Economics Chapter 8 The Problem That Even The Timing Some

Chapter 8

Business Cycles: An Introduction

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline

Business Cycle Basics

Business Cycle Illustration

Macroeconomic Variables and the Business Cycle

Real GDP and Its Components

Macroeconomics in the News: Leading Economic Indicators

Unemployment

A Brief History of U.S. Business Cycles

Pre–World War I

Time Horizons in Macroeconomics

Keynesian and Classical Views on Economic Fluctuations

The Short Run Versus the Long Run

Price Stickiness

Perfect Competition Versus Monopolistic Competition

Road Map for Our Study of Business Cycles

Chapter Overview and Teaching Tips

This chapter provides an introduction to Part Four of the book by first discussing the basic features of business

cycles and how key macroeconomic variables—real GDP and its components, unemployment, inflation,

interest rates, stock prices, and term and credit spreads—vary over the business cycle. Discussing the cyclical

movements of these variables with Figures 8.2 to 8.9 lets students know what data the aggregate demand-

82 Mishkin • Macroeconomics: Policy and Practice, Second Edition

◼ Answers to End of Chapter Review Questions and Problems

Answers to Review Questions

Business Cycle Basics

1. Business cycles are fluctuations in aggregate economic activity that follow a sequence of expansion,

peak, contraction, and trough. The period between a peak and a trough is a business cycle contraction

Macroeconomic Variables and the Business Cycle

2. The distinction is based on the direction of change in a variable’s value relative to changes in the

overall level of aggregate economic activity. Procyclical variables move in the same direction as

3. The distinction is based on the timing of directional changes in a variable’s value relative to business

cycle peaks and troughs. A variable whose value starts to rise before a business cycle trough and to

4. Real consumer spending: procyclical, coincident; real investment spending: procyclical, coincident;

unemployment: countercyclical, timing is uncertain; inflation: procyclical, lagging; S&P 500 Index:

A Brief History of U.S. Business Cycles

5. The “Great Inflation” was the period from the mid-1960s to the early 1980s when annual inflation

rates rose from an average of less than 2 percent to more than 15 percent and exhibited extremely

Chapter 8 Business Cycles: An Introduction 83

Time Horizons in Macroeconomics

6. Flexible prices and wages rise and fall in response to demand and supply shocks and move to new

7. In the long run, prices and wages are completely flexible and fully adjust to their long-run

equilibrium values. In the short run, prices and wages are sticky and do not fully adjust to long-run

8. Classical macroeconomists hold that prices and wages are flexible so that the economy adjusts

quickly to long-run equilibrium following demand and supply shocks. (In other words, the short run

is a very short period of time.) They advise that government policymakers, therefore, should focus

Price Stickiness

9. Classical macroeconomists treat economic actors as price takers who buy or sell standardized

products at prices determined in perfectly competitive markets. Given this market structure, prices

10. Menu costs refer to the costs a firm incurs when it changes its prices. These costs may include

printing new catalogs, price lists, or menus, informing salespeople of new prices, advertising to

inform customers of the new prices, and re-marking the prices of goods on shelves and in inventories.

Answers to Problems

Business Cycle Basics

1. a. There are two expansions according to this graph: (1) from January 1912 to January 1913, which

lasted 12 months, and (2) from December 1914 to August 1918, which lasted 44 months, or 3

2. This statement is not entirely correct. A contraction is a decrease in aggregate economic activity,

measured by changes in many economic indicators. The NBER Business Cycle Dating Committee

uses many sources of information to determine when the economy is experiencing a contraction or

84 Mishkin • Macroeconomics: Policy and Practice, Second Edition

3. a. Although home prices declined slightly before aggregate economic activity declined, home prices

decreased during the current contraction, suggesting this could be a cyclical variable. As of May

4. a. Considering only changes in real GDP, the economy reached its peak in February and reached its

trough in April.

5. a. Real GDP and stock prices index:

Chapter 8 Business Cycles: An Introduction 85

b. Unemployment and inflation rates:

c. Considering real GDP and the unemployment rate, it is not clear that the economy reached its

trough in April because the unemployment rate kept increasing after that period. Using other

indicators, the trough would probably be determined at some date between April and May (when

the next quarter, depending on the ever changing economic environment.

