knoop - recessions and depressions; understanding business cycles, 2e (2010)

List of Figures2.3 Monthly Percentage Increases and Decreases in Industrial Production during Business Cycles 163.1 Supply and Demand in the Cobweb Theory after a TemporaryFall in Supply

RECESSIONS AND DEPRESSIONS

Understanding Business Cycles

Second Edition

Todd A Knoop

Professor ofEconomics and BusinessCornell College

An Imprint of ABC-CLIO, LLC

RECESSIONS AND DEPRESSIONS

RECESSIONS AND DEPRESSIONS

Understanding Business Cycles

Second Edition

Todd A Knoop

Professor ofEconomics and BusinessCornell College

An Imprint of ABC-CLIO, LLC

All rights reserved No part of this publication may be reproduced, stored in aretrieval system, or transmitted, in any form or by any means, electronic,mechanical, photocopying, recording, or otherwise, except for the inclusion ofbrief quotations in a review, without prior permission in writing from thepublisher.

Library of Congress Cataloging-in-Publication Data

Knoop, Todd A

Recessions and depressions : understanding business cycles /

Todd A Knoop — 2nd ed

p cm

Includes bibliographical references and index

ISBN 978–0–313–38163–8 (hard copy : alk paper) — ISBN 978–0–313–38164–5(ebook)

1 Business cycles 2 Economic forecasting 3 Business cycles—United States—History 4 Business cycles—History—20th century I Title

HB3711.K63 2010

338.5’42—dc22 2009036152

14 13 12 11 10 1 2 3 4 5

This book is also available on the World Wide Web as an eBook

Visit www.abc-clio.com for details

Praeger

An Imprint of ABC-CLIO, LLC

ABC-CLIO, LLC

130 Cremona Drive, P.O Box 1911

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This book is printed on acid-free paper

Manufactured in the United States of America

Deb, Edie, and Daphne.

omers respecting one of the planets Some, in their folly, commenced

a war of words, and wrote hot books against each other; others, intheir wisdom, improved their telescopes and soon settled the ques-tion forever Education should mitigate the latter

Horace Mann, Lectures on Education (1855)

Part II: The Macroeconomic Theory of Business Cycles

about Business Cycles

251

List of Figures

2.3 Monthly Percentage Increases and Decreases in Industrial

Production during Business Cycles

163.1 Supply and Demand in the Cobweb Theory after a TemporaryFall in Supply

273.2 Effects of a Tax on Labor Income on the Labor Market

and Aggregate Demand and Supply

373.3 Effects of a Tax on Savings (or Investment) on the Labor

Market and Aggregate Demand and Supply

37

4.3 Unemployment and Inflation Rates in the United States

during the 1960s

48

4.5 The Price Level, Nominal Wage, and Real Wage during the

Great Depression

50

5.1 The Effects of an Increase in the Money Supply in the

Monetarist Model

59

5.3 The Unemployment Rate and the Natural Rate of Unemployment 625.4 The Phillips Curve Trade-Off Changes as the Expected Price

Level Increases

63

5.8 Unemployment and Inflation Rates in the United States,

1960–2002

69

7.1 Solow Residuals and Real Output Growth 91

9.1 Interest Rate Spread and Commercial Lending in the United States 124

15.2 Current Account Balances and Private Savings Rates:

The United States and China

238

List of Tables

6.2 Estimates of the Real Effects of Aggregate Demand Shocks,

1952–1967

827.1 Business Cycle Data for the U.S Economy and a Real BusinessCycle Economy

93

11.2 Unemployment Rates in Four Countries before and during theGreat Depression

149

12.2 Contributions to Growth in the U.S Economy: Capital, Labor,and Multifactor Productivity

17312.3 Standard Deviations of Percent Changes during Prewar,

Interwar, and Postwar Periods

17912.4 Standard Deviations of Percent Changes during the

Postwar Period

179

It has been said that capitalist economies are like drunks—they have ble moving in a straight line While that analogy might be amusing, thereal consequences of these economic lurches are often devastating Notonly do recessions and depressions reduce standards of living andincrease poverty, but they undermine the public’s confidence in the bene-fits of capitalism and often democracy As we are seeing during the globalfinancial crisis that began in 2007, economic downturns also have thepotential to spread fear, encourage xenophobia, and undermineinternational political and economic systems that have taken decades todevelop Understanding the nature and causes of business cycles in aneffort to develop policies to eliminate them is a noble endeavor withpotentially extraordinary implications for human welfare

trou-The study of business cycles has greatly contributed not only to ourunderstanding of economic contractions but also to our understanding

of macroeconomics in general While to the uninformed it might seemthat economists are no closer today to understanding business cycles thanthey were 200 years ago, when business cycle theory is examined within ahistorical context it becomes obvious that major advancements have beenmade However, our knowledge is still far from complete Moderndepressions in East Asia and Japan, as well as the recent global financialcrisis, point both to the validity of much of our present economic theoryand also to areas that need to be explored further before economists cancompletely understand business cycles and enact policies to preventthem

This book covers the empirics, the theory, and specific case studies ofrecessions and depressions This book is written in a nontechnical narra-tive aimed at upper-level undergraduate students or general readers withsome background and interest in economics As a result, it should havebroad interest for use in college courses on Business Cycle Theory, Inter-mediate Macroeconomics, and the History of Macroeconomic Thought,

as well as be of interest to a more general audience interested in betterunderstanding economic crises.

