Measuring Business Cycles

Hausarbeit, 2009

24 Seiten


Table of Contents

Executive Summary

List of Abbreviations

List of Figures

List of Tables

1. Business cycle
1.1. Introduction
1.2. General progression
1.3. Causes
1.4. Economic impacts

2. Measurements
2.1. Determination of variables
2.2. Potential income and real gross domestic product
2.3. Full employment and unemployment rate
2.4. Price Stability and inflation rate
2.5. Economic indicators and solutions


Appendix 1: ITM-Checklist 1: 360-degree analysis

Appendix 2: Nominal GDP calculation

Appendix 3: Calculation of unemployment rate

Appendix 4: Calculation of inflation rate

Executive Summary

This assignment covers the topic “Measuring Business Cycles”. A business cycle is defined as recurrent but not period fluctuations in business economics. It includes four different phases: contraction (decrease of business activities), trough (lower turning point), expansion or recovery (increase of business activities) and peak (upper turning point followed again by contraction). One business cycle can either last from trough to next trough or from one peak to another. Business cycles present fluctuations around a given growth-trend.

According to the impulse-propagation approaching fluctuations are caused by three types of shocks: supply shock, private demand shock and policy shock. Short-time shifts in aggregate supply and aggregate demand have an impact on output, employment and price level as these factors are closely interconnected. Therefore economists use variables to track output, employment and price level in order to find out the current business cycle phase and to select the correct instruments or if necessary to start the counteractive measurements.

The most important factor in determining the phase of the business cycle is the economic activity measured by gross domestic product (GDP), a procyclical variable. A positive GDP indicates that the economy is growing (expansion phase) and vice versa a negative GDP shows the economy is declining (contraction phase). Potential GDP shows the possible output under full employment. The harmonisation of potential and real GDP can be influenced by decreasing the unemployment rate (share of unemployed people of labor force. Unemployment rate develops counter cyclically. In case economic activity increases (expansion phase), unemployment rate will fall and vice versa. Another important factor is inflation. High inflation devaluates value of money and rising inflation will increase the demand for higher wages leading to lower output.

The objective of macroeconomic policy is to track the variables and to find the correct respond to each development. Possible instruments may be focussing on stability in employment, prices and growth.

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1: Phases of a business cycle

Figure 2: A hypothetical pattern of business cycles

Figure 3: Classification of population determining labor force

List of Tables

Table 1: Relationship between economy and variables

Table 2: Nominal GDP calculation

1. Business cycle

The first chapter starts with a brief introduction on the topic in subchapter 1.1, followed by the general progression of a business cycle described in 1.2, the causes of business cycles in 1.3 and finally the economic impacts are focussed in 1.4.

1.1. Introduction

Against to macroeconomic theories the reality does not usually show equilibrium in economic activities. Currently economy is facing an enormous crisis. People are unemployed, those who are employed have less working hours and in general many people have less money and economic output is declining while in the past the situation was different. All countries are facing fluctuation of their aggregate business activities influenced by the behaviour of households, firms and the government. What are these fluctuations, what causes them and how can government prevent them? To answer these questions economists have to know business cycle theory.

1.2. General progression

Business cycle theory deals with the explanation of fluctuations in aggregate business activities. These activities include the aggregate supply as well as the aggregate demand which reflect the development of production, employment, prices and international trade. Business Cycles are short-term fluctuation of these economic activities. Despite the association of the term cycle the fluctuations are not regular or periodic but recurrent varying in frequency, magnitude and duration.

A business cycle includes four phases: contraction, trough, expansion (also called recovery) and peak. The following figure 1: Phases of a business cycle shows the hypothetical course of a business cycle (Thune, K. 2007):

Figure 1: Phases of a business cycle

illustration not visible in this excerpt

Source: Understanding Cycles Part 2: Stocks & The Economy, 2007

1. Contraction:

If the economic activity is slowing down, the output will decline. This is called contraction or even recession if the decline is severe enough. A long lasting recession is known as a depression.

2. Trough:

When the output reaches the lowest level and therefore the contraction turns into the next phase, the expansion, the turning point, called trough is exceeded.

3. Expansion or recovery

An expansion occurs when output increases. In this phase the economic activity speeds up again.

4. Peak

Finally the expansion reaches the turning point and the output will contract again. This upper turning point is called peak. Afterwards the business cycle continues with the contraction ending in a trough, the starting point of the next cycle.

