c

c
c
c
c
c
c





c
The ups and downs of the general level of
economic activity.c
c
c
c
c
c
c
c
c
4/7/2008

Vivek Agrawal
c c

2
 


c
c

The business cycle is the ups and downs of the general level of economic activity. All
modern, industrialized countries have fluctuations in their rates of economic activity,
leading to the observation that one nation's economy is "booming" while another
economy is in a "recession." When an economy goes from a positive to a negative
rate of growth, it is said to have reached a "peak" and entered a recession. When an
economy goes from a negative to a positive rate of growth, it is said to have reached
a "trough" and entered a "recovery."


c
c
c


cc

Although something worthy of being called "the business cycle" does exist, attempts
at finer classifications or subcategories of business cycles have not been particularly
fruitful. Some economists have simply used a broad dichotomy bet ween "major" and
"minor" cycles. Descriptively this can be meaningful. A particularly severe recession is
referred to as a "depression." The Depression of the 1930s was quantitatively
different from the 1990 -1991 recession. The output of the economy fell b y almost 50
percent in the former and by less than 1 percent in the latter.

It is sometimes useful to speak of the cycles of specific time series; that is, the
interest rate cycle, the inventory cycle, the construction cycle, and so forth. Given
the diversity of general economic cycles, one can find turns in the general level of
economic activity in which individual sectors of the economy do, at least for a time,
appear to be independent of the rest of the economy. The most frequently
mentioned individual cycles are the inventory cycle, the building or construction
cycle, and the agricultural cycle. The standard business cycle is sometimes referred
to as the inventory cycle, and some business cycle theorists popularly explain the
severity of turns in the economy by the coincidence of timing in the individual cycles.

The idea of the timing of individual time series relative to the general level of
business implies specific dates for the business cycle. How does one establish the
peaks and troughs for the busin ess cycle? To say whether something leads or lags the
business cycle, one must have some frame of reference; hence, the business cycle is
referred to as the M
M    and its peaks and troughs as M
M   M 

  . (See Table 1.)

For the United States, the reference turning points are established by the National
Bureau of Economic Research (NBER), a nonprofit research organization. This

3
organization, originally under the guidance of Wesley Claire Mitchell (1874 ʹ1948),
pioneered business cycle research in the late 1920s. Today the NBER's decisions
regarding the reference cycle are taken as gospel, although they are, in fact, quite
subjective. No single time series or group of time series is decreed to be 
reference cycle. A committee of professional business cycle analysts convened by the
NBER establishes the official peaks and troughs in accordance with the following
definition:

   M  

 
  

M
     

    M
    M M        MM        

   MM 
                 
 
  M
 M M    M    M       M
   
    
            
 
  M MM   
 M   M      M
MM    M M  
 M    M        M M   
  M M M     
M   M (Burns and Mitchell, 1946, p. 3)

With slight modification, this definition has been used since 1927. Although most of
the definition is self-explanatory, it is not all that rigorous. It does not say something
like, for example, if the total output of the economy (real GDP) falls at an annual rate
of 1 percent for two consecutive quarters, we have entered a recession. The
definition does say unambiguously that business cycles are "recurrent but not
periodic." The only real constraint in the definition is that if yo u define a business
cycle, say, from peak to peak, you should not be able to find another cycle of equal
amplitude between those two peaks. If so, you did it wrong.

As of mid-2000, Table 1 is still relevant. The most recent turning point identified by
the NBER was March 1991. As of April 2000, the U.S. economy continued to expand.
Notice from the table that all that is established with regard to  business cycle is
the peak and trough of each cycle. This determination tells us absolutely nothing
about the rate of rise or fall in the general level of economic activity, nothing about
the magnitude of the boom or the severity of the recession. The most commonly
used series as a proxy for the business cycle when more than just turning points is
required is real GDP if one can get by with quarterly data, or the industrial
production index if monthly data are required. The industrial production index is a
measure of economic activity published monthly by the Federal Reserve Board in
Washington, D.C. As might be g uessed from the attention given them by the media,
the consumer price index and the unemployment rate are commonly used measures

4
of the severity of the business cycle. Neither corresponds very closely to the
reference cycle.

  
c c c


c c

The first lecture in an introductory economics course usually makes the point that
the expenditures of one economic unit are the incomes of other economic units. This
provides a fairly firm basis for expecting sympathetic movements in many sectors of
the economy. A good theoretical basis and substantial empirical support exist for
cumulative upward and downward movement in the economy. One sector's
expansion is the basis for another sector's expansion, general prosperity lowers risk
and makes credit more readily available, and so on; but the weakest part of business
cycle theory and the toughest problem in forecasting is turning points. Why does the
general upward or downward movement end? Sometimes it is obvious. When, for
example, a war begins or ends wit h a commensurate and dramatic change in military
expenditures, the cause of the beginning or end of an economic boom is fairly
unambiguous. Historically, however, only a small minority of the turning points are
the result of specific, identifiable occurren ces. There are many theories as to other
causes of the business cycle.