While this book does not necessarily challenge any current thinking inthe field of business cycle research, it does contribute to the ongoingdebate over the nature and causes of recessions and depressions by gath-ering together the basics of business cycle research and organizing it in anunderstandable and interesting way My belief is that this book willencourage a deeper understanding of the issues that surround businesscycles for those who read it In addition, I hope that this book will gener-ate interest in business cycles so that future researchers will want toinvestigate questions related to economic contractions To that end, thisbook clearly points to future avenues for business cycle research Specifi-cally, more research needs to be conducted on the interplay betweenfinancial fundamentals, risk, and macroeconomic volatility Open-economy models that incorporate the effects of exchange rate fluctua-tions, foreign investment inflows and outflows, monetary policy andinflation, nominal wage and debt rigidities, and the implications of thesefactors on the balance sheets of firms and banks should be the focus offuture business cycle research Also, as current events are illustrating, agreat deal more effort needs to go into understanding the appropriatepolicies to restore financial stability during financial crises This is par-ticularly true regarding the massive national bailouts of financial systemsacross the globe that are now underway

The first edition of this book grew out of research that I conducted for

an upper-level undergraduate course that I taught at Cornell College tled ‘‘Recessions and Depressions.’’ As I was thinking about how toorganize this course, I looked for an appropriate text Somewhat surpris-ingly, I found nothing that was satisfactory for use in an upper-levelundergraduate course on business cycles There was no existing book thatcovered the empirics, the theory, and international case studies of reces-sions and depressions In addition, no book on business cycles had beenwritten in a nontechnical narrative aimed at the upper-level undergradu-ate student or the general reader with some background and interest ineconomics As a result, when I first taught this ‘‘Recessions and Depres-sions’’ course, I was forced to rely on primary readings that in many caseswere not written at an appropriate level for undergraduates To help stu-dents understand these primary resources, I developed a set of lecturenotes for students to use These lecture notes were well received by stu-dents and other faculty that reviewed them, encouraging me to write abook that would allow me to more formally and completely discuss mythoughts on business cycles I believe that my skills as a teacher helped

enti-me write a book that will not only further the knowledge of businesscycles but also point to specific areas of business cycle research that mightinterest many students in their future study of economics

Of course, no book is perfect, and soon after writing the first edition,even before the current global financial crisis, it became evident to me

that one of the areas that I gave insufficient attention to was the role thatfinancial systems play in generating recessions and expansions Thanks

to the success of the first edition, the good people at Praeger, and theinterest sparked in business cycles by current economic events, I havethe chance to correct for this deficiency in the second edition of the book.Not only have I created a new chapter that focuses on new research intothe role that finance plays in macroeconomic volatility, but I have alsoadded a chapter discussing the causes and consequences of the

2007 Global Financial Crisis In addition, this second edition of the bookhas allowed me the opportunity to revise and update every other chapterfrom the first edition

A number of people were of great help to me in writing both editions ofthis book, and I am indebted to each of them Numerous students in mycourses provided feedback, including students in my ‘‘Recessions andDepressions’’ courses Many Cornell faculty also provided feedback, par-ticularly other members of the Economics and Business department Iwould also like to thank Cornell College for awarding me a Campbell R.McConnell Fellowship Award, which provided many of the resourcesthat were needed to produce this book Finally, I would like to thankand send my love to my exceptionally supportive wife Debra DeLaetand my two daughters, Edie and Daphne, for sharing the highs with

me and putting up with the lows

Part I

The Facts of Business Cycles

of what is actually driving the operations of fully functioning economiesbecome more readily apparent Contractions are an opportunity foreconomists to pop open the hood and take a look inside the engine ofmodern economic systems.

The best example of the learning opportunities economic crises vide is the Great Depression, an unprecedented economic downturn of amassive scale that eventually turned the whole discipline of economics

pro-on its ear The Great Depressipro-on played a crucial role in the development

of macroeconomics as a separate field of study from that of nomics, and also in the development of Keynesian economics, the mostfundamental change in the way that economists think about the worldsince 1776 when Adam Smith published Wealth of Nations Keynesian eco-nomics in turn spawned some of the most radical developments in publicpolicy since the industrial revolution and provided the theoretical

microeco-foundation for the modern welfare state Of course, the global financialcrisis that began in 2007 has led many to wonder whether we are going

to suffer through a second Great Depression, and also whether there arenew lessons to be learned and time-tested policies to combat businesscycles to be rethought

This book will provide in-depth analyses of the following twoquestions:

1 Why are economies subject to periods of negative output growth(recessions)?

2 How do you explain severe economic contractions (depressions)?

As mentioned above, many of the key developments in macroeconomictheory both before and after Keynes have centered on these two questions.The big problem, unfortunately, is that after more than 200 years of debatethere is still no general agreement about what causes recessions anddepressions There continues to be multiple competing models of businesscycles used among economists In fact, there is a large disconnect betweenthe models used by academics and those used by private sector economists.This debate over the root causes of business cycles continues to be a keyquestion in the development of macroeconomic thought The goal of thisbook is not necessarily to put an end to this debate by providing a definitiveanswer on why business cycles exist—because there is none at this point—but rather to understand all of the competing theories and factors in thedebate

