BUSINESS CYCLES: The recurring, but irregular, expansions and contractions of economic activity in the macroeconomy.

While business cycles are frequently measured by real gross domestic product, they show up in many aggregate measures of economic activity, including the unemployment rate, the inflation rate, consumption expenditures, and tax collections, to name just a few. The study of macroeconomics is largely the study of business cycles. Macroeconomic theories seek to understand business cycles and macroeconomic policies seek to correct the problems of business cycles. Business cycles are irregular, nonperiodic fluctuations in the macroeconomy, especially seen by changes in the unemployment rate, the inflation rate, and growth rate of real GDP. This means that the overall economy expands and grows for a while. How long? It could be a couple of years. It might be up to a decade. No one knows for sure. But then it contracts and declines for a while. How long? It could be six months. It might be a few years. No one knows. The economy expands. The economy contracts. It grows in spurts, it stops, it declines. Things are good, then bad. Unfortunately, no one knows how long the good times will last before they turn bad. This is the non-periodic, irregular nature of business cycles. The economy might expand for a year or it might expand for a decade before it contracts. While the term "cycle" is used to indicate these fluctuations, business cycles are not cyclical or periodic in the same way as other noted cycles, such as the daily cycle of sunrise and sunset, the lunar cycle of full moon and new moon, or the seasonal cycle of spring, summer, fall, and winter. Macroeconomics The study of business cycles is intertwined with the macroeconomic branch of economics. In fact, macroeconomics is largely the study of business cycles. A Typical Business Cycle Macroeconomic theories seek to explain why business-cycle fluctuations exist. Macroeconomic policies are proposed to correct business-cycle fluctuations. Macroeconomic measures are devised to track business-cycle fluctuations. The key macroeconomic problems of unemployment and inflation result from business-cycle fluctuations. If it were not for business-cycle fluctuations, economists would have significantly less interest in the study of macroeconomics. The Business Cycle Pattern Business cycles tend to be irregular, and thus largely unpredictable, fluctuations in the economic activity. However, on average, a complete cycle lasts from four to five years and tends to follow a consistent pattern of expansion, then contraction. A typical business cycle is presented in the exhibit to the right. The four parts of a business cycle are contraction, expansion, peak, and trough. The jagged red line, which presents a hypothetical tracking of real GDP, can be used to illustrate the alternative parts of a business cycle. • • • • • Contraction: A period of decline in which economic activity decreases for at least six months is termed a contraction. Contractions, are also termed recessions. Trough: The end of a contraction and transition to an expansion is designated a trough. Expansion: A period of growth in which economic activity tends to increase from month to month and year-to-year is termed an expansion. Expansions usually last about three to four years, but some have gone on as a long as a decade. The early part of an expansion is often termed a recovery. Peak: The end of an expansion and the transition to a contraction is designated a peak. Long-Run Trend: Business-cycle expansions and contractions fluctuate around the long-run trend, indicated in this exhibit as the straight, blue line. The long-run trend represents the production capacity of the economy and full employment.

The two most noted macroeconomic problems, inflation and unemployment, tend to be most pressing during specific phases of business cycles. The unemployment rate, for example, is almost guaranteed to increase during a contraction and decrease during an expansion. The inflation rate, by contrast, tends to increase during an expansion and decrease during a contraction.

