BUSINESS CYCLE
n The short-term variations in economic activity are known as
BUSINESS CYCLE.
n Economic history shows that the economy never grows in a
smooth and even pattern.
n Upward and downward movements in output, inflation, interest
rates, and employment form the Business Cycles
that characterizes all market economies.
n Business Cycles are the irregular expansions and
contractions in economic activity.
n Business Cycles are economy-wide fluctuations in total
National Output, Income, and Employment, usually last for a
period of 2 to 10 years, marked by widespread expansion or
contraction in most sectors of the economy.
FEATURES OF THE BUSINESS CYCLE
n Economists divide Business Cycle into two phases:
1. Recession: The downturn of a business cycle is called
Recession.
n A period of decline in output, income & employment.
n Usually lasts from 6 months to a year.
2. Expansion: Upward turn of Business Cycle is called Expansion.
ä A period of rapid growth in output, national income, and
employment.
ä Factories work overtime and earn fabulous profit.
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DEPRESSION
n The contraction in business cycle persists for a decade and causes
widespread economic hardships. CYCLE
American History
n History of American Capitalism witnessed fabulous boom in 1990s.
n Recession begin in March, 2001 and ended in November, 2001.
n Great Depression in 1930s.
PEAKS and TROUGHS
n Peaks and troughs mark the turning points of the cycle.
n Peaks turn downward towards contractions, and
n Troughs lead upward towards expansions.
CHARACTERISICS OF A RECESSION
n Often consumer’s purchases decline sharply.
n Business inventories of automobiles & other durable goods
increase unexpectedly.
n Production/Output decline – real GDP falls
n Business investment in plants & equipments also fall sharply.
n The demand for labour falls – first seen in a drop in the average
workweek followed by layoff & higher unemployment.
n Inflation slows.
n Demand for raw materials decline – price tumble.
n Wages & prices of services are unlikely to decline.
n Business profit falls sharply.
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n Price of common-stock usually fall as investors sniff the scent of a
business cycle downturn.
n Because demand for credit falls – interest rates generally fall in
recession.
Business Cycle Theories
n Economists classify different sources of Business Cycle into two
categories.
1. Exogenous
2. Internal cycle
EXOGENOUS
n The exogenous theories find the sources of the Business
Cycle in the fluctuations of factors outside the economic system, i.e.
n Wars
n Revolutions
n Elections
n Change in Oil Prices
n Discoveries of gold, land, resources
n Scientific breakthroughs
n Technological innovations
n Migration
n Climate or weather changes
INTERNAL CYCLE
n Internal cycle theories look for mechanism within the economic
system itself – give rise to self generating Business Cycles.
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n In this approach, every expansion breeds recession and
contraction.
n And every contraction breeds revival and expansion – repeating
chain.
n Internal theory of the business cycle shows a mechanism, like the
motion of pendulum. etc.
Role of Multiplier-accelerator
Theory in Business-Cycle.
n According to this principle, rapid output growth stimulates
investment.
n High investment in turn stimulates more output growth – this
process continues until the capacity of economy is reached – at this
point, economy growth rate slows.
n The slower growth rate in turn reduces investment spending and
inventory accumulation, which tend to send economy into a
recession.
n The process then work in reverse as reached to trough, and the
economy then stabilizes and Business Cycle vs Aggregate
Demand
n What causes Business Cycles/fluctuations?
n How can govt. policies reduce their virulence?
n Keynes pointed out the importance of the forces of Aggregate
Demand in determining Business Cycle.turn up again.
KEYNESIAN ECONOMICS SUGGESTS
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äChanges in Aggregate Demand can have a powerful impact on the
overall level of output, employment, and price in the short-run.
äBusiness cycle fluctuations in output ,employment and prices are
often caused by shift in aggregate demand.
äThese shifts occur as consumers, businesses and governments
change total spending relative to the economy’s potential productive
capacity.
FORECASTING BUSINESS CYCLES
n Economists have developed forecasting tools to help them foresee
changes in the economy.
n In an earlier era: economists try to look at easily available data on
items like money, boxcar loadings & steel production
n If steel production is dropped, it means business purchases are
reduced – economy would soon slow down.
n This process combines with several different statistics into an
“index of leading indicators”.
n The index does give an early & mechanical warring on whether
the economy is heading up or down.