For an example of how disagreements persist in macroeconomics, sider the U.S recession of 1990–1991 Some economists have argued that

con-it was caused by an aggregate demand downturn resulting from a tion in consumer confidence during the Gulf War or by a decrease in themoney supply by the Federal Reserve Others have argued that it wascaused by a decrease in aggregate supply brought about by an increase

reduc-in the price of oil durreduc-ing the war or the delayed effects of tax reduc-increasesand new government regulations adopted in the late 1980s To this day,there is no single cause that is generally agreed upon among economists.Another example of the discord among economists is evident in theirhandling of the East Asian crisis from 1997 to 1999, the most significantinternational economic crisis since the Great Depression (at least untilrecently) Economists did not forecast the East Asian crisis Most disturb-ingly, there was no agreement at the time among economists about thepolicies that should have been followed to best deal with the crisis In fact,the crisis occurred in countries that were previously thought to be modeleconomies that were fundamentally sound Then, of course, there is the

2007 Global Financial Crisis Not only did most economists fail to see itcoming, but many refused to believe their eyes as it occurred Also, econ-omists as a group had no clear and unified set of policies to deal with thedownturn Clearly, there is still much work to be done before economists

can come to any sort of consensus about the causes of recessions anddepressions and how to deal with them.

Given the obvious difficulties inherent in this topic, many people(including many economists) have asked: Why study business cycles if,

in the long run, they all average out? This is a question that is only asked

by someone who has not lived through a major economic contraction.Business cycles are extremely costly to a society, not just in terms of lostincome but in terms of disrupted lives—higher suicide and homiciderates, higher poverty levels, and higher divorce rates among other mea-sures of well-being—that have economic, social, and personal effectswhich persist for a very long time Keynes’s (1923) response to the ques-tion posed at the beginning of this paragraph is one of the classic retorts

this long run is a misleading guide to current affairs In the long run weare all dead Economists set themselves too easy, too useless a task if intempestuous seasons they can only tell us that when the storm is longpast the ocean is flat again.’’

OUTLINE OF THE BOOK

This book is divided into four parts

Part I: The Facts of Business Cycles Chapter 2 describes business cyclesboth quantitatively and qualitatively This chapter provides a summarydiscussion of the duration and depth of business cycles both in the UnitedStates and internationally across developed countries, with a focus on sixbasic facts about business cycles In addition, the behavior of the compo-nents of GDP over the business cycle is also described Finally, thischapter summarizes the cyclical behavior of other important macroeco-nomic time series variables, including whether each variable is a reliablyleading, coincident, or lagging indicator of turning points in a businesscycle

Part II: The Macroeconomic Theory of Business Cycles and Forecasting Theevolution of thought on the nature of business cycles also traces theevolution of a large part of modern macroeconomic theory In order tocomprehend macroeconomics as it is practiced today and where it isheaded in the future, it is crucial to understand the theoretical groundalready covered and the economic events that precipitated changes inthe way that we view macroeconomic fluctuations

The main objective of this section is to cover the evolution of the economic theory of business cycles Numerous early business cycle theo-ries were developed before the Great Depression, each of them failing tomake a clear distinction between the behavior of individuals and thebehavior of economies as a whole However, these early theories high-light many important characteristics of economic contractions The study

macro-of modern business cycles began with Keynesian economics whichfocused on the macroeconomic effects of market failure and, after a

neoclassical resurgence during the 1970s and 1980s, business cycleresearch has returned to the study of market failure However, modernbusiness cycle models have greatly improved upon the microeconomicexplanations of why markets often do not work efficiently and thespecific role that various forms of imperfect competition play in outputfluctuations While these new models are more intuitively appealingand are more consistent with the empirical data, they have not yetimproved the ability of economists to forecast the future or to pre-emptively act in order to prevent recessions and depressions.

Part II presents seven primary models: the Classical model(Chapter 3), the Keynesian model (Chapter 4), the Monetarist model(Chapter 5), the Rational Expectations model (Chapter 6), the Real Busi-ness Cycle model (Chapter 7), the New Keynesian model (Chapter 8),and models of credit (Chapter 9) For each of these models, the relevantchapter discusses (1) the historical context in which the model wasdeveloped, (2) the basic theory behind the model, which includes adescription of how the model explains business cycles, (3) a discussion

of the policy implications of the model, and (4) a look at whetherexisting empirical research supports the model’s principal implications.Each of these models is discussed in a rigorous but nontechnicalnarrative with an emphasis on making the discussion accessible to thegeneral reader or undergraduate student

This section concludes with a chapter on macroeconomic forecasting,Chapter 10 Economic forecasting is a difficult topic to cover in a nontech-nical book such as this Adding to this difficulty is the fact that macroeco-nomic forecasting has had a not-so-storied history and a questionablefuture This chapter briefly describes the current state of macroeconomicforecasting by discussing the four primary forecasting methods: macro-economic indicators (such as the index of leading economic indicatorsand the yield curve), econometric models, structural models, anddynamic general equilibrium models

Every chapter in this book provides suggested readings that can beused to supplement this text The purpose of these suggested readings isfourfold First, they offer readers a chance to expose themselves to some

of the seminal, but more accessible, research in the business cycle field.Second, they allow readers to explore the insights of groundbreakingeconomists in their own words in order to better understand the impor-tant contributions these authors made Third, they give readers an ideaabout how economists talk to each other, as difficult as it may be to inter-pret these discussions at times Finally, these readings give readers thebenefit of working through a piece of research and all of its difficulties

by themselves as opposed to having material presented to them in easilydigestible ways Each of these readings has been chosen because theyare written at an appropriate level for an advanced undergraduate readerand are either important articles in the business cycle field or are written

by significant authors in the field who are providing an overview of anarea of research.