Expenditures on production by all four sectors (household. gives people the opportunity to convert financial wealth into something less affected. This explanation goes something like this: An expanding economy causes interest rates to rise. One is academic. But that is the roller coaster ride of the economy. especially unemployment and inflation. with a capital B. and foreign) were all down. Dozens of specific aspects of the macroeconomy can. Total production declined about 40 percent. too. can be addressed. which causes decreases in gross domestic product. The Great Depression was a monumental economic bust that lasted for over a decade. and never fell below 10 percent during the entire decade. But unemployment was not the only indication of difficult economic times. government purchases (especially those associated with war-time military expenditures). Knowing a downturn is imminent lets people plan for an extended period of unemployment. government. The severity of the Great Depression is perhaps best seen through the unemployment rate. In modern times. created expansions and contractions. decades of study by economists suggest two notable causes worth highlighting--investment and political elections. business. The decline in investment triggers a multiplier effect. All aspects of the economy were bad. Because capital investment is often undertaken with borrowed funds. human lives are seriously affected by the ups and downs of business cycles. interest rates begin to fall. Causes Business cycles appear to be the result of the inherent instability of a complex economy. However. • Investment: A primary cause of business cycles that surfaces time and time again. higher interest rates increase the cost of borrowing and discourage investment. a few years earlier. it is good. With additional spending on gross domestic product. Life was good. Unemployment was down. by inflation. Government purchases declined by 15 percent. and household consumption (especially when affected by changes in consumer confidence and expectations about the future state of the macroeconomy). This rate is likely to increase into the 8 percent range during contractionary bad periods. The Great Depression While the existence of economy-wide booms and busts has been common knowledge since the onset of the industrial revolution. the other tends to be somewhat selfish. • First. they are part of the mechanism of the economy. key macroeconomic problems. in the 1920s. The economy is up. While a number of events could. The unemployed take a serious hit to their living standards during recessionary downturns. foreign trade (especially changes in imports caused by trade barriers). the formal study of business cycles received a significant boost during the Great Depression of the 1930s. and then it fell apart. an unemployment rate in the range of 5 percent is common during expansionary good times. business cycles are an inherent part of the macroeconomy. national income. and then it drops. is business sector investment in capital goods. on the academic side. in the 1930s it approached 25 percent. Investment expenditures on capital goods by the business sector were down a whopping 90 percent. Those with fixed incomes or financial wealth take a serious hit to their living standards during inflationary upturns. it is high. cause business-cycle instability.The Study of Business Cycles The macroeconomic study of businesses cycles is undertaken for two main reasons. on the selfish side. A few notable examples of business cycle inducing instability are taxes (especially federal income taxes). The study of business cycles makes it possible to anticipate and prepare for these problems. Second. and consumption. Understanding the ups and downs of business cycles means a better understanding of the macroeconomy. This was Bad. and probably have. Production was up. The economy enters a contraction. Consumption by the household sector was off about 40 percent. the economy was quite prosperous. as the economy contracts. or even helped. Through this understanding. And net exports by the foreign sector declined by 60 percent. capital investment (especially when triggered by new technology or interest-rate changes). Lower interest rates reduce the cost of borrowing and entice greater capital investment. In direct contrast. However. in theory. • . Knowing that the economy is on the verge of higher inflation.

Stabilization policies are designed to work in the OPPOSITE direction of the business cycle. As such. increasing government purchases. especially fiscal policy and monetary policy. decide to promote a business-cycle expansion because they know the public re-elects politicians during expansions and elect new ones during contractions. The goal of stabilization policies is not merely to prevent contractionary declines. especially raising taxes. • Political Elections: A second explanation of business cycle ups and downs is politics. causing inflation and unemployment. especially higher inflation and budget deficits. especially reducing taxes. and restricting the money supply. and expanding the money supply. but this time increasing national income and consumption. businesses make the individual decisions that collectively trigger business-cycle expansions and contractions. the contraction hits after the election and only lasts about a year. but to stabilize the overall business cycle pattern. Such post-election policies cause a business-cycle contraction. to achieve their own political ends. government leaders manipulate the economy. The red line is the "natural" business cycle. and to keep expansion from running wild. governments (especially the Federal. but occasionally state governments. Fortunately for the elected leaders. causing business-cycle expansions and contractions. to be countercyclical. the re-elected leaders realize that they must now address the problems created by the over expansion leading up to the election. Contractionary policy that seeks to restrict the economy is recommended to avoid or correct the inflationary problems of excessive expansion. This political explanation implies that business-cycle instability is the result of a government policies and not a consequence of natural market-based economy. and abusing