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PART III.
Business Cycles and Macroeconomic Policy
I. Goal of Part III
A. What causes business cycles?
B. How should policymakers respond to cyclical fluctuations?
1. Classical economists see no need for government actions (monetary or
fiscal)
2. Keynesian economists think government intervention can smooth business
cycles
C. Coverage of Chapters 8 to 12
1. Chapter 8: Business cycle facts and features
2. Chapter 9: Basic IS-LM model of business cycle analysis
3. Chapter 10: Classical model of business cycles
4. Chapter 11: Keynesian model of business cycles
II. Goal of Chapter 8
A. Basic features of the business cycle
B. Definition and history of U.S. business cycles
C. Review of business cycle characteristics
D. An introduction to AD-AS model
Outline:
I. What is a business cycle?
Burns and Mitchell (NBER, 1946) made 5 points about a business cycle:
1. Fluctuations in aggregate economic activity, not a specific variable
or sector
2. Has four phases: expansion, peak, recession, trough
a. A business cycle is the sequence from one peak to the next, or one
trough to the next,
b. Peaks and troughs (turning points) are officially designated and announced
by the NBER Business Cycle Dating Committee
3. Recurrent but not periodic
a. Recurrent: the pattern of contraction, trough, boom, and peak repeat
itself
b. Not periodic: does not occur at regular and predictable intervals
4. Persistent
a. Declines followed by further declines; growth followed by further growth
b. Thus, important to forecast turning points
5. Co-movement. Many economic variables have regular and predictable
patterns of behavior over the course of business cycles.
II. The American Business Cycle: The Historical Record
A. The pre-WWI period (1865-1917)
1. Recessions common: 338 months recessions and 382 months of boom
2. Longest contraction 65 months; Oct. 1873-March 1879 (Civil War)
B. The Great Depression and WWII
1. Worst contraction in U.S. history. From 1929 to 1933
a. Real GDP fell by 30%
b. Unemployment rose from 3% to 25%
c. Major bank failures
d. Rise in protectionist policies, decline in world trade
2. Great depression ended with the start of WWII (1939)
a. Unemployment rate fell below 2%
b. Real GDP doubled from 1939 to 1944
C. Post-WWII business cycles
1. 1945-1970: five mild contractions
2. Longest expansion 106 months, Feb. 1961 - Dec. 1969
3. Some assumed the end (death) of business cycles
4. Three major recessions followed:
a. 1973 due to OPEC oil shock. GDP fell 3%, unemployment 9%, inflation
10%
b. 1981-82 due to tight monetary policy. Unemployment 11%; inflation 4%.
c. 1990-91 short recession
D. Have business cycles become less severe?
1. Earlier studies showed milder cycles in post-WWII era as compared to
the pre-1929 era
Average Recession Average Expansion
Pre-1929 21 months 25 months
Post-1945 11 months 50 months
2. Romer's Argument: The results are no correct due to pre-1929 measurement
errors.
3. More recent studies: Support earlier findings.
4. Results important because policy-makers have tried to smooth cycles
using monetary and fiscal policies over the post-war era. Thus, milder
cycles imply effective policies.
III. Business Cycle Facts
A. The Cyclical Behavior of Economic Variables
1. Direction: What is the direction of a variable's movement relative
to aggregate economic activity?
a. Pro-cyclical: same direction
b. Counter-cyclical: opposite direction
c. A-cyclical: No direction
2. Timing: What is the timing of a variable's movement relative to aggregate
economic activity?
a. Leading: move in advance
b. Lagging: move behind
c. Coincident: move at the same time
B. Cyclical Behavior of Key Macroeconomic Variables
1. Pro-cyclical variables:
a. Industrial production, consumption, business fixed investment, employment
(Coincident)
b. Residential investment, inventory investment, average labor productivity,
money growth, stock prices (Leading)
c. Inflation, nominal interest rates (Lagging)
d. Real wages, government purchases (timing unspecified)
2. Counter-cyclical variables:
a. Unemployment rate (timing unspecified)
3. A-cyclical variables
a. Real interest rate (timing unspecified)
C. The Index of Leading Indicators
a. A weighted average of ten variables that lead the business cycle and
are promptly reported
b. Developed by Mitchell and Burns (1938)
c. A decline in the index for two or three months in a row warns a recession
d. Problems with the leading indicators
1. Data revised frequently, may give wrong signal
2. Provides little info. on timing and severity of recessions
3. Must be revised to reflect structural changes in the economy.
D. International Aspects of the Business Cycles
a. Key macro variables behave similarly cross countries
b. Recessions and booms occur about the same time in industrial countries.
VI. Business Cycle Analysis: A Preview
A. Theories of Business Cycles
1. Two classes of theories
a. Classical theory
b. Keynesian theory
2. Two components of theories
a. A description of the shock
b. A model of the economy' response to the shock
B. Aggregate-Demand / Aggregate-Supply model
a. Three components
§ Aggregate demand: negatively sloped
§ Short-run aggregate supply: positively sloped
§ Long-run aggregate supply: vertical
b. Equilibrium in AD/AS model
§ Short-run equilibrium: AD crosses short-run AS
§ Long-run equilibrium: AD crosses long-run AS
c. Two types of shocks hit the economy
§ Demand-side shocks: autonomous changes in C, I, X, G, T, shifts
the demand curve
§ Supply-side shocks: changes in K, L, A, oil prices, shifts the
supply curves
d. How long does it take to get to the long-run?
1. Classical theory: prices adjust rapidly
§ Recessions are short-lived
§ No need for government intervention
2. Keynesian Theory: prices adjust slowly
§ Adjustment may take several years
§ Government policies may useful
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