Part III: Business Cycles in the United States The first chapter in thissection (Chapter 11) deals with the Great Depression, primarily from theU.S standpoint but also its international ramifications While manypossible factors will be examined as potential causes of the GreatDepression, the primary explanation in this chapter centers on four facts.First, all countries that experienced a depression were on the gold stan-dard and maintained fixed exchange rates Second, there were severebalance of payment imbalances in place when the gold standard wasrestored after World War I Third, asymmetries in the way the gold stan-dard was administered made it unstable Finally, a massive internationaldeflation was the result of a strict adherence to the gold standard andnaı¨ve macroeconomic policy This chapter explains in detail the theorybehind why deflation is so costly, especially in terms of its effects onfinancial intermediation It also compares this explanation with tradi-tional Keynesian and Monetarist explanations of the Great Depression.Finally, this chapter discusses the events that initiated the recovery fromthe Great Depression, principally dropping off the gold standard andreinflation

Chapter 12 deals with postwar business cycles in the United States

up through the mid-2000s After a brief case study of each of thesebusiness cycles is a discussion of how postwar business cycles differfrom pre–Great Depression business cycles The basic conclusion of thissection is that while there have not been any dramatic changes, postwarbusiness cycles have occurred less frequently and have been slightlyshorter than prewar business cycles Finally, this chapter discussesthe role of postwar macroeconomic policy in mitigating (or magnifying)business cycles

Part IV: Modern International Recessions and Depressions This section willinvestigate three international economic crises First, the East Asian crisis

is discussed in Chapter 13 After a brief description of other recentcurrency crises (Mexico in 1994, Latin America in the 1980s, and theEuropean Monetary System in 1992), the East Asian crisis is compared

to these previous crises The critical difference is that the East Asian crisiswas actually two distinct crises in that it was a currency crisis thatoccurred in conjunction with a banking crisis The large devaluations thatresulted from the currency crisis led to complete collapses of fragile bank-ing systems throughout the region, resulting in capital flight, a massivereduction in financial intermediation, and a severe decline in economicactivity Chapter 13 describes this process in detail This chapter alsoinvestigates the culpability of foreign investors and the InternationalMonetary Fund (IMF) in precipitating the crisis Finally, recommenda-tions for economic reform in East Asia are discussed and comparisonsmade between the Great Depression and the East Asian crisis

Chapter 14 examines the decade-long recession in Japan The Japaneseeconomy, including the nature of its inefficient markets and fragilebanking system, is characterized This is followed by an examination ofthe reasons for deflation in Japan and the failure behind macroeconomicstabilization to end this recession This chapter concludes with a descrip-tion of economic policy reforms that are needed to facilitate an end to theJapanese recession.

Chapter 15 examines the 2007 Global Financial Crisis, ongoing as of thetime of this writing This crisis is developing into the largest economic cri-sis to strike developed nations since the Great Depression This chapterexamines the buildup to the crisis, primarily driven by two factors:(i) financial innovation in the form of securitized home mortgages andfinancial derivatives, and (ii) the trade and savings imbalances betweenChina and the United States that fueled excessive debt and asset bubbles

in the United States A near miss, and an indication of the building crisis,occurred as early as 1997 with the failure of the hedge fund Long-TermCapital Management (LTCM), discussed here Next, the timeline of theevents leading up to the crisis in the United States is discussed, and theU.S government’s often times incoherent and inadequate policyresponses to the crisis up to April of 2009 are examined One of the mostdramatic events of this global crisis was the complete and historiccollapse of Iceland’s economy, which provides an excellent case study

of the dangers of modern unregulated global finance This chapterconcludes with some lessons learned from the crisis and proposals forthe future that will prevent (or postpone) future such crises