their power. As such. Fiscal policy is changes in government spending and taxes. This investment explanation implies that investment-induced business-cycle instability is a natural consequence of a market-based economy. the goal is to avoid contraction and promote expansion. Politicians typically begin the onset of an expansion 2 to 3 years before an election. But it rises and falls too much. They have plenty of time to get the economy expanding once again before the next election 2 to 3 years down the road. This explanation goes something like this: Elected leaders. the government's fiscal budget. After the election. too) undertake assorted stabilization policies.the multiplier effect is triggered once again. This is accomplished by contractionary policies. Counter cyclical Stabilization Policies To counter the problems associated with business cycles. politicians cause business-cycle expansions and Stabilization Policies contractions. Monetary policy is changes in the amount of money circulating around the economy and interest rates. Acting in their own best interests. can be corrected by limiting or even preventing government intervention. decreasing government purchases. This stimulation can be achieved through expansionary fiscal and monetary policies. that is. This then prompts the onset of another expansion. The economy would rather have a business cycle more like that revealed with a click of the [Policy] button. business-cycle instability. business-cycle instability is best corrected by government intervention. According to this explanation. As such. seeing an election on the horizon. especially high rates of unemployment and inflation. Too much expansion can be just as problematic as a contraction. Expansionary policy that seeks to stimulate the economy is the recommended course of action to correct or avoid the unemployment problems of a contraction. Doing what is best for them. Primary Policies . Rising and falling around the long-run trend line. The exhibit to the right can be used to illustrate the goal of stabilization policies.

A business cycle is comprised of distinct phases. interest rates decline. Inflation worsens during an expansion when buyers try to buy more than the economy can produce. The transition from contraction to expansion is a trough and the transition from expansion to contraction is a peak. indicated by the red line. buy more production. and inflationary pressures are reduced. An expansion is a period of increasing economic activity and a contraction is a period of declining economic activity. In other times actual real GDP grows slower than potential real GDP. as this exhibit reflects actual real GDP. households and business are able to spend more. This line has a positive slope because the economy's production capabilities increase over time as the quantity and quality of resources increase. The long-run trend is illustrated by the blue line in the exhibit at the right. Or taxes can be reduced. The two most popular types are expansionary fiscal policy and expansionary monetary policy. Contractionary policies are appropriate when a business-cycle expansion heats up to the point of higher inflation. Along with the decrease in the money supply. Contractionary monetary policy reduces the amount of money in the economy. pattern of business cycles can be divided into two basic phases--expansion and contraction. the business-cycle expansion flattens. The two types are contractionary fiscal policy and contractionary monetary policy. well. Long-Run Trend . Along with the increase in the money supply. can be reduced directly by reducing government purchases or indirectly by increasing taxes and diverting household income away from consumption expenditures. The positive slope of the long-run trend line reflects a 3 percent annual growth of production capabilities. • Contractionary policies are. Contractionary policies counter an expansion and expansionary policies counter a contraction. With more money. Greater government spending can offset the drop in investment. which leaves more spendable income in the hands of the consumption-spending household sector. Greater spending is just the thing needed if investment is the cause of business cycles. a general period of expansion followed by a general period of contraction. does not coincide with this long-run trend of potential real GDP. During some periods actual real GDP is greater than potential real GDP and in other periods actual real GDP is less than potential real GDP. • BUSINESS CYCLE PHASES: The recurring. This boost in consumption can also offset the drop in investment. Potential real GDP is the amount of output that the economy can produce if all resources are fully employed. The transition from expansion to contraction is termed a peak and the transition from contraction to expansion is termed a trough. and the inflationary pressure. then they buy less stuff.Expansionary policies are designed to counter a business-cycle contraction. first consider the long-run trend of real GDP. Expansionary monetary policy is an increase in the amount of money in circulation. And on occasion actual real GDP declines even though potential real GDP continues to rise. or what is termed either potential real GDP or fullemployment GDP. the exact opposite of expansionary policies. Again note that these are a countercyclical policies. The fact that actual real GDP does not coincide with the long-run trend of potential real GDP is the essence of business cycles and instability of the macroeconomy. but irregular. This excessive spending. Business-cycle fluctuations gyrate around the long-run trend that tracks full-employment production capabilities. • Contractionary fiscal policy is higher taxes or fewer government purchases. At some times actual real GDP grows faster than potential real GDP. If people have less money. • Expansionary fiscal policy is increasing government purchases or reducing taxes. The early portion of an expansion is often referred to as a recovery. Long-Run Trend Before getting to the specific phases. These two phases are marked by two transitions. and counter the contraction. However. which encourages expenditures made by borrowing. interest rates rise. which discourages expenditures made by borrowing.

but could be as short as six months or as long as eighteen months. like a contraction. then the greater inflationary problems are likely to be. . The end of an expansion. In addition. The longest contraction on record. when real GDP reaches the long-run trend and when actual real GDP is equal to potential real GDP. Clearly real GDP declines over this segment. unemployment results when real GDP is below the long-run trend. Inflationary problems. The long-run trend is commonly represented as a positively-sloped line in a diagram depicting business-cycle phases. A peak means that the expansion has ended and that a contraction is about to begin. An expansion typically lasts about three to four years. might not seem like a good thing. is illustrated in this exhibit. Because the long-run trend represents full employment. Peak An expansion. then the greater is unemployment. Clearly real GDP increases over this segment. it really is. which is a period of declining economic activity.Contraction Contraction One of the two primary business-cycle phases is a contraction. but could be as short as one year or as long as a decade. eventually comes to an end. The peak in the previous exhibit is indicated by point C. the lower real GDP dips below the longrun trend. The early part of an expansion is usually termed a recovery because the economy is "recovering" from the contraction. Trough A contraction does not last forever. It is the end of the previous expansion that took the economy from point B to point C. A contraction typically lasts about a year. it really has a down side. or when actual real GDP is less than potential real GDP. is illustrated in this exhibit. the highest level of the business cycle might seem like a good thing. Moreover. then the economy has full employment. The longest expansion on record. at least none have so far. occurring during the Great Depression. lasted ten years. An expansion. A contraction generally takes the economy from at or above the longrun trend to below the long-run trend. A contraction. the more real GDP rises above the long-run trend. lasted almost four years. Expansion The second of the two primary business-cycle phases is an expansion. however. It is the end of the previous contraction that took the economy from point A to point B. This slope captures the economy's expansion in its production possibilities resulting from increases in the quantity and quality of resources. Because the long-run trend represents full employment. The trough in the previous exhibit is indicated by point B. Expansion LONG-RUN TREND: The pattern of potential real gross domestic product of an economy based on full employment of available resources. While a trough. the lowest level of the business cycle. While a peak. arise when the actual real GDP exceeds potential real GDP as is the case in this diagram near point C. An expansion generally takes the economy from below the long-run trend to at or above the long-run trend. The end of a contraction. occurring during the 1990s. A trough means that the contraction has ended and that an expansion is about to begin. which is a period of increasing economic activity. and the onset of an expansion is a trough. and the onset of a contraction is a peak. The shaded segment of the real GDP line between points B and C is the expansion. The shaded segment of the real GDP line between points A and B is the contraction.