FORECASTING MODELS
n For a more detailed look into the future, economists turn to
computerized econometric forecasting models.
n Econometric model is a set of equations, representing the
behavior of the economy, that has been estimated using historical
data.
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n Pioneers in this area were Jan Tinbergen of Netherlands &
Lawrence Klein of University of Pennsylvania.
n Today, there is an entire industry of econometricians estimating
macroeconomics models & forecasting future of the economy.
n Generally, modellers start with an analytical framework containing
equations both aggregate demand & aggregate supply.
n In small models there are one or two dozen equations.
n While, large systems forecast from a few hundred to 10,000
variables.
n Using modern techniques, each equation is “fitted” to the
historical data to obtain parameter estimates (MPC, the slop of the
investment demand function, etc.).
n Once the exogenous and policy variables are specified (population,
govt. spending & tax rates, monetary policy, etc.), the system of
equations can project important economic variables into the future.
Aggregate Demand (AD)
n Ad is the total or aggregate quantity of output that is willingly
bought at a given level of price, other things hold constant.
n AD is the desired spending in all product sectors:
1. Consumption ( C )
2. Private Domestic Investment ( I )
3. Govt. Purchases of good & services ( G )
4. Net Exports ( X )
AD = C + I + G + X
Major Components of AD
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n AD has 4 major components:
1. Consumption ( C )
2. Private Domestic Investment ( I )
3. Govt. Purchases of good & services ( G )
4. Net Exports ( X )
AD = C + I + G + X
CONSUMPTION ( C ).
ä Consumption primarily determined by disposable income i.e.
personal income-taxes.
ä Other factors affect consumption are:
ä Long-term trends in income (permanent income)
ä Household wealth &
ä Aggregate price level.
AD Analysis focuses on the determinants of real consumption i.e.
nominal or dollar consumption divided by the price index for
consumption.
INVESTMENT ( I )
n Spending includes purchases of buildings, software, & equipments
and accumulation of inventories.
n Major determinants of investment are:
n Level of output
n Cost of capital (as determined by tax policies, interest rates &
other financial conditions).
n The major channel by which economic policy can affect investment
is monetary policy.
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GOVERNMENT PURCHASES ( G )
n Govt. purchases of goods & services.
n Purchases of goods like: tanks or road building equipments.
n Purchases of services like: services of judges & public school
teachers.
n This component of AD is determined directly by govt. spending
decisions.
NET EXPORTS
n Net exports are equal to the money value of exports minus money
value of imports.
n Export value determined by foreign incomes & outputs, by relative
prices & by foreign exchange rates.
n Net export, then determined by domestic & foreign income,
relative prices and exchange rates.
Movements along the AD Curve
n Holding other things constant, the level of real spending declines
as the overall price level in the economy rises---AD Curve slopes
downward.
n The reason of downward slope is that--- there are some elements
of income or wealth that do not rise when price level rises. (i.e.
personal income, govt. transfer payments,
minimum wages, company’s pension etc.).
n When price level goes up, real disposable income falls---leads to a
declined in real consumption expenditures.
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n Some elements of wealth may be fixed in nominal terms, e.g.
saving certificates or bonds purchases on promises to pay a certain
amount for a fixed period---if price level rises, the real wealth
declines--- leads to lower level of real consumptions.
n A rise in price level with a fixed money supply causes a decline in
investment & consumption.
n The AD curve slopes downward---real spending declines as the
price level rises, other things remain constant.
n Real spending with a higher price level decreases because of the
effect of higher prices on real incomes, real wealth & real money
supply.
Shift in AD Curve
n Macroeconomic policy variables under govt. control, i.e. monetary
policy & fiscal policy.
n Monetary Policy: Supply of money & interest rates.
n Fiscal Policy: Taxes & govt. expenditures
n Exogenous variable: wars, revolutions, foreign economic
activity.
Assignment
n Find annual data on real GDP for the United States for the period
of 1948-2003 (see the web site of the Bureau of
Economics Analysis, www.bea.gov )
n A. define “recessions” as years in which real GDP declined. Which
years were recessions?
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n Calculate the average growth rate of real GDP for the year 1948,
1973, 1988, 1998 & 2003.
n Collect data of real growth rate (GDP) of Pakistan from Bureau of
Statistics of Pakistan, and show recession & expansion in a business
cycle through a table and graph.
n Suggest possible measures to reduce the intensity of the present
recession occur in our economy.
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