The main conclusion that can be gained from these international casestudies is that the study of major international contractions is a somewhatdifferent topic than the study of business cycles in general There arethree major distinctions between recessions and major contractions/depressions (apart from just their size) First, major contractions/depressions tend to be international in nature, not primarily isolated tojust one country Second, major contractions/depressions tend to involvethe collapse of financial markets in general, the banking industry in par-ticular Third, major contractions/depressions almost always begin withsome sort of macroeconomic policy mistake, in the form of runaway mon-etary and fiscal policy, misaligned exchange rates, deregulation of finan-cial markets, or all of the above The Great Depression, the East Asiancrisis, the Great Recession in Japan, and the 2007 Global Financial Crisiseach follow this general pattern Current business cycle research has notyet been able to provide a complete model that adequately incorporateseach of these factors Much of our current macroeconomic theory betterexplains recessions than it does major contractions and depressions.However, these recent international crises have served as a wake-up call

to many economists and have spurred much needed research in economy models of business cycles that incorporate the macroeconomiceffects of market failure, particularly within banking systems

open-The final chapter, Chapter 16, is a brief conclusion in which the history

of economic theory on business cycles is reviewed and the principalinsights that have been gained from the study of business cycles are dis-cussed This is followed by a list of questions which economists are stillstruggling to provide answers to, questions that serve as signposts toguide future economic research on business cycles

of both individual and average economic contractions and expansions.The second purpose of this chapter is to describe the qualitative aspects

of business cycles, meaning how different macroeconomic variables move

in relation to each other during contractions and expansions Both U.S.and international data will be examined A good understanding of thebusiness cycle data will provide some basic empirical facts which can beused to evaluate the competing theories that have attempted to provideexplanations to the two primary questions posed in this book: (1) Whyare economies subject to periods of negative output growth (recessions)?(2) How do you explain severe economic contractions (depressions)?

BASIC DEFINITIONS

Economists from the Business Cycle Dating Committee of the NationalBureau of Economic Research (NBER), the preeminent economic researchorganization in the United States, date the beginning and end of economiccontractions and expansions in the United States To do this, the NBERneeds a working definition of what constitutes a recession and an expan-sion The NBER defines a recession as two or more consecutive quarters ofnegative GDP growth This implies that an expansion is two or moreconsecutive quarters of positive GDP growth The peak of an expansion isthe point in time at which the level of GDP reaches its maximum before it

starts to decline Thus, the peak of an expansion dates the beginning

of a recession Likewise, the trough of a recession is the point in time at whichGDP falls to its lowest level before it begins to rise again, meaning that atrough dates the beginning of an expansion Figure 2.1 graphs real GDPgrowth rates in the United States between 1948 and 2008 and indicates thedates of peaks (beginning of recessions) and troughs (end of recessions).Table 2.1 provides a complete list of business cycles (measured frompeak to peak) in the United States since dating began in 1854 Looking atrecent business cycle episodes, there have been 11 postwar recessions inthe United States The last complete recession began in March of 2001and ended in November of that same year, making it one of the shortestrecessions ever Before this, the United States experienced the longestexpansion ever recorded This expansion lasted more than 10 years, fromMarch 1991 to April 2001 The recession in the United States associatedwith the current global financial crisis began in December of 2007 At thetime of this writing this building recession had not yet reached its trough.Like any specific definition of a difficult concept, the NBER’s definition

of what constitutes a recession has been criticized along a number of lines.One problem with this definition is that a lag exists between getting dataand making decisions Output must be falling for at least six monthsbefore the NBER will declare a recession This means that the economy

is already at least half a year into a recession before it can be officiallyrecognized as one by economists For example, the recession that began

in the United States in December of 2007 was actually not recognized

as such by the NBER until December 2008, a full year after it began Thisrecognition might delay a policy response until it is too late to be effective.Another criticism of this definition is that it ignores growth recessions, orperiods of positive but below average growth The problem here is that aperiod of growth that is below trend, or the long run average GDP growthrate, is generally regarded as a recession by the public but not technicallyconsidered a recession by economists

FIGURE 2.1 Real GDP Growth, Recessions Noted (chained 1996 dollars)

A final problem with this definition is that it defines recessions in terms

of quarters Quarterly data averages out many monthly movementsand might provide a misleading picture of the economy A good example

of this occurred during September of 2001 Because of the economic

TABLE 2.1 Data on Timing of U.S Business Cycles

Duration (in months) of Trough Peak Contraction Expansion Cycle (trough to trough)

disruptions caused by the terrorist attacks, output fell dramatically ing September—enough to make output growth negative during the thirdquarter when it otherwise may not have been negative Because outputgrowth was also negative in the second quarter of 2001, a recession wasofficially declared by the NBER However, output growth in the fourthquarter was positive and strong because a great deal of economic activitythat did not occur in the September was pushed into October and Novem-ber Thus, technically the recession ended as soon as it was declared, and

dur-it is not at all clear that GDP had actually been declining for six ous months, only two consecutive quarters On the other hand, it couldalso be hypothetically possible for GDP growth to be negative for six con-secutive months but for no recession to be declared by the NBER If thesesix months were in three different quarters, measured GDP growth mightonly be negative during one of these quarters if output growth in themonths before and after these six months was strong enough

continu-Despite these criticisms, these definitions of recessions, peaks, andtroughs are the best that economists have to work with Lags in gettingand interpreting data are impossible to avoid given the difficulties incollecting economic data Quarterly data is usually preferable to monthlydata because monthly data is very costly to collect and its collection reliesmore heavily on estimation, which makes it less reliable Defining agrowth recession is more difficult than defining a recession using theNBER’s definition This is because the definition of a growth recessionrelies on measuring growth relative to its trend, and trend output growth

is difficult to determine if the trend is not constant over time As a result,the NBER’s definitions of recessions, expansions, troughs, and peaks will

be the working definitions used throughout this book

There is no formal definition of a depression, though an old joke saysthat a recession is when your neighbor loses his or her job, a depression

is when you lose your job An informal definition is an economiccontraction in which output falls by more than 10 percent During the erafor which we have reliable economic data, the only depression that hasoccurred in the United States was the Great Depression of the 1930s

