Chapter 8  The Business Cycle, Part One

In this chapter we begin to build a model of our economy that will explain and predict changes in GDP, unemployment, and prices.

We first turn our attention to changes in GDP. We know that both real and nominal GDP have grown over time, but it is also true that GDP exhibits cyclical behavior: it rises for a period of time then falls for a period time. This cycle of alternating growth and contraction in GDP is known as the business cycle.

Business cycles are a powerful thing. The Great Depression of the 1930s shaped the attitudes and behaviors of a generation of Americans. The contraction in GDP in 1990-91 most likely cost George Bush re-election. Do you remember the slogan of President Clinton's successful 1992 campaign? "It's the economy, stupid."

Even in the 2000 election, some were baffled that the economic expansion of the 1990s did not give Al Gore a victory.

Business cycles are also a controversial thing. There is substantial disagreement among macroeconomists about the causes of business cycles and what, if anything, should be done about them.

All About Business Cycles

We measure a business cycle by changes in real GDP, so we are focusing only on changes in output.  The business cycle has four parts:  peak, contraction, trough, expansion.

A peaks are high points for real GDP, while the troughs are low points.  The period between a peak and a trough is known as a contraction, or also a recession.  Officially recessions are periods of declining real GDP that lasts at least 6 consecutive months (two quarters). Very serious recessions are called depressions.  The period between a trough and a peak is known as an expansion, which is characterized by increased real GDP.  As of November 2000, the United States economy has been in an expansion since March 1991, or 117 months, the longest expansion on record.  The last recession ran from July 1990 to March 1991 or 8 months.

The graph below shows the history of U.S. business cycles since 1930.

 There are a few interesting things to note;

Prior to 1930s, many economists, known as the classical economists, argued that the market economy was inherently stable, and that business cycles were nothing to be concerned about--just short and temporary inconveniences. The market economy would always return itself to growth and prosperity, or "self-correct." Why?  Because wages and prices would adjust to keep us at equilibrium.  If people were unemployed, then wages would quickly fall, and people would again be hired.  If inventories piled up, prices would fall and consumers would buy more.

The Great Depression sort of blew that theory right out of the water. From 1930-33, output fell 30% and unemployment rose to 25%, hardly a minor inconvenience. John M. Keynes criticized the classical economists in his famous book, The General Theory, arguing that market economies are naturally unstable and that waiting for the economy to self-adjust is a mistake. Keynes argued that wages and prices are not flexible, causing long periods of unemployment. His solution? The government should intervene during business cycle downturns to ease the pain of unemployment. Keynes has had a huge influence on macroeconomics and economic policy, with Keynesian economics forming the foundation for most college economics textbooks.

If we want to understand why business cycles occur and what possible remedies exist, we need a model of how the economy works. We begin to build this model in part 2.

FYI: Related Links

The Great Depression A superb collection of links to resources on the Great Depression maintained by Willard Smith

The National Bureau of Economic Research is a nonprofit, nonpartisan research organization that officially dates all past recessions, depressions, and expansions.