Ratio of the number of unemployed persons to the labor force.
- Activity ratio (participation ratio): Ratio of labor force to total population of working
age persons.

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PRODUCTIVITY MEASURES
Labor force indicators:
The unemployment rate (the ratio of the number of unemployed persons to the
labor force) lags the current environment.
Issues:
- Distortions from discouraged workers: The number of unemployed may drop
because workers become discouraged and may increase when they rejoin
the workforce to resume searching.
- Reluctance of employers to lay off workers when business slows and to hire
when business increases.
Payroll growth does not fully cover employment at small businesses.
Hours worked (including overtime) and use of temporary workers are indicators
of slowing and recovering businesses.

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INFLATION
Inflation is an increase in the level of prices in the economy.
- The inflation rate is the percentage change in a price index.
- The purchasing power of money decreases.
- The liability of the borrower decreases if the loan has fixed monetary terms.
Deflation is a sustained decrease in the aggregate price level (negative
inflation rate).
- The purchasing power of money increases.
- The liability of the borrower increases if the loan has fixed monetary terms.
Hyperinflation is an extremely fast increase in the aggregate price level.
- It generally occurs when government spending is not backed with tax
revenues and the money supply is increased (or unlimited).
Disinflation is a decline in the inflation rate.

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MEASURING INFLATION
A price index reflects the weighted average price of a basket of goods and
services, with the index = 100 at a specified period of time (that is, base year).

- A Laspeyres index is a price index in which the basket of goods and

services is held constant.
Biases in an index:
- Substitution bias: People may substitute goods and services as prices
change.
- Addressed somewhat using a chained price index formula (e.g., Fisher
index and Paasche index).
- Quality bias: The utility of a good may improve over time, but this may be
interpreted as a price increase.
- New product bias: Not included in a fixed basket of goods and services.

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INFLATION INDICES
Price indices may differ with respect to scope and weights on goods and
services.
Examples:
- The consumer price index (CPI) is used to track inflation within a given
economy.
- In the United States, the CPI covers only urban areas.
- It is used by US Treasury inflation protected securities (TIPS) and other
contracts.
- The personal consumption expenditures (PCE) price index covers all
consumption using surveys.
- The producer price index (PPI), also known as the wholesale price index
(WPI), tracks inflation in prices of goods and services to domestic producers.

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SOURCES AND MEASURES OF

INFLATION EXPECTATIONS
Sources of inflation
- Cost-push: Rising costs to businesses result in increased prices to consumers.
- Measure: Unit labor cost (ULC) = Total labor compensation per hour per
worker (W) divided by output per hour per worker (O) = W/O
- Demand-pull: Prices increase because of an increase in demand.
- Measures: Money supply indicators and money supply growth compared with
growth in the nominal GDP
- The velocity of money is the ratio of nominal GDP to the money supply and
is a measure of the likelihood of inflationary pressures.
Measures of inflation expectations:
- Extrapolation of trends in inflation
- Surveys of inflation expectations
- Comparison of yields on inflation-adjusted securities with non-inflation-adjusted
securities
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ECONOMIC INDICATORS
An economic indicator is a measure that provides information about the state
of the overall economy.
A leading economic indicator is a measure that has turning points that
precede changes in the economy.
A coincident economic indicator has turning points that coincide with the
changes in the economy.
A lagging economic indicator has turning points that are later than changes
in the economy.

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ECONOMIC INDICATORS, EXAMPLES

Leading Economic
Indicators
Average weekly hours
Average weekly initial
claims for unemployment
insurance
Manufacturers new orders
for consumer good and
materials
Vendor performance, slower
deliveries diffusion index
Manufacturers new orders
for nondefense capital
goods
Building permits for new
private housing units
S&P 500 Index
Money supply, real M2
Interest rate spread
between 10-year Treasury
yields and the federal funds
rate
Index of Consumer
Expectations
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Coincident Economic
Indicators
Aggregate real personal
income
Employees on nonfarm
payrolls
Industrial Production Index
Manufacturing and trade
sales

Lagging Economic
Indicators
Average duration of
unemployment
Inventory-to-sales ratio
Change in unit labor costs
Average bank prime lending
rate
Commercial and industrial
loans outstanding
Ratio of consumer
installment debt to income
Change in consumer price
index for services

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ECONOMIC INDICATORS AND

THE BUSINESS CYCLE
Increase in weekly hours,
manufacturing

Leads an expansion

Increase in the Index of

Consumer Expectations

Leads an expansion

Increase in the money supply

not accounted for by inflation

Leads an expansion

Increase in Industrial
Production Index

Coincides with a contractionary

phase

Increase in the average

duration of unemployment

Follows contractionary phase

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CONCLUSIONS AND SUMMARY

Business cycles are a fundamental feature of market economies and consist of
four phases (trough, expansion, peak, and contraction), but their amplitude and
length varies considerably.
Keynesian theories focus on fluctuations of aggregate demand (AD) and
advocate for government intervention.
Monetarists argue that the timing of government policies is uncertain, and it is
generally better to let the economy find its new equilibrium unassisted but
ensure that the money supply keeps growing at an even pace.
New classical and real business cycle theories also consider fluctuations of
aggregate supply (AS). Government intervention is generally not necessary
because it may exacerbate the fluctuation or delay the convergence to
equilibrium.
New Keynesians argue that frictions in the economy may prevent convergence
to equilibrium and government policies may be needed.

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CONCLUSIONS AND SUMMARY

The demand for factors of production may change in the short run as a result of
changes in all components of GDP: consumption, investment, government, and
net exports. Any shifts in AD and AS will affect the demand for the factors of
production (capital and labor) that are used to produce the new level of GDP.
Unemployment has different subcategories, including frictionally unemployed,
long-term unemployed, discouraged workers, and voluntarily unemployed.
There are different types of price-level movements: inflation, disinflation,
deflation, and hyperinflation.
Economic indicators are statistics on macroeconomic variables that help in
understanding which stage of the business cycle is occurring.
Price levels are affected by real factors and monetary factors.
Inflation is measured by many indices, including consumer price indices and
producer price indices.

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