A few additional definitions are extremely useful in characterizing thequalitative relationships between macroeconomic variables over thebusiness cycle A variable is referred to as procyclical if it has a constantpositive correlation with GDP, meaning it falls when GDP falls and riseswhen GDP rises Some obvious examples of variables that are procyclicalare consumption, investment, and employment A variable is countercyclical

if it has a constant negative correlation with GDP Unemployment is anobvious example of a variable that is consistently countercyclical and riseswhen GDP falls An acyclical variable is one that has no consistent correla-tion with changes in GDP

Finally, economists are always looking for macroeconomic variablesthat can help predict the peaks and troughs of business cycles A leadingindicator is a variable that peaks (troughs) before GDP peaks (troughs)

For obvious reasons, economists closely watch leading indicators whentrying to forecast business cycles A lagging indicator is a variable thatpeaks (troughs) after GDP peaks (troughs) A coincident indicator is onethat peaks or troughs at the same time as GDP.

SIX BASIC BUSINESS CYCLE FACTS

What general properties and relationships can be gathered fromstudying business cycle data? While economists have collected andpoured over an inordinate amount of information related to recessionsand expansions over the years, six basic facts are crucial to understandingthe fundamental properties of business cycles both in the United Statesand internationally

(1) Business cycles are not cyclical The term business cycle is really a nomer, because it implies that recessions and expansions follow a regular,predictable pattern They do not In fact, business cycles vary considerably

mis-in size and duration over time Refer back to Table 2.1 The shortestrecession in U.S history was in 1980–1981 (though it was a very sharp reces-sion) and lasted only six months It was followed by the shortest expansion,which lasted only 12 months The longest modern recession lasted

43 months between 1933 and 1937, while the longest expansion ended in

2001 and lasted 121 months, or more than 10 years In between theseshortest and longest recessions and expansions there is a wide variety ofspacing and length The length of the previous business cycle is not areliable indicator of the length of the next business cycle

(2) Business cycles are not symmetrical In U.S history, expansionsaverage 38 months in length, while recessions average only 17 months.Thus, expansions are about twice as long as recessions on average.However, output changes tend to be much larger during recessions thanthey are during expansions

These same asymmetries between recessions and expansions holdinternationally as well Figures 2.2 and 2.3 provide some summary data

of business cycles across a small subset of developed countries Looking

at Figure 2.2, notice that across all of these countries expansions last siderably longer than recessions There is a great deal of similarity acrossthese countries in terms of the length of their recessions Excluding Spainand Germany, expansions also tend to last roughly the same amount oftime across countries Figure 2.3 presents percentage increases anddecreases in industrial production across countries Recessions tend to

con-be characterized by larger changes in output than expansions Thus, as ageneral rule across countries, recessions tend to be shorter but withsharper changes in GDP, while expansions tend to be longer but withmore gradual changes in GDP

(3) Business cycles have changed over time Newer and better historicaldata has given economists a clearer picture of historical business cycles

in the United States, and this better data suggests that postwar recessions

have moderated, particularly in regards to their length A quick glance atthe data averages reported at the bottom of Table 2.1 suggests that reces-sions are about half the length they were in the prewar period, whileexpansions have gotten significantly longer This means that recessionshave been less frequent than they were in previous eras, although thisresult has been largely driven by two long expansions in the 1980s and

FIGURE 2.2 Average Duration of Expansions and Recessions

Source: Artis, Kontolemis, and Osborn (1997).

FIGURE 2.3 Monthly Percentage Increases and Decreases in IndustrialProduction during Business Cycles

Source: Artis, Kontolemis, and Osborn (1997).

1990s The moderation of business cycles, and an examination of itscauses, will be discussed in more detail in Chapter 12 on postwar busi-ness cycles in the United States.

(4) The Great Depression and the World War II expansion dominate all otherrecessions and expansions GDP fell by 50 percent between 1929 and 1932,while unemployment rose to a peak of 25 percent in 1933 The GreatDepression dwarfs the next largest recession that took place during1973–1975, in which GDP declined by 4.2 percent and unemploymentrose to 9 percent Likewise, the expansion that began in 1938 and contin-ued throughout World War II was unparalleled, with GDP rising by

64 percent between 1941 and 1944 alone The explanation for this largeexpansion obviously had a lot to do with the huge increases ingovernment purchases and the massive mobilization of resources thattook place during the war The explanation for the Great Depression

is less apparent Obviously, something unprecedented happenedduring the late 1920s and 1930s that must be explained in order to have

a plausible theory of what causes recessions and depressions The GreatDepression will be discussed throughout this book and will be examined

in detail in Chapter 11

(5) The components of GDP exhibit much different behaviors than GDP itself.The components of GDP are consumption, investment, governmentpurchases, and net exports Investment, durable consumption, and netexports are highly volatile and change more than output over thebusiness cycle, while nondurable consumption and governmentpurchases are stable and change much less than output over the businesscycle

