Business Cycle

Three Types of Business Cycle

Business Cycle Phases

Business Cycles as shifts in AD and AS

Business Cycle Theories

Business Cycle

• The business cycle occurs when economic activity speeds up or slows down.

• A business cycle is a swing in total national output, income and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in many sectors of the economy.

Business Cycle

Potential output

Actual output

Business cycles are the

irregular expansions and

contractions in economic

activity.

Q

t (in years)

Three Types of Business Cycle

• Economic theory define three types of business cycle: Short-term (Kitchin) cycle: from 2 to 4 years, it

results from the changes in business inventories.

Medium-term (Jouglar) cycle: from 7 to 11 years, it refers to new business investment.

Long-term (Kondratiev) cycle: from 30 to 50 years, it results from the technological innovation.

Business Cycle

• A business cycle can be divided into four major phases: Recession – the downturn of a business cycle.

This is a period in which real GDP declines for at least 6-10 months. A recession that is large in both scale and duration is called a depression.

Trough – the lowest point of real GDP at the end of a recession.

Business Cycle

Expansion (boom) is a period in which output increases and approaches potential GDP or perhaps even overshoots it.

Peak – the point at which recession begins, the highest point in real GDP before a recession.

Characteristics of a recession

• Investments, housing, consumption, production, real GDP slows down, inflation increases.

• Employment falls sharply.• As output falls, inflation slows.• Business profits fall sharply.• Interest rates decline due to steps taken by

the system.

Business Cycles and AD

• Business cycle generally occurs as a result of shifts in the AD. Decline in the AD lowers output and as a result of downward shift in the AD curve, the gap between actual and potential GDP becomes greater during a recession.

Business Cycles as Shifts in AD

P ASQP

AD1

Q1

P1

AD

Q

PE

E1

0

Characteristics of the recession:• Consumers purchases decline and

businesses react by holding back

production. Real GDP falls.

Businesses investment also falls.• The demand for labor falls.• The prices of many commodities fall.

Wages are less likely to decline, but

they tend rise less rapidly.• Business profit fall, because the

demand for credit falls, interest rates

generally also falls.

Business Cycles as Shifts in AD

Q

P ASQP

AD1

Q1

P1

AD

Q

PE

E1

0

The case of a boom is,

naturally, just the opposite

of recession.

Business Cycles and Shifts in AS

Q

P ASQP

AS1

Q1

P1

AD

Q

PE

E1

0

Business Cycle Theories• Although the main interpretation of

business cycles looks to changes in AD, we may classify the different theories into two categories: The external theories find the root of the

business cycles in the fluctuations of something outside the economic system (wars, revolutions, elections, economic policy, migrations, oil prices, gold discoveries, discoveries of new lands and resources).

The internal theories look for mechanism within the economic system itself (self-generating business cycles).

Business Cycle Theories• Some of the most important business cycle

theories are: Neoclassical theories attribute the business

cycle to the expansion and contraction of money and credit.

Keynesian theories attribute fluctuations to the economic system itself. They think that the macro economy is prone to extended business cycles, with high levels of unemployed resources for long period of time. They further hold that the government can stimulate the economy.

Business Cycle Theories

Political theories of business cycle attribute fluctuations to politicians who manipulate fiscal and monetary policies in order to be reelected.

Business Cycles and AD• Business cycle generally occurs as a result of

shifts in the AD. Decline in the AD lowers output and as a result of downward shift in the AD curve, the gap between actual and potential GDP becomes greater during a recession.

• Large wars, burst of innovation, fiscal expansion lead to expansion.

• Every expansion breeds contraction and every contraction breeds revival and expansion. (multiplier and accelerator theory)

Business Cycles as Shifts in AD

P ASQP

AD1

Q1

P1

AD

Q

PE

E1

0

Characteristics of the recession:• Consumers purchases decline and

businesses react by holding back

production. Real GDP falls.

Businesses investment also falls.• The demand for labor falls.• The prices of many commodities fall.

Wages are less likely to decline, but

they tend rise less rapidly.• Business profit fall, because the

demand for credit falls, interest rates

generally also falls.

Business Cycles as Shifts in AD

Q

P ASQP

AD1

Q1

P1

AD

Q

PE

E1

0

The case of a boom is,

naturally, just the opposite

of recession.

Business Cycles and Shifts in AS

Q

P ASQP

AS1

Q1

P1

AD

Q

PE

E1

0

Indicators• Leading Indicator- an economic variable that tends

to move in advance of aggregate economic activity .

• Coincident variable- is one whose peaks and troughs occur at about the same time of as the corresponding business cycle peaks and troughs.

• Lagging Indicator- variable- is one whose peaks and troughs occur later than the corresponding business cycle peaks and troughs.

Indicators

• Leading Indicator-inventory investment, average labor productivity, money supply growth, stock prices,

• Coincident variable- Production, consumption, investment, employment

• Lagging Indicator variable- inflation, nominal interest rates,

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