In 1917 an eminent American economist by the name of J. M. Clark published an

article entitled "Business Acceleration and the Law of Demand: A Technical Factor in
Economic Cycles." His technical factor was the observation that with a fixed capital -
output ratio, a small percentage change in final sales would give rise to a large
percentage change in investment. Each innovation generates a temporary demand
for the required investment goods . Once the initial investment has been made, the
replacement market requires a lower rate of investment. This is referred to as the
M    
   M . Ifit takes $10 worth of steel mills to produce $1 worth of
steel per year, growth in demand for s teel by $1 will  MM  generate $10 worth
of demand for steel mills.

Another early business cycle theorist, Joseph Schumpeter (1883 ʹ1950), noted that
nothing is constant over the business cycle and nothing ever really returns to its
starting place. That is what makes each business cycle unique. The economy grows
and changes with each cycle Ͷnew products, new firms, new consumers. As
Schumpeter observed in 1939, "As a matter of history, it is to physiology and
zoology, not to mechanics, that our science is indebted for an analogous distinction
which is at the threshold of all clear thinking about economic matters" (p. 37). The

5
economy
M and changes. He referred to this as the process of "creative
destruction."

Schumpeter concluded that what most of us consider "progress" is at the source of

the problem.

c cc c

c



cc

 
c
c 
 

c c c

!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

1. 30 cycles.

2. 15 cycles.

3. 25 cycles.

4. 13 cycles.

December
June 1857 Ͷ 30 Ͷ Ͷ
1854

6
c c c
!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

December October
18 22 48 40
1858 1860

June 1861 April 1865 8 46 30 54

December
June 1869 32 18 78 50
1867

December October
18 34 36 52
1870 1873

March March
65 36 99 101
1879 1882

March
May 1885 38 22 74 60
1887

April 1888 July 1890 13 27 35 40

January
May 1891 10 20 37 30
1893

7
c c c
!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

December
June 1894 17 18 37 35
1895

June 1897 June 1899 18 24 36 42

December September
18 21 42 39
1900 1902

August
May 1907 23 33 44 56
1904

January
June 1908 13 19 46 32
1910

January January
24 12 43 36
1912 1913

December August
23 44 35 67
1914 1918

March January
71 0 51 17
1919 1920

8
c c c
!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

July 1921 May 1923 18 22 28 40

October
July 1924 14 27 36 41
1926

November August
13 21 40 34
1927 1929

March
May 1937 43 50 64 93
1933

February
June 1938 13 80 63 93
1945

October November
8 37 88 45
1945 1948

October
July 1953 11 45 48 56
1949

August
May 1954 10 39 55 49
1957

9
c c c
!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

April 1958 April 1960 8 24 47 32

February December
10 106 34 116
1961 1969

November November
11 36 117 47
1970 1973

March January
16 58 52 74
1975 1980

July 1980 July 1981 6 12 64 18

November
July 1990 16 92 28 108
1982

March
8 Ͷ 100 Ͷ
1991

Average, all cycles:

1
1854ʹ1991 (31 cycles) 18 35 53 53

10
c c c
!"cc#"$
!


"!"c
*(!"c
'"%$c "#c
"%$ !& '"%$c "c "%$c !&c"#c
("c "#c
(!&) ("c
(!&) ("c
(!&
"%$

2
1854ʹ1919 (16 cycles) 22 27 48 49

1919ʹ1945 (6 cycles) 18 35 53 53

1945ʹ1991 (9 cycles) 11 50 61 61

Average, peacetime
cycles:

3
1854ʹ1991 (26 cycles) 19 29 48 48

4
1954ʹ1919 (14 cycles) 22 24 46 47

1919ʹ1945 (5 cycles) 20 26 46 45

1945ʹ1991 (7 cycles) 11 43 53 53

He felt that as M M  M come up with new ways of doing things, this disturbs
the equilibrium and creates fluctuations. Schumpeter distinguishes between
   (which may gather dust for years) and   , which are commercial
applications of previous inventions. Inventions occur randomly through time.
Innovations tend to be bunched, thereby creating cycles of economic activity.

11
Many business cycle theorists give a prominent role to the monetary system and
interest rates. Early in the twentieth century, a Swedish economist, Knut Wicksell
(1851ʹ1926), argued that if the "natural" rate of interest rose above the "bank" rate
of interest, the level of economic a ctivity would begin to increase. In contemporary
terms, the natural rate of interest is what businesses expect to earn on real
investment. The bank rate is the return on financial assets in general and commercial
bank loans in particular. The boom begins w hen, for whatever reason, the cost of
borrowing falls significantly below expected returns on investment. This difference
between the rate of return on real and financial assets generates a demand for bank
loans by investors seeking to exploit the opportun ity for profit. The economy booms.

At some point the bank rate will start to rise and/or the real rate will start to fall.
When the expected rate of return on investment falls below the rate at which funds
can be borrowed, the process will begin to reverse itselfͶand the recession is on. As
bank loans are paid off (or defaulted on), bank credit is reduced, and the economy
slows accordingly.

In recent years, business cycles theory has centered on the argument about the
source of cyclical instability. The que stion of the root causes of ups and downs in the
level of economic activity received a lot of attention in the 1980s and 1990s.

Figure 1 shows how the parties to the debate are divided up. First, there is the
question of whether the private sector of the e conomy is inherently stable or
unstableͶwhich is to say, do the observed fluctuations originate in the government
or private sector? On one side are what might be called   economists, who
are convinced that the economy is inherently stable. They co ntend that, historically,
government policy has destabilized it in a perverse fashion. On the other side are
what might be called    , named after the famous British economist John
Maynard Keynes (1883ʹ1946). Keynesians think that psychological shif ts in
consumers' purchasing and savings preferences and in businesses' confidence are a
substantial source of instability.

There is a whole body of literature on        . As a contemporary

economist, William D. Nordhaus, noted in 1989, "T he theory of the political business
cycle, which analyzes the interaction of political and economic systems, arose from
the obvious facts of life that voters care about the economy while politicians care
about power" (p. 1). The idea is that politicians in power will tend to follow policies
to promote short-term prosperity around election time and allow recessions to occur
at other times. The evidence that the state of the economy influences voting
patterns is strong, as is the apparent desire of incumbent politicians to influence the

12
economy; but it is difficult to make a case that the overwhelming determinant of the
level and timing of business fluctuations is politically determined. At some points in
recent history, politically determined policies were ap parently a determining factor
and at other times not.

With respect to the impact of governmental policies, there is a dispute as to the

relative importance of monetary policy (controlling the money supply) and fiscal
policy (government expenditures and tax es). Those who believe that monetary
policies have had a generally destabilizing effect on the economy are known as
 M  . Most economists accept the fact that fiscal policy, especially in wartime,
has been a source of cyclical instability.

As noted above, it is the so-called Keynesian economists who think that the private
sector is inherently unstable. While noting the historical instability of investment in
tangible assets, they have also emphasized shifts in liquidity preference (demand for
money) as an independent

source of instability. As a counter to the standard Keynesian position, there has in

recent years arisen a school of thought emphasizing M    . This school
contends that nonmonetary variables in the private sector are a maj or source of
cyclical instability. They contend that the observed sympathetic movements between
monetary variables and the level of economic activity result from a flow of causation
from the latter to the former. The changes in real factors  the monetary factors
to change, not vice versa. In this way they are somewhat like Wicksell, discussed
earlier.

 +
 c

Blanchard, Oliver. (2000). "What Do We Know about Macroeconomics That Fisher

and Wicksell Did Not?" National Bureau of Economic Research Wor king Paper No.
W7550, February. New York: National Bureau of Economic Research.

Burns, Arthur F., and Mitchell, Wesley C. (1946).   M 

     . New
York: National Bureau of Economic Research.

Clark, J. M. (1917). "Business Acceleration and the Law of Demand: A Technical

Factor in Economic Cycles." M
!  " March: 217-235.

Hicks, J. R. (1958). # #M  . London: Oxford University Press.

King, Robert, and Plosser, Charles. (1984). "Money, Credit and Prices in a Real
Business Cycle." $ M " %   June: 363-380.

13
King, Robert, and Rebelo, Sergio. (2000). "Resuscitating Real Business Cycles."
National Bureau of Economic Research Wo rking Paper No. W7534, February. New
York: National Bureau of Economic Research.

Long, John, and Plosser, Charles. (1983). "Real Business Cycles." M 
 !  
" February: 777-793.

Lucas, Robert E. (1981). &     # M. Cambridge, MA: MIT Press.

Lucas, Robert E., and Sargent, Thomas J., ed. (1981). %  "    
" M !M  . Minneapolis: University of Minnesota Press.

Mankiw, N. Gregory. (1989). "Real Business Cycles: A New Keynesian Perspective."

#  M
" ! M    Summer: 79-90.

Mitchell, Wesley Claire. (1952). # " &  . New York: National Bureau of
Economic Research.

Nordhaus, William D. (1989). "Alternative Approaches to the Political Business

Cycle." M 
! M " $   2:1-50.

Rotemberg, Julio J., and Woodford, Michael. (1996). "Real -Business-Cycle Models
and the Forecastable Movements in Output, Hours, and Consumption." # 
$ M " %   March: 71-89.

Schumpeter, Joseph. (1939).    . New York: McGraw-Hill.

Schumpeter, Joseph. (1961). #  # M 
 "  '    . New York:

Oxford University Press.

Su, Vincent. (1996). " (  (M   

. New York: HarperCollins.

Wicksell, Knut. (1901). ) M !  ". New York: Augustus M. Kelly.

Willet, Thomas D., ed. (1988). !        #  !   " 

 *
 +   . Durham, NC: Duke University Press.

Zarnowitz, Victor. (1992).      # M , M * M  

(M   
. Chicago: University of Chicago Press.

14