(8) average workweek in manufacturing. in other periods actual real GDP is growing slower than potential real GDP. To reveal the long-run trend of real GDP. and inflation is likely to occur. (5) new building permits for private housing. business leaders. (7) the M2 real money supply. BUSINESS CYCLE INDICATORS: Assorted economic statistics that provide valuable information about the expansions and contractions of business cycles. then falls. During some periods actual real GDP is growing faster than potential real GDP. (2) an index of vendor performance. Clearly real GDP rises. The fact that actual real GDP does not coincide with the long-run trend of potential real GDP is the essence of business cycles and instability of the macroeconomy. . that are a fundamental part of business cycles.S.Long Run Growth The long-run trend is a positively sloped line on a diagram that plots the movement of actual real gross domestic product over time. the ups and downs. and lagging indicators used to analyze business-cycle instability. then the economy is temporarily overshooting its full employment potential. then falls. and the Dow Jones Company. These statistics are grouped into three sets--lagging. The red line represents the value of real gross domestic product (real GDP) over a period of several months. Leading economic indicators tend to move up or down a few months BEFORE business-cycle expansions and contractions. This blue line represents the amount of real GDP that the economy can produce if all resources are fully employed. If actual real gross domestic product is above the long-run trend due to an expansion. indicated by the red line lying above or below the blue line. and lagging. this long-run trend represents approximately a 3 percent annual growth of production capabilities and potential real GDP. • Leading Economic Indicators: This group includes ten measures that generally indicate business cycle peaks and troughs three to twelve months before they actually occur. (4) the Standard & Poor's 500 index of stock prices. then rises. and (10) average weekly initial claims for unemployment insurance. Treasury bonds and Federal Funds. resulting in potential real GDP. Business cycle indicators are a series of economic measures compiled from a variety of sources by The Conference Board that track monthly business cycle activity. and leading. (6) the interest rate spread between U. Lagging economic indicators tend to rise or fall a few months AFTER business-cycle expansions and contractions. (3) manufacturers' new orders for nondefense capital goods. coincident. It has a positive slope because the economy's production capabilities increase over time due to increases in the quantity and quality of resources. This is the instability. During some periods actual real GDP is greater than potential real GDP and in other periods actual real GDP is less than potential real GDP. coincident. The diagram displayed in this exhibit can be used to illustrate the macroeconomy's long-run trend. The ten leading indicators are: (1) manufacturers' new orders for consumer goods and materials. And in some cases actual real GDP declines even though potential real GDP continues to expand. These measures are then compiled by economists and number crunchers at the Conference Board into leading. (9) an index of consumer expectations. and policy makers with a bit of insight into the current state of the economy and glimpse into where the economy might be headed. It is primarily used to identify unemployment and inflation problems generated by the business-cycle instability. Clearly actual real GDP does not follow this long-run trend of potential real GDP. click the [Long-Run Trend] button. If actual real gross domestic product is below the long-run trend. The Big Three The business cycle indicators compiled by the Conference Board are grouped into one of three categories-leading. Historically. including the Bureau of Labor Statistics. the Federal Reserve System. coincident. then the economy is not living up to its full employment potential and the economy has in a contraction and unemployment. Coincident economic indicators tend to reach their peaks and troughs AT THE SAME TIME as business cycles. indicated by the red line having a steeper or flatter slope than the blue line. The actual measures used as business cycle indicators are collected by several different government agencies and private organizations. or potential real GDP. They provide consumers.

add a little extra into his savings account. • Leading: A click of the [Leading] button reveals a thin blue line that rises and falls a few months before real GDP rises and falls. Handy Composites The individual indicators are useful in their own right. The ten separate leading economic indicators are combined into a handy composite index of leading economic Business Cycle Indicators indicators. This green coincident indicator line lies virtually on top of the red real GDP line. Dan Dreiling works in an industry that tends to suffer high rates of unemployment during contractions. He might want to postpone expenditures.