Macroeconomic Variables and the Business Cycle

6. Real GDP is procyclical and coincident. Consumer and investment spending also appear to be

procyclical and coincident. Unemployment is countercyclical and its timing is uncertain. Inflation is

A Brief History of U.S. Business Cycles

7. The longest expansion took place between March 1991 and March 2001 and lasted 120 months. The

shortest expansion took place between March 1919 and January 1920 and lasted 10 months only. The

longest contraction took place between October 1873 and March 1879 and lasted 65 months. The

fewer months than their previous episodes would lead one to believe.

Time Horizons in Macroeconomics

8. This statement is not correct. Keynes stated that we should primarily focus on short-run fluctuations

because it takes a long time for the economy to reach its long-run equilibrium. Waiting for such a

long time would be useless, Keynes argued, because there are policy tools that can be used to reduce

86 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Price Stickiness

9. a. Dairy products are considered to be quite standardized. The market for dairy products is,

therefore, a pretty competitive market, in which buyers and sellers are price takers.

10. If an economy is composed of only competitive markets, then prices would be more flexible than in

11. There are a few aspects of wage determination that contribute to their relative stickiness, in particular

in the downward direction. Wages are usually set for a year or maybe more. Employers and employees

◼ Answers to Data Analysis Problems

1. a. The most recent recession, according to the National Bureau of Economic Research (NBER)

spanned 2008:Q1 through 2009:Q2.

b. See table below, for averages from 2008:Q1 through 2013:Q1.

2. a. The most recent recession, according to the NBER spanned January 2008 through June 2009.

b. From January 2008 to June 2009, the unemployment rate increased from 5.0 percent to 9.5

percent, an increase of 4.5 percentage points. From July 2009 through June 2013, the

unemployment rate fell from 9.5 percent to 7.6 percent, a decline of 1.9 percentage points. The

Chapter 8 Business Cycles: An Introduction 87

3. a. The most recent recession, according to the NBER, spanned January 2008 through June 2009.

b. The average of the consumer sentiment index is 63.6 during the recessionary period and 71.6

from July 2009 to January 2013. Consumer sentiment is procyclical, declining during recessions

and rising during expansions.

c. Industrial production declined from 100.5 in January 2008 to 83.8 in June 2009, a decrease of

16.6 percent during that period. After that, it increased from 84.5 in July 2009 to 99.0 in June

2013, and increase of 17.2 percent during that time. Industrial production is procyclical, declining

during recessions and rising during expansions.

4. a. See table below.

b. The highest average real GDP growth occurred during the Great Moderation period at 3.3

percent, while the lowest occurred most recently from 2008:Q1 to 2013:Q1, at just 0.7 percent.

Real GDP Growth

Inflation Rate

Average

Standard

Deviation

Average

Standard

Deviation

Great Inflation Period

2.5

2.94

Great Moderation Period

3.3

1.61

2.6

0.83

7.0

1.93

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Dating and Measurement of Business Cycles

Data Source

Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/GDPCA?cid=106. Here you

can get access to a chart showing the evolution of real GDP. Note how during the shaded periods (i.e.,

recessions as determined by the NBER) real GDP either stagnated or decreased.

88 Mishkin • Macroeconomics: Policy and Practice, Second Edition

What are the consequences of a business cycle contraction for a college graduate?

Answer: The determination of a business cycle contraction depends on many indicators, all of them related

B. For Information About the Behavior of Macroeconomic Variables During

the Business Cycle and International Business Cycles

Data Source

The Conference Board: http://www.conference-board.org/data/bcicountry.cfm?cid=1. Follow the “press

release with graph and summary table” link to download a PDF file showing the latest changes in the

index of leading economic indicators (LEI).

Discussion Question

Business cycles now have the ability to propagate quite quickly across countries. What are the

implications for policymakers of this relatively new scenario?

Answer: The recent financial crisis that originated in the United States in 2007 reinforced the idea that