REAL GDP CHANGES AND THE BUSINESS CYCLE

Buckle Your Seat Belts

Over the last fifty years, America has undergone alternating periods of recession and economic expansion. The ups and downs have occurred against a background of long-run economic growth. In other words, from year to year the GDP may go up and down overall but the trend is upward. Since 1960, the U.S. real GDP has increased by more than $10 trillion.

EXPANSION AND CONTRACTION

Economists refