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Chapter 8:Business Cycle 8.1 What is a Business Cycle?

Business cycle is a decline in aggregate economic activity to a low point (contraction or recession), followed by recovery of activity (expansion) to a high point. It could be measure from peak to pear (high point) or from trough to trough (a low point). Business cycle chronology is a detailed history of business cycle in the US and other countries. (Done by the NBER) Aggregate economic activity. We look at broad economic variables such as real GDP, unemployment and some financial market variables. 2. Expansion and contraction. Five points in this definition Contraction or recession is a period of falling aggregate economic activity. Depression is a severe contraction or recession. Trough is the low point of the business cycle. Expansion or boom is the period of increase aggregate economic activity. Peak is the high point of an expansion. Turning points are all the peaks and troughs One goal of business cycle research is to determine the turning points. NBER determines when a through or peak has occurred. 3. Co-movement. Expansions and contractions occur at about the same time in many economic activities. 4. Recurrent but not periodic. It does not occur at regular predictable intervals and does not last for a fixed or predetermined length of time. 5. Persistence. It is the tendency for a growth in aggregate economic activity to be followed by further growth and a decline by a further decline. 1.


Business Cycle Facts

I. The Cycle Behavior of Economic Variable: Direction and Timing Two characteristic of the cyclical behavior of macroeconomic variables are: The first is the direction in which a macroeconomic variable moves relative to the direction of aggregate economic activity. The second is the timing of the variables turning points relative to the turning points of the business cycle. Direction Procyclical is an economic variable that moves in the same direction as aggregate economic activity. Countercyclical is a variable that moves in the opposite direction to aggregate economic activity. Acyclical is a variable that do not display a clear pattern over the business cycle. Timing Leading variables is one whose peaks and troughs occur before the corresponding business cycle peaks and troughs. Coincident variable is one whose peaks and troughs occur at about the same time as the corresponding business cycle peaks and troughs. Lagging variable is one whose peaks and troughs tend to occur later than the corresponding peaks and troughs in business cycle.

II. Production The level of production is a basic indicator of aggregate economic activity; peaks and troughs in production tend to occur at about the same time as peaks and troughs in aggregate economic activity. Industries that produce relatively durable goods respond strongly to the business cycle, producing at high rates during expansions and at much lower rates during recessions. Industries that produce relatively non-durable or shirt-lived goods or services are less sensitive to the business cycle. Expenditure For components of expenditure durability is the key to determining sensitivity to the business cycle. Investment is made up primarily of spending on durable goods and is strongly procyclical. Consumption of nondurable goods are much smoother. Government purchases of goods and services generally are procyclical. Rapid military buildups are usually associated with economic expansions. Employment and Unemployment The civilian unemployment rate is strongly countered cyclical, rising sharply in contraction but falling more slowly in expansion. In recent recessions, the unemployment has continued to increase despite the cycle passing the trough. 8.3 Business Cycle Analysis: A Preview In general, theories of the business cycle have two main components: 1. Descriptions of the types of factors that have major effects on the economy this are known as shocks. 2. Models of how the economy responds to the various shocks.

Aggregate Demand and Aggregate Supply: A Brief Introduction Aggregate demand curve shows for any price level the total quantity of goods and services demanded by households, firms and governments. The aggregate demand curve is downward sloping. For a specific price level, any change in the economy that increases the aggregate quantity of goods and services demanded will shift the AD curve to the right.

Any change that decreases the quantity of G&S demanded will shift the AD to the left. Aggregate supply curve indicates the amount of output producers are willing to supply at any particular price level. There are two aggregate supply curves: 1. Short Run aggregate supply curve: it captures the idea that in the short run the price level is fixed and that firms are willing to supply any amount of output at that price (realistic if time span is small). 2. Long Run aggregate supply curve is where the output supply equals the full employment output supply. a. Aggregate Demand Shock Aggregate demand shock is a change in the economy that shifts the AD curve 1. Consumers become pessimistic and reduce their consumption] 2. Increase in government spending 3. Change in tax incident 4. Interest rates (nominal, real and expected inflation) 5. Marginal productivity of capital 6. Changes in Ms or Md. 7. Change in wealth. When you have a decrease in AD companies will not like to stay producing below their normal capacity. b. Aggregate Supply Shock

Aggregate supply shock is a change in the economy that causes the long-run aggregate supply curve to shift. 1. 2. 3. 4. Change in expected prices. Unanticipated changes in the nominal money supply (recall that money has no affect if we know that it will increase [i.e. anticipated]). Change in the nominal wages Change in expected and real exchange rate.