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ECON 313 Ch 8

Business Cycle
Fluctuation in aggregate economic activity in which many economic activities expand and contact together in a recurring, but not a periodic fashion
Business Cycle Illustration
– Trough: Low point in economic activity. (T)
– Peak: High point in economic activity. (P)
– Business Cycle Expansion: Period T to P. AKA Boom
– Business Cycle Contraction: Period P to T. AKA
Long-run trend
Potential output (Yp)
– All prices fully adjust so that resources are fully utilized
– Determined by Tech, Capital, and Labor. (A, K, L)
Short-run deviations from trend
Output gap (Y – Yp)
– Shocks to the economy
– Hard to measure so estimates can be inaccurate
– Co-Movement of Economic Variables
Variable moves up during expansion and down during contraction
Variable moves down during expansion and up during contraction
Variable with ups and downs that do not coincide with those of the business cycle.
Timing of Variables
Leading variable
Lagging Variable
Coincident Variable
Leading variable
Reaches a peak or trough before the turning points of a business cycle
Lagging Variable
Reaches a peak or trough after the turning points of a business cycle
Coincident Variable
Reaches a peak or trough at the the same time of a business cycle
Index of Leading Indicators: From The Conference Board
1. Regularly revises when more accurate data become available
2. Changes components of index over time to improve history record
3. Uses real-time data at time is less accurate than revised data Leading variables
Macroeconomic Variables and the Business Cycle
– Real GDP: Broad measure of aggregate economic activity. Sometimes proxy for bus cycle
– Real Consumer pending and Investment:Procyclical and coincident. Investment more volatile.
– Unemployment: Countercyclical
– InflationL Procyclical and lagging
Financial Variables
– Ex: Stock and bond prices are procyclial and tend to be leading the business cycle
– Interest rate paid on short-term U.S. government bonds, known as Treasury bills, is both procyclical and lagging
– Differnece in interest rates between long-term and short-term government bonds is leading and pro cyclical, and good predictor of recessions
– Difference in interest rates on corporate bonds and government bonds in countercyclical. Companies a more likely to run out of money in recessions and thus have to pay higher interest rates for corporate bonds
International Business Cycles
– In a globalized economy, business cycles of many countries are correlated with those of the United States
– Global financial markets have become more integrated. US financial crisis in 2008 made other economies crash too
Time Horizons in Macroeconomics
– The study of business cycles focuses on short-run economic fluctuations
– John Maynard Keynes questioned the classical view that economies moved quickly to their long-run equilibrium
– Said we should primarily focus on the short-run. In the long run, we are all dead.
– Keynesians: Argue that the govt should pursue active policies to stabilize economic fluctuations
– Ex: Promot high long run economic growth such as keeping inflation low.
The Short Run Versus the Long Run
– Long Run, prices of goods/services as well as labor (wages) are flexible
– They adjust all the way to their long-run equilibrium where supply equals demand
Classical dichotomy
– where there is a total separation between real and nominal variables
– Change in nominal variables such as inflation and the money supply have no effect on real varibles such as aggregate output (Real GDP), real interest, saving, or investment.
– Flexible price models that display classical dichotomy determine Real GDP only by the production function with labor and capital
– Keynesian Models: Model with Sticky Prices – Short run prices respond slowly to changes in supply and demand. Move to long-run equilibrium slowly.
Perfect competition and monopolistic competition
– Classical Models
– Assumes perfect competition in markets where buyers and sellers are price takers who only decision is how much to buy or sell. Equilibrium price will prevail over all others.
– Keynesians Model: Focuses on the importance of market (monopoly) power in a market with monopolistic competition as firms have the ability to set prices.
Source of Price Stickiness
– Menu Costs: Costs a firm bears when it changes the price of its goods, are one source of price stickiness. Must change menu prices, make new guidelines for sales people, advertise new product, re-mark prices of goods. Important because

– Changing prices is a complex process that involves many hidden costs
– Collecting information is costly, so firms and households may engage in rational inattention by making decisions about prices only at infrequent intervals. Rational because reviewing pricing condition a few times a year because of time and effort
– Changing prices frequently may alienate customers.

– Staggered Price Setting
– Occurs when competitors adjust prices at different intervals, so that staggered prices slow down price adjustment

Empirical Evidence on Price Stickiness
– Indicates substantial price stickiness in markets
– Ex: Alan Blinder found that only 10% of firms changed their prices as often as once a week, and close to 40% changed prices once year and 10% less than once a year
– Can change % with inflation

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