Table 2.2 presents the components of GDP and their contribution toboth average GDP growth and to changes in GDP during recessions.Consumption includes both nondurables (like food and clothing),

TABLE 2.2 Behavior of the Components of GDP

Component of GDP Average sharein GDP (%) GDP during recessions (%)Average share of fall in

durables (like appliances and automobiles), and services Both bles and services contribute less to falls in GDP than they do to the level

nondura-of GDP, meaning that they are considerably more stable than GDP as awhole and, in fact, are only mildly procyclical Durables, however, aresignificantly more volatile than GDP as a whole, strongly procyclical,and a coincident indicator of peaks and troughs in GDP

Investment as a whole is consistently procyclical, a leading indicator ofchanges in GDP, and about 3.5 times more volatile than GDP Investmentincludes new residential construction, fixed nonresidential investment(investments made by firms), and changes in inventories Looking atTable 2.2, we see that each of the components of investment is consider-ably more volatile than its share of GDP, together accounting for morethan 70 percent of the changes in GDP during recessions Especiallyimportant are inventories, which account for less than 1 percent of GDPbut 40 percent of the changes in GDP during recessions Inventories arealso a leading indicator of business cycle turning points Investmentclearly plays a crucial role in initiating and propagating business cycles

As a result, investment has also played an integral part in many of thetheories of business cycle behavior Government purchases includegovernment acquisitions of goods and services but ignore transferpayment programs such as social security and welfare Governmentpurchases are roughly acyclical and not very volatile

Finally, net exports are the difference between exports and imports.Net exports are actually a negative share of GDP because the UnitedStates has consistently run trade deficits since the mid-1980s Net exportsare slightly countercyclical, meaning that net exports tend to rise duringrecessions and offset some of the falls in output This is primarily becauseexchange rates tend to fall during a recession, decreasing the price ofexports and increasing the price of imports However, net exports, whilevolatile, are not a reliable indicator of peaks and troughs in GDP

(6) Business cycles are associated with big changes in the labor market.Unemployment is strongly countercyclical and changes in employmentare much larger during recessions than the changes in other inputs intoproduction Over the long run, increases in the capital stock account forroughly one-third of trend per capita GDP growth, while increases inproductivity account for the other two-thirds Changes in employmentaccount for essentially none of the increases in trend per capita GDP(this makes sense if employment and the population grow at roughlythe same rate, which they do) However, during business cycles (timeswhen output is growing at a rate different than trend), the story is exactlythe opposite The capital stock changes very little over business cyclesbecause it is largely fixed in the short run, meaning it contributes little

to changes in output over the business cycle Changes in employment,

on the other hand, account for two-thirds of the cyclical changes in percapita GDP, while changes in productivity account for one-third of cycli-cal changes In other words, during recessions and expansions, changes

in employment appear to be driving a large portion of the changes in put This seems to suggest that any plausible theory of business cycles has

out-to give a prominent role out-to the cyclical behavior of the labor market

THE CYCLICAL BEHAVIOR OF OTHER IMPORTANT

MACROECONOMIC VARIABLES

As mentioned earlier, economists are always looking for clues to helpthem forecast the future and to help them evaluate competing models ofbusiness cycle behavior A few of the most closely followed macroeco-nomic variables are briefly described here

Unemployment A worker is classified as being unemployed if he/she iscurrently without work and has been actively looking for work duringthe previous four weeks Total unemployment is strongly countercyclicaland is a lagging indicator of both peaks and troughs Total unemploy-ment lags peaks in output because when the economy first slows down,some workers are still finding jobs (even as new layoffs may be increas-ing) so that unemployment lags peaks When the economy begins toimprove, the last inputs to be readded by firms are more workers, sounemployment also lags troughs

Economists also closely follow two other variables related to ment The first is the duration of unemployment, which is countercyclicaland a lagging indicator of peaks and troughs The second is initial unem-ployment claims, which are the number of new claims for unemploymentinsurance Initial unemployment claims are more sensitive to changes inthe business cycle than total unemployment Unlike total unemployment,which lags peaks and troughs because of lags in the hiring process, initialunemployment claims are a leading indicator because firms anticipatechanges in economic conditions and increase layoffs before productionfalls and decrease layoffs before conditions improve

unemploy-Inflation There are two commonly used measures of inflation The GDPdeflator measures changes in the price of all goods produced within U.S.borders and included in GDP Inflation as measured by the GDP deflator

is weakly procyclical, only falling during six of the eleven postwar sions It lags peaks and troughs primarily because it includes investmentgoods and government purchases, the prices of which are slow torespond to changes in economic conditions

reces-The consumer price index (CPI) measures changes in the prices of sumer goods Like the GDP deflator, it is only mildly procyclical, fallingduring seven of the eleven postwar recessions Unlike the GDP deflator,changes in the CPI are roughly coincident with business cycle turningpoints because consumer prices are more sensitive to changes in preva-lent market conditions

con-It is important to note that while both measures of inflation havebeen mildly procyclical on average, they have exhibited periods of

countercyclical behavior as well The variability of the cyclical behavior ofinflation is a puzzle that economists need to explain.