• • Coincident Economic Indicators: This category contains four measures that indicate the actual incidence of business cycle peaks and troughs at the time they actually occur. The lagging indicators are: (1) labor cost per unit of output in manufacturing. (3) real personal income (after subtracting transfer payments). this blue leading indicator line parallels movements of the red real GDP line. (5) consumer credit as a fraction of personal income. • • When combined all three indicators reveal a particular pattern. . but when combined as composite measures. How They Track The exhibit to the right can be used to illustrate each of the three sets of business cycle indicators individually and how they relate to the official tracking of business cycle peaks and troughs. especially peak and trough turning points. but it does so earlier. but it does so after the fact. take note of the somewhat jagged red line displayed in the exhibit. (2) industrial production. • If. It provides a hypothetical tracking of real gross domestic product over several months. they provide even greater insight into the business cycle activity. The coincident indicators rise and fall with the business cycle. (2) the average prime interest rate. marked by T. Coincident: A click of the [Coincident] button reveals a thin green line that rises and falls together with the rise and fall of real GDP. for example. So too are the four coincident and seven lagging indicators combined into handy composite indicators. this information can help anticipate and possibly avoid the problems of unemployment and inflation that tend to arise during specific business cycle phases. thus anticipating the peaks and troughs of the business cycle. In effect. [Coincident]. The leading indicators rise and fall before the business cycle. (4) the Consumer Price Index for services. can be quite useful. Or to display all three simultaneously. (6) the average duration of unemployment. One trough is displayed as well. click the [All] button. First. coincident economic indicators are a primary source of information used to document the "official" business cycle turning points. Valuable Information Tracking business cycle activity. then identifying business cycle peaks that mark the onset of contractions can help him prepare for an upcoming layoff. The coincident indicators are: (1) the number of employees on nonagricultural payrolls. And the lagging indicators rise and fall after the business cycle. In fact. (3) the amount of outstanding commercial and industrial debt. or even search for other employment. labeled with P. A composite for any of the three groups of indicators can be displayed by clicking the corresponding [Leading]. and (7) the ratio of inventories to sales for manufacturing and trade. tracking along with the peaks and troughs of the business cycle. Lagging: A click of the [Lagging] button reveals a thin purple line that rises and falls a few months after real GDP rises and falls. the purple lagging indicator line also parallels movements of the red real GDP line. and (4) real manufacturing and trade sales. and [Lagging] buttons. In this case. Lagging Economic Indicators: This is a group of seven measures that generally indicate business cycle peaks and troughs three to twelve months after they actually occur. Two peaks are evident. At the very least.

Knowing that an expansion is about to begin. • • • . coincident indicators document what the economy is currently doing and lagging indicators reinforce what happened to the economy a few months back. In particular. Coincident indicators are some of the timeliest economic measures available. they predicted 3 contractions that never happened. However. Because the public has entrusted these folks with the responsibility of solving economic problems and guiding the country to prosperity. while leading indicators TEND to predict business cycles. they MUST stay informed about business cycle activity. Knowing what WILL happen is almost always more important that knowing what IS happening or what DID happen already. Having accurate information about CURRENT economic conditions is not as easy as it might seem. however. leading indicators have actually predicted "12 of the last 9 contractions. if not months.) are available almost instantaneously. leading indicators tend to get the most notoriety. Of what good is knowing the state of the economy several months AFTER the fact? In the wacky world of economic number crunching. processing. Working Together Of the three sets of indicators. and Chairman of the Federal Reserve System). it is nice to document the actual event. he might want to rearrange his investment portfolio. While individuals can personally benefit from business cycle indicators. All three. they are not always correct. NOT staying informed is just the sort of thing that can transform a President into an EX-President or an elected politician into a lobbyist. transferring his financial wealth between stocks. and assorted bank accounts. Collecting. interest rates. if Winston Smythe Kennsington III has a great deal of financial wealth that could be reduced by inflation. most information about the economy is available only weeks. In fact. The Here and Now: While leading indicators might predict business cycles. In other words. Congress.• Alternatively. lagging indicators are needed to "finalize" the most recent contraction. While financial data (stock market prices. have important roles to play in tracking business cycles. • On the Horizon: Leading indicators "predict" what the economy will be doing a few months down the road. bonds. The reason is probably obvious--by virtue of forecasting coming events. lagging indicators actually have a useful role. and analyzing data takes time. which is the role of coincident indicators. In contrast. the next recession cannot start until the lagging indicators indicate that the last one is over. etc. Lagging indicators must mark the trough of the previous contraction before leading indicators can signal the peak of the current expansion and the beginning of the next contraction. then identifying business cycle troughs that mark the onset of expansions can also provide valuable information." In other words. after the fact. Over and Done: At this point there might be some question about the usefulness of lagging indicators. this information is perhaps even more useful to government policy makers (especially the President.

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