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Business cycles

Ignacio Hernandez's picture

As every Friday, we are posting a lecture note prepared by Raj Nallari and Breda Griffith for PGP courses on Economic Policies for Growth and Poverty Reduction.

 

Business cycles

The economic system traditionally goes through 'boom' and 'bust' cycles called business cycles. An active macro policy tries to smooth out the business cycle by balancing growth, unemployment and inflation. Policies that reduce unemployment might lead to a rise in inflation, while keeping the lid on inflation may prevent growth in jobs, at least in the short run. Thus, there is often a political struggle over inflation and unemployment levels. The solid line in the graph below represents a “representative” pattern of economic booms and busts, as measured by GDP growth.
When we look at the GDP growth rate, we notice that it reaches maximum and minimum points (peaks and troughs) with some degree of regularity. Generally, after a boom, there is a slowdown.  Individual business cycles vary substantially in duration and intensity, but they all display common phases:

  • Peak - The peak is the point at which business activity has reached a temporary maximum. The economy is at full employment and the level of real output is at or very close to its capacity. The price level may rise during this phase.

  • Recession - The peak is followed by a period of decline in total output, income, employment and trade lasting at least six months. This is known as a recession. Business in many sectors of the economy contracts but the price level is unlikely to fall unless the recession is severe and prolonged as would be the case during a depression.
  • Trough – The trough of the recession or depression is the phase in which output and employment bottom out at their lowest levels. The trough phase of the cycle may be short lived or quite long.
  • Recovery – In the expansion or recovery phase, output and employment increase toward full employment. As recovery intensifies, the price level may begin to rise before there is full employment and full capacity production.

Business Cycle Graph

Business cycles

Economic developments are typically described by documenting movements in variables that are related in some way to output (GDP, GNP, growth, employment, unemployment, prices, job creation, interest rates, housing, consumption, etc.) Some variables follow a cycle similar to GDP; when GDP is growing faster, they are also growing faster, and vice versa. These variables are said to be procyclical like consumption, imports, etc. Other variables go in the opposite direction, and are said to be countercyclical, like net exports or the unemployment rate. Finally some variables are acyclical, meaning they are not moving in a way that is linked systematically to GDP.

 

Other factors

Not all changes in business activity result from business cycles. Some examples include:

  • Seasonal variations – certain times of the year cause buying surges which cause considerable fluctuations in the tempo of business activity each year, for example the holiday season.
  • Secular trend – business activity may also expand or contract over a long period of years, which is known as a secular trend.

While each sector of the economy typically is impacted by business cycle fluctuations, different individuals and businesses are impacted in various ways and to different degrees. With regard to production and employment, service industries and industries producing nondurable consumer goods are typically most insulated from the most severe effects of any recession. However, firms and industries producing capital goods and consumer durables are usually hard hit by recessions. Two factors explain this:

  • Postponability – Within limits, purchases of durable goods can be postponed. During recessions, producers frequently delay the purchase or more modern production facilities and the construction of new plants, whereas in good times, capital goods are often replaced before they completely depreciate. Similarly, during recessions, households often delay the purchase of big-ticket items, including automobiles, white goods, and so on.
  • Monopoly Power – Many industries producing capital goods and consumer durables are found in high concentration, i.e. a small number of large firms dominate the market. These firms can set above-competitive prices to increase their profit. When recession hits, these firms are reluctant to lower prices since this would upset the industry price structure, possibly sparking a price war. This reluctance means that the initial effects of a drop in demand are primarily a decline in production and an increase in employment.

 

Volatility

Another important concept is that of volatility. By volatility, we mean how large deviations from the mean typically are for a given series (usually measured using standard deviation). A variable is more volatile if the swings from peak to trough are big. GDP is relatively volatile: by looking at the variables that comprise GDP, their shares in GDP, and their relative volatility, we can gauge what factors influence GDP the most. For example perhaps consumption of non-durables and services account for roughly 60% of our measure of GDP, with broad investment and government consumption accounting for 20% each.