Advanced Macroeconomics
Course Instructor | Dr. Abidemi Somoye
ADVANCED MACROECONOMICS | ECO 605
Business Cycle
Business Cycle
Business Cycle
Business Cycle
Economic history shows that no
economy grows in a smooth and even
pattern. A country may enjoy several
years of economic expansion and
prosperity, with rapid increases in
stock prices (as in the 1990s) or
housing prices (as in the early
2000s).
Business Cycle
Then, the irrational exuberance may
flip over to irrational pessimism as,
during the 2007–2009 period, lenders
stop issuing mortgages or car loans
on favourable terms, banks slow their
lending to businesses, and spending
declines. Consequently, national
output falls, unemployment rises, and
profit and real incomes decline.
Business Cycle
Eventually the bottom is reached and
recovery begins. The recovery may be
incomplete, or it may be so strong as to
lead to a new boom. Prosperity may mean a
long, sustained period of brisk demand,
plentiful jobs, and rising living standards.
Or it may be marked by a quick,
inflationary flare-up in prices and
speculation, followed by another slump.
Business Cycle
Upward and downward movements
in output, inflation, interest rates, and
employment form the business cycle
that characterizes all market
economies.
What exactly do we mean by
“Business Cycle”?
Business Cycle
The business cycle is a term used by
economists to describe the increase
and decrease in economic activity
over time. The economy is all
activities that produce, trade, and
consume goods and services such as
businesses, employees, and
consumers.
How Does Business Cycle Work?
The duration of a business cycle is the
period containing one expansion and
contraction in sequence. One
complete business cycle has four
phases: expansion, peak, contraction,
and trough. They don’t occur at
regular intervals or lengths of time,
but they do have recognizable
indicators.
How Does Business Cycle Work?
Three factors cause each phase of the
business cycle: the forces of supply and
demand, the availability of capital, and
consumer and investor confidence
(Congressional Research Service, 2022). The
most critical is confidence in the future—
when consumers and investors have faith in
the future and policymakers, the economy
tends to expand. It does the opposite when
confidence levels drop (Federal Reserve
Bank, 2010).
Expansion
An economic expansion is a period
of growth throughout an economy.
Because productivity is increasing, it
is generally represented on a curve as
an upward movement. The expansion
phase is also known as the economic
recovery phase because it occurs
after the economy has contracted for
a long period.
Expansion
Gross domestic product is the measurement that
is most used to indicate economic output.
During the expansion phase, it increases.
Economists consider a GDP growth rate range
of between 2% to 3% to be healthy. In an
expansion, the stock market experiences rising
prices, and investors are confident. Businesses
receive more funding and make more, and
consumers have more money to spend. An
economy can remain in the expansion phase for
years.
Peak
The peak is the second phase of the cycle.
It occurs when all of the expansionary
indicators begin to level off. The
economy might take weeks or a year to
transition into the contraction phase. The
GPD growth rate falls below 2% and
continues to decline. The peak is
displayed on a graph as the highest
portion of the curve before moving
downward.
Contraction
The third phase is the contraction stage. It begins
after the economy peaks and ends when GDP and
other indicators cease to decrease. In this stage,
the economy does not experience growth; instead,
it shrinks. When the GDP rate turns negative, the
economy enters a recession. Businesses lay off
employees, the unemployment rate rises above
normal levels, and prices begin to decline (IMF,
2020). A contraction is generally portrayed on a
graph as the part of the curve that is consistently
decreasing.
Trough
The trough is the fourth phase of the
business cycle. The declining GDP begins to
decrease its rate of negative change,
eventually turning positive again. The
economy begins a transition from the
contraction phase to the expansion phase. A
trough is displayed on a graph as the lowest
point of the curve. The business cycle begins
again when GDP begins to increase, and the
curve moves upward consistently.
Business Cycle
Business cycles are economy wide
fluctuations in total national output, income,
and employment, usually lasting for a period
of 2 to 10 years, marked by widespread
expansion or contraction in most sectors of
the economy.
Economists typically divide business cycles
into two main phases:
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Business Cycle
Peaks and troughs mark the turning points of
the cycle. Figure 1. shows the successive
phases of the business cycle. The downturn
of a business cycle is called a recession. A
recession is a recurring period of decline in
total output, income, and employment,
usually lasting from 6 to 12 months and
marked by contractions in man sectors of
the economy. A recession that is large in both
scale and duration is called a depression.
Expansion
Recession
Business Cycle
NBER defines a recession as “a
significant decline in economic
activity spread across the economy,
lasting more than a few months,
normally visible in real GDP, real
income, employment, industrial
production, and wholesale-retail
sales.”
Business Cycle
While individual business cycles are
not identical, they often share a family
similarity. If a reliable economic
forecaster announces that a recession
is about to arrive, what are the typical
phenomena that you should expect?
The following are a few of the
customary characteristics of a
recession:
Business Cycle
Investment usually falls sharply in
recessions. Housing has generally
been the first to decline, either because
of a financial crisis or because the
Federal Reserve has raised interest
rates to slow inflation. Consumer
purchases often decline sharply as
well. As businesses slow production
lines, real GDP falls.
