short run biz cycles
Business cycles
chapter 14 since the time of the Industrial Revolution the Western world has experienced a
tremendous growth of total output. In Book One we focused on this long-run aspect
of economic development. But history tells us that economic growth has been far
from steady. In the short and medium term the growth rate fluctuates considerably, as
you can see from Fig. 14.1 which plots quarterly data for the logarithm of real GDP for a
number of Western countries. If the growth rate of the economy were constant, the log of
GDP would follow the straight lines in Fig. 14.1. The fact th at the graphs lor the log of
actual GDP are sometimes steeper and sometimes flatter than the straight lines reflects
th at periods of rapid growth tend to alternate with in tervals of slow growth. Indeed, the
graph has frequently had a negative slope, indicating that the growth rate sometimes
even becomes negative. Note that the data underlying Fig. 14.1 are seasonally adjusted,
so the fluctuations do not reflect the regular changes in business activity occurring with
the changing seasons of the year, for example, the seasonal s\>Vings in construction
activity due to changing weather conditions. Thus there are more fundamental forces
causing an uneven pace of economic growth.
The rest of this book studies these short-term fluctuations in economic activity,
co nun only known as business cycles. How can we explain that the state of the economy
repeatedly alternates between business cycle expansions characterized by rapid growth.
and business cycle co11trnctions or recessions characterized by declining econ omic activity?
To answer this question is one of the basic challenges of macroeconomic theory.
Why business cycles are important
The fact that economic growth is repeatedly interrupted by recessions is a major source of
concern for economic policy makers and the general public. since recessions bring considerable
economic hardship to workers who lose their jobs. to entrepreneurs and homem.
vners who go bankrupt, and to ordinary consumers who suffer capital losses on their
assets. Even for those who are not directly allected by layoffs and bankruptcies. recessions
may cause a decline in well-being by generating fears ofj ob losses and offuture reductions
in income and wealth. Understanding business cycles is therefore not only of academic
interest; it may also help the economist to oller advice to policy makers on the possibility
of reducing business fluctuations through macroeconomic stabilization policy, that is,
active monetary and tiscal policy. At the very least an insight into the workings of the
business cycle may enable the economist to suggest how policy makers can avoid
amplifying the business cycle through misguided macroeconomic policies.
On several occasions in history, recessions have developed into severe economic
depressions paving the way for social and political disaster. A glance at Fig. 14.2 should
convince you why it is important to understand the causes of depressions and the means
to avoid them. The figure shows a striking correlation between the unemployment rate in
interwar Germany and the share of total votes in Reichstag elections going to Adolf
Hitler's Nazi Party. In the 1928 election, when unemployment stood at the low level of
2. 8 per cent. the Nazi Party captured only 2 . 6 per cent of the votes and were not considered
a serious political force. But as the democratic system of the Weimar Republic proved
unable to prevent the mass unemployment and human suffering caused by the Great
Depression, a rapidly growing number of Gennans became receptive to Hitler's radical
critique oft be parliamentary system. By 19 33 . with unemployment close to 30 per cent of
the labour force. Hitler obtained a vote share of almost 44 per cent in the last free election
before he established his Nazi dictatorship and steered Germany towards the Second
World War. Although there were several other factors explaining Hitler's rise to power,
there is no doubt that the economic depression made it easier for him to gather support.
The Great Depression of the 1930s was exceptional in its severity and in its social and
political consequences. Nevertheless we have several recent examples of economic downturns
wh!ch have caused social upheaval, including the South-east Asian crisis of
199 7- 9 8 which brought down the Indonesian government and led to serious civil
unrest, and the economic crisis in Argentina in 2001 which forced the government to
resign after riots in the streets. By studying business cycles we will not only learn more
about the workings of a market economy; we will also improve our understanding of the
general course of social and political events.
The reason why it mal<es sense to theorize about business cycles is that, even though
no two business cycles are identical. they usually have some important features in common. Nobel laureate Robert Lucas of the University of Chicago made this point in the
following way:
Though there is absolutely no theoretical reason to anticipate it, one is led by the facts to conclude
that, with respect to the qualitative behavior of comovements among series (economic
variables), business cycles are all alike. To theoretically inclined economists, this conclusion
should be attractive and challenging, for it suggests the possibility of a unified explanation of
business cycles, grounded in the genera/ laws governing market economies, rather than in
political or institutional characteristics specific to particular countries or periods. 1
In the rest of this chapter we will describe some of those co-movements of economic
variables which are characteristic of business cycles. Before we start theorizing about
business cycles, we want to get some idea of the phenomenon which our theory is
supposed to explain. We will begin in the next section by restating a definition of business
cycles which has become familiar in the literature. We will then move on to the question
how we can measure business cycles in quantitative terms. That is, bow can we separate
short-term business cycle fluctuations in economic activity from the long-term economic
growth trend? Following this. we '.viii be ready to describe in quantitative terms the
co-movements of important economic variables during a 'typical' business cycle.