In reality business cycles never happen to be periodic and therefore predictable as shown in figure 1, e.g. time frame varies from less than one year to even more than ten years (Rutherford, D., 2002, p. 84). Average duration of an expansion is 44.8 months and the average duration of a recession is 11 months. Even though, duration may vary, according to Burns-Mitchell the path of a business cycle is influenced by a long-term growth rate. As a result business cycles present fluctuations around a given growth-trend as seen in figure 2: A hypothetical pattern of business cycles:

Figure 2: A hypothetical pattern of business cycles

illustration not visible in this excerpt

Source: Macroeconomics in the global economy,1993, p.516

The growth trend can be determined e.g. by the rate of savings, labor force growth or technical change.

1.3. Causes

Classical theory teaches that on perfect competitive markets with full employment aggregate supply and aggregate demand will always lead to equilibrium prices, but in reality economy faces alterations in supply as well as in demand which do not lead to equilibrium prices on the short-run. Business cycles are short-term fluctuations destroying any equilibrium as a result of “random shocks hitting the economy” (Sachs, J.D. and Larrain, F., 1993, p. 520). According to the impulse-propagation approaching there are three types of shocks: supply shock, private demand shock and policy shock.

Supply shock:

Supply is driven by firms which are interested in profit maximization. A supply shock can be positive as well as negative. During a positive supply shock the output suddenly increases immensely in a short period of time, e.g. due to technical progress the efficiency of production can be improved leading to higher output. An increasing production level leads to higher employment resulting in an expansion phase.

The opposite is reflected in a negative supply shock. For instance output declines as a result of a change in raw material prices like in 1973 when the oil price unexpectedly increased. Possible results are lower output accompanied by a high level of unemployment. Economy will be facing a recession.

According to Mankiw the origin of an alteration in supply can be traced back to three models: sticky price model, imperfect information model and sticky wage model. Prices are sticky. They are altering slowly and with a time lag. Firms do not adjust their prices immediately when demand changes, e.g. due to long-term contracts or because the price change involves high costs. Next to sticky prices imperfect information about the current price level leads to wrong decisions of firms on how much to supply. Suppliers will raise their output “when actual prices exceed expected prices” (Mankiw 2002, p.353). Additionally, wages are sticky. According to sticky wage model wages are strongly connected to the price level. If price level rises, real wages decrease. Firms will hire more people because labor is cheap resulting in higher output.

Private demand shock:

A private demand shock is caused by shifts in investment and consumption. Households can either invest or consume. For instance, if households decide to save their money, they are shifting their consumption to the future. Current demand declines lead to a lower supply level disturbing also the level of employment. On the other hand, if demand increases, output of economy will rise as well. This effect is additionally pushed by price stickiness. As a result firms are going to hire more people or ask their existing workers to work longer. Over time, a higher level of aggregate demand pulls up wages and prices. These higher economic activities will be seen in the business cycle as an expansion phase.

Policy shock:

The policy shock reflects actions of the macroeconomic authorities like the government. Even though government is interested in avoiding fluctuations, t they can influence or cause fluctuations by decisions regarding monetary and fiscal policy. Mostly the government influences the demand side of a market e.g. by using monetary instruments to increase the demand by lowering the prime rate or influencing the velocity of money.

All kinds of shocks can occur within a country as well as be imported via trade from other countries. Nevertheless, they have in common that they hit the economy suddenly and disturb economies equilibrium.

1.4. Economic impacts

Each phase of a business cycle have different impacts on the economy. In order to determine the current fluctuation economists need to know how the different phases impact the economy, especially the recession as this is a risky phase for economy. When economists know, how the different factors of economy react towards recession, they can define variables as indicators for a specific phase of a business cycle. For that reason the focus will be now on the level of total output and income, the level of employment and price level.

Output and income

During a recession less is produced. Due to a lower level of output, firms will hire less and fire more people. Furthermore they are reducing working time. Wages tend to stay the same or only increase very slowly. As a result households have less income and less money to spend. Aggregate supply and demand are declining. To avoid a recession and/or to enhance an expansion the government has to ensure to increase output and income.


The biggest problem of a recession is a rise in unemployment, especially when the recession is caused by a demand shock. A decline in aggregate demand reduces output (short-term) because prices do not adjust immediately. After a sudden fall in aggregate demand, firms still have their high prices. A low demand and a high price lead to lower sales. Firms will reduce production and as they demand fewer workers, economy faces a rise in unemployment.

The solution for this problem is full employment. If all labor force participants would work, the firms could produce high output and due to their wages the households could afford a high demand.

Price level

Despite the fact, that prices tend to be sticky on the short run, the price level is still important. On the long run prices change during a recession. They will probably increase as the households will save their money for later consumption. If the price level increases, each transaction requires more money. As a result “the number of transactions and thus the quantity of goods and services purchased must fall” (Mankiw 2002, p. 243).


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Measuring Business Cycles
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Simone Dommer (Autor), 2009, Measuring Business Cycles, München, GRIN Verlag,


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