Business Cycle
Employment usually falls sharply in the
early stages of a recession. It sometimes is
slow to recover in what are often called
“jobless recoveries.”
As output falls, inflation slows and the
demand for crude materials declines, and
materials’ prices tumble. Wages and the
prices of services are unlikely to face a
similar decline, but they tend to rise less
rapidly in economic downturns.
Business Cycle
Business profits fall sharply in recessions. In
anticipation of this, common-stock prices
usually fall as investors sniff the scent of a
business downturn.
Generally, as business conditions deteriorate
and employment falls, the Federal Reserve
begins to lower short–term interest rates to
stimulate investment, and other interest rates
decline as well.
Monetarist view of Business Cycle
(Milton Friedman)
Monetarist view
The monetarist theory explains business
cycles with upward sloping short–run
aggregate supply curve and changes in money
supply.
The short–run aggregate supply or SRAS also
known as the aggregate supply is an upward–
sloping curve that shows the quantity of total
output that will be produced at each price
level in the short run.
Monetarist view
Wage and price stickiness account for the
SRAS curve’s upward slope.
Price stickiness refers to the market tendency
where price remains constant after hikes—it
does not fall back to optimal levels. The
stagnation of price hikes could be brought out
by lack of competition, monopoly, shortage of
goods, unavailability of similar products,
consumer choice, lack of options, or consumer
needs.
Monetarist view
The sticky wage theory highlights how
wages grow very slowly—even in
scenarios of inflation and
unemployment. Though wages increase
slowly, employees keep working. This
is due to inflation, personal liabilities,
lack of income sources, and
unemployment. It is also called nominal
rigidity.
Monetarist view
Reasons for sticky wages
Employment contracts: Workers may agree on
deals with firms to raise wages by say 3% a
year in return for productivity deals. If there is a
fall in demand for labour (due to recession or
fall in popularity of product), the firm may be
stuck with the employment contract and be
unable to cut wages at least in the short–term.
Minimum wages: A firm may face a legal
minimum wage and be unable to cut wages
below the national statutory minimum wage.
Reasons for sticky wages
Efficiency wage theories: This is an argument that
paying a higher wage increases workers morale,
loyalty and willingness to work hard. A cut in wages
is a psychological blow, which will seriously reduce
labour morale and productivity. Therefore, the firm
may feel that the cost savings of lower wages will be
offset by a fall in productivity.
Annual contracts: Wages are often set a year at a
time. therefore, at least in the short-term, wages are
fixed and inflexible. In the long-term, wages may be
more flexible.
Reasons for sticky wages
Trade unions: Trade unions will resist wage cuts. Also,
they are more likely to be concerned about the pay of
those in work, than those who are unemployed and not
in a trade union. The unemployed may be willing to
work at lower wages, but those ‘insiders’ who are
employed don’t want to see wage cuts.
Costs of hiring and firing workers: Labour is not the
same kind of commodity as buing inputs of raw
material. Once a worker is trained and used to
working, a manager will try to avoid the emotion of
sacking a worker or cutting wages because of the
human costs involved.
Reasons for sticky wages
Deflation and nominal rigidity: In a period of deflation
or very low inflation, wages are more likely to be
‘sticky’. The reason is that if inflation is 9%, then a firm
can increase nominal wages by 8% to achieve a real
wage cut of 1%. However, if inflation is 0%, to achieve
the same real wage cut, the firm would have to cut
nominal wages by 1%. This nominal wage cut is a much
greater psychological blow than increasing nominal
wages by 8%, in a time of inflation.
Money illusion posits that people have a tendency to
view their wealth and income in nominal dollar terms,
rather than recognize their real value, adjusted for
inflation.
Monetarist view
According to monetarists, when there is
slowdown in growth in money stock by the
action of the Central Bank of the country,
aggregate demand decreases. With the
upward sloping short–run aggregate supply
curve, given the wage rate, the decrease in
aggregate demand brings about decline in
both price level and national output and
employment causing unemployment in the
economy. That is, the economy experiences
recession.
Monetarist view
This is shown in Fig. 27A.2 where to begin with AD0
is the aggregate demand curve which cuts both the
vertical long run aggregate supply curve LAS and the
upward–sloping short–run aggregate supply curve
SAS at point E.
At point E, the system is in long–run equilibrium.
Now if there is a slowdown in growth of money
supply causing a leftward shift in aggregate demand
curve from AD0 to AD1. As a result, the economy
moves to the new equilibrium point B at which
aggregate demand AD1cuts the short-run aggregate
supply curve SAS.
Monetarist view
Monetarists believe that wage rate is only
temporarily sticky. When aggregate
demand decreases due to slowdown in
growth of money supply and causes
increase in unemployment, money wage
rate will eventually begin to fall. As
shown in Fig. 27A.2, with the fall in
money wage rate short–run aggregate
supply curve (SAS) shifts downward
result in fall in price level.