chapter 14 since the time of the Industrial Revolution the Western world has experienced a
tremendous growth of total output. In Book One we focused on this long-run aspect
of economic development. But history tells us that economic growth has been far
from steady. In the short and medium term the growth rate fluctuates considerably, as
you can see from Fig. 14.1 which plots quarterly data for the logarithm of real GDP for a
number of Western countries. If the growth rate of the economy were constant, the log of
GDP would follow the straight lines in Fig. 14.1. The fact th at the graphs lor the log of
actual GDP are sometimes steeper and sometimes flatter than the straight lines reflects
th at periods of rapid growth tend to alternate with in tervals of slow growth. Indeed, the
graph has frequently had a negative slope, indicating that the growth rate sometimes
even becomes negative. Note that the data underlying Fig. 14.1 are seasonally adjusted,
so the fluctuations do not reflect the regular changes in business activity occurring with
the changing seasons of the year, for example, the seasonal s\>Vings in construction
activity due to changing weather conditions. Thus there are more fundamental forces
causing an uneven pace of economic growth.
The rest of this book studies these short-term fluctuations in economic activity,
co nun only known as business cycles. How can we explain that the state of the economy
repeatedly alternates between business cycle expansions characterized by rapid growth.
and business cycle co11trnctions or recessions characterized by declining econ omic activity?
To answer this question is one of the basic challenges of macroeconomic theory.
Why business cycles are important
The fact that economic growth is repeatedly interrupted by recessions is a major source of
concern for economic policy makers and the general public. since recessions bring considerable
economic hardship to workers who lose their jobs. to entrepreneurs and homem.
vners who go bankrupt, and to ordinary consumers who suffer capital losses on their
assets. Even for those who are not directly allected by layoffs and bankruptcies. recessions
may cause a decline in well-being by generating fears ofj ob losses and offuture reductions
in income and wealth. Understanding business cycles is therefore not only of academic
interest; it may also help the economist to oller advice to policy makers on the possibility
of reducing business fluctuations through macroeconomic stabilization policy, that is,
active monetary and tiscal policy. At the very least an insight into the workings of the
business cycle may enable the economist to suggest how policy makers can avoid
amplifying the business cycle through misguided macroeconomic policies.
On several occasions in history, recessions have developed into severe economic
depressions paving the way for social and political disaster. A glance at Fig. 14.2 should
convince you why it is important to understand the causes of depressions and the means
to avoid them. The figure shows a striking correlation between the unemployment rate in
interwar Germany and the share of total votes in Reichstag elections going to Adolf
Hitler's Nazi Party. In the 1928 election, when unemployment stood at the low level of
2. 8 per cent. the Nazi Party captured only 2 . 6 per cent of the votes and were not considered
a serious political force. But as the democratic system of the Weimar Republic proved
unable to prevent the mass unemployment and human suffering caused by the Great
Depression, a rapidly growing number of Gennans became receptive to Hitler's radical
critique oft be parliamentary system. By 19 33 . with unemployment close to 30 per cent of
the labour force. Hitler obtained a vote share of almost 44 per cent in the last free election
before he established his Nazi dictatorship and steered Germany towards the Second
World War. Although there were several other factors explaining Hitler's rise to power,
there is no doubt that the economic depression made it easier for him to gather support.
The Great Depression of the 1930s was exceptional in its severity and in its social and
political consequences. Nevertheless we have several recent examples of economic downturns
wh!ch have caused social upheaval, including the South-east Asian crisis of
199 7- 9 8 which brought down the Indonesian government and led to serious civil
unrest, and the economic crisis in Argentina in 2001 which forced the government to
resign after riots in the streets. By studying business cycles we will not only learn more
about the workings of a market economy; we will also improve our understanding of the
general course of social and political events.
The reason why it mal<es sense to theorize about business cycles is that, even though
no two business cycles are identical. they usually have some important features in common. Nobel laureate Robert Lucas of the University of Chicago made this point in the
following way:
Though there is absolutely no theoretical reason to anticipate it, one is led by the facts to conclude
that, with respect to the qualitative behavior of comovements among series (economic
variables), business cycles are all alike. To theoretically inclined economists, this conclusion
should be attractive and challenging, for it suggests the possibility of a unified explanation of
business cycles, grounded in the genera/ laws governing market economies, rather than in
political or institutional characteristics specific to particular countries or periods. 1
In the rest of this chapter we will describe some of those co-movements of economic
variables which are characteristic of business cycles. Before we start theorizing about
business cycles, we want to get some idea of the phenomenon which our theory is
supposed to explain. We will begin in the next section by restating a definition of business
cycles which has become familiar in the literature. We will then move on to the question
how we can measure business cycles in quantitative terms. That is, bow can we separate
short-term business cycle fluctuations in economic activity from the long-term economic
growth trend? Following this. we '.viii be ready to describe in quantitative terms the
co-movements of important economic variables during a 'typical' business cycle.
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