Real wages Real wages (real meaning adjusted for changes in inflation) donot behave consistently over business cycles, although changes in the realwage do consistently lag behind peaks and troughs in GDP During therecessions of the 1970s, real wages were procyclical During the GreatDepression, real wages were countercyclical If measured over the entirelength of U.S data that is available, however, real wages are either acyclical

or mildly procyclical

As mentioned in fact (6) earlier in this chapter, the volatility of ployment indicates that the labor market plays a critical role in businesscycles As a result, the behavior of real wages is an integral component

unem-of many unem-of the theories that will be examined in this book Differences

in how each of these models views the labor market provide a usefulcriterion by which to compare and contrast alternate explanations ofbusiness cycles This puzzle regarding the inconsistent behavior of realwages is one that will be referred to repeatedly throughout ourdiscussions

Interest rates Both short- and long-term interest rates are procyclical.However, there are a myriad of interest rates that can be tracked andsome are more reliable predictors of business cycles than others One ofthe most reliable is the three-month Treasury Bill rate, which has fallenduring 10 of the 11 postwar recessions Even though many long-terminterest rates are less reliable indicators of business cycles thanshort-term rates, they probably have a more direct effect on investmentdecisions and economic activity In general, short- and long-term interestrates are lagging indicators of business cycle turning points because infla-tion is a key determinant of the level of interest rates, which tends to lagbusiness cycle fluctuations

Capacity utilization Capacity utilization is the employment rate of capital.For obvious reasons, capacity utilization is procyclical Its downturns tend

to lead peaks because firms typically purchase large amounts of capitalduring expansions and this capital typically comes on line before adownturn, reducing capacity utilization On the other hand, capacityutilization lags troughs because firms first reduce inventories and delaynew investment projects for as long as possible during downturns

Output per hour (productivity) Increasing productivity is the primaryway that economies improve the standards of living of its citizens overthe long run However, in the short run, the relationship between GDPand productivity is much less clear Productivity is procyclical, fallingduring 10 of the 11 postwar recessions, and it does lead peaks and troughs

in the business cycle However, the reasons behind why this might beremain unclear Do new technologies drive expansions and technologicalinefficiencies drive recessions? Or could it simply be that firms ask theiremployees and their capital to work harder during expansions becausefirms are pushing their capacity constraints, and then allow their workers

and capital some slack during recessions because these same constraintsare less pressing?

Consumer confidence The most popular measure of consumer tions is based on household survey data collected by the University ofMichigan’s Survey Research Center An index is generated based onhousehold responses to questions regarding (1) the family’s economicprospects over the next 12 months; (2) the U.S economic prospects overthe next 12 months; and (3) the U.S economic prospects over the next fiveyears This Consumer Confidence Index is strongly procyclical and aleading economic indicator However, it is much more volatile thanGDP, meaning the Consumer Confidence Index often provides falsesignals of business cycle turning points

expecta-Expectations play a key role in many of the explanations of businesscycles discussed later in the book because of its importance in influencinginvestment and consumption decisions As a result, measures of con-sumer confidence are very closely watched by economic forecasters.Stock prices One of the most visible and closely followed macroeconomicseries, stock prices are procyclical and a leading economic indicator ofpeaks and troughs The same holds true for two other variables that arekey determinants of stock prices: consumer expectations and corporateprofits The problem with using the stock market to predict business cycles

is that stock prices are much more volatile than GDP Stock prices cannot berelied on exclusively when forecasting because of the high probability offalse signals

The money supply M2 is the most commonly used definition of themoney supply, which includes currency, checkable deposits, savingsdeposits, money market mutual funds, small certificates of deposit, andtraveler’s checks M2 is strongly procyclical and a leading indicator ofpeaks and troughs in the business cycle Federal Reserve policy largely,but not completely, determines the level of M2 The critical issue is this:

do changes in the money supply lead to changes in output, or do changes

in output cause the money supply to change in ways that the Fed cannotcontrol? These questions will be an important topic for later discussion

CONCLUSIONS

The empirics of business cycles have not been completely covered inthis chapter, but in reality, this is impossible to do New theories oftenprovide economists with new ideas about things to look for in their eco-nomic data Albert Einstein makes this interaction between theory andempirics quite clear in the following quote: ‘‘It is quite wrong to try

which decides what we can observe’’ (Heisenberg, 1971)

The goal for economists interested in why business cycles occur andwhat can be done about them is straightforward: find a theory that fitsthe empirical facts of business cycles as they are understood While this

goal is clear, how to achieve this goal has not been A number of differentmodels have been developed over the past 250 years that have attempted

to explain the nature and causes of recessions and depressions Many ofthese models generate predictions that are consistent with much (thoughnever all) of this economic data How do we evaluate these competingmodels? Is a model’s ability to match economic data the only measure ofits worth? Or do things like logical structure and consistency with micro-economic theory matter just as much? These are just some of the manyquestions that will be dealt with when the macroeconomic theory ofbusiness cycles and forecasting is reviewed in the next section

SUGGESTED READINGS

National Economic Trends, International Economic Trends, and Monetary Trends: Thesepublications are made available by the St Louis Federal Reserve Theycontain a wide variety of current macroeconomic data as well as economicanalysis of the current state of the economy They are available by subscrip-tion through the mail or found on the Internet at http://research.stlouisfed.org/publications/