Monetarist view
Short–run aggregate supply curve (SAS) goes
on shifting downward until the equilibrium is
reached at point C at the level of potential
GDP level VF where full employment
prevails. Thus, according to monetarist
theory, through adjustment in money wage
rate and price, the economy again reaches full
employment equilibrium and unemployment
is eliminated.
Monetarist view
In this way monetarists explain how
with the fall in growth of money
supply, the economy goes into
recession and then through adjustment
in wage rate and price level new full
employment equilibrium is
automatically achieved at lower wage
rate and price level.
Monetarist view
The Monetarists also believe that changes in
money supply (time lag) do not immediately
affect aggregate demand or spending on
goods and services. The initial effect of
changes m money supply is on interest rate
and wealth. The initial expansion in money
supply is spent on financial assets, i.e. bonds
etc. driving their prices up and thereby
lowers interest rate.
Monetarist view
Eventually lower interest rate and increase in
their wealth leads to increase in investment
demand for capital goods and demand for
consumer goods and services (note that rise
in prices of bonds and shares causes wealth of
individuals to increase). How this changes in
aggregate demand for goods, both capital and
consumer goods, affect the price level and
aggregate output (GDP) depends on, as
explained above, on the response of supply of
output to it.
Monetarist view
It needs to be emphasized that the lag
between the increase in money supply and its
effect on aggregate demand is uncertain and
variable. Further, monetarists think that
economy is inherently stable and left to itself
it would automatically correct itself through
adjustment in wages and prices to restore
equilibrium at full-employment (i.e. potential
GDP) level. Therefore, they are of the view
that Central Bank or Government of the
Country should pursue non–interventionist
policy.
The Keynesian School
The Keynesian School
According to the Keynesian model, substantial
economic slumps come from falling aggregate demand
—the sum of overall consumption, investment, and
government spending within the economy.
When Aggregate Demand falls, producers of goods and
services lose revenue and are forced to adjust. How
does the market handle this economic adjustment?
In order for businesses to maintain profit levels, they
must reduce production costs. However, cost cutting is
difficult because of what economists call sticky wages
and prices.
The Keynesian School
Cutting wages can cut morale and, in turn, cut
productivity. In the end, employers wind up
cutting people altogether in order to escape the
sticky situation. So stickiness translates into
higher levels of unemployment.
Unemployment leads to decreased spending and
further depresses aggregate demand. Falling
aggregate demand combines with wage
stickiness, dragging the economy into systemic
crisis.
The Keynesian School
The Keynesian model accurately describes
real–world business fluctuations. Falling
aggregate demand has paved the way to
major downturns, including the Great
Depression. However, aggregate demand is
not the primary culprit in all crises. In
addition, when it comes to curing crises, the
Keynesian model comes up short.
The Austrian School
The Austrian School
What is the central claim of Austrian Business Cycle
Theory? Cowen boils down the Austrians' boom-bust
explanation: when the government manipulates the
money supply, entrepreneurs get false ideas about the
economy and make unsustainable decisions.
When the central bank inflates the supply of money,
the real interest rate falls because there is more
money to be lent out. Since money is cheaper to
borrow, entrepreneurs ramp up investment and take
on riskier long-term projects—a boom often follows.
But the man-handled market environment doesn't
hold.
The Austrian School
False hopes lead to failures and an apparent boom,
well, busts. Tyler points to the housing bubble as a case
study. Between 2001 and 2004, the Federal Reserve
played fast and loose with credit. Booming borrowing
to invest in housing inflated the housing bubble. But
when house prices fell, these long-term investments
proved to be unprofitable and brought on the bust. How
can we escape the cycle? Austrians propose that we
steer clear of inflation—institute a gold standard or a
monetary rule to avoid financial disaster. The rationale:
a tighter money market means a more stable monetary
supply that will enable entrepreneurs to keep
expectations and investments in check.
The Austrian School
For many Austrians, kicking inflation takes on
additional urgency based on their claim that once
inflationary effects occur, the only corrective is to let
investments fail and re-allocate remaining resources.
The Ideas in Action: Turning to the Great Depression
and our current financial crisis, Cowen explains that
Austrians and Keynesians explain the downturns quite
differently. For Keynesians and monetarists, both big
busts could have been avoided if there was an increase
in aggregate demand. Austrians, on the other hand,
blame the effects of loose monetary policy misleading
entrepreneurs.
The Austrian School
Which theory does historical evidence support? One
point in the Austrian corner: many credit bubbles, the
Great Depression and recent recession included,
correspond with periods of loose monetary policy. But
the Austrian angle has its shortcomings. First, put
yourself into the mind of a bright entrepreneur for a
moment; if you can reliably predict that loose money
leads to riskier long term investments, wouldn't you
exercise caution while taking on new projects in easy-
money times? Second, we have to look at more than
two historical case studies; in a broader field of view,
we can find many economic downturns that have been
caused by monetary contractions rather than
expansions.
References
Paul Samuelson and Williams Nordhaus. Economics.
Nineteenth Edition
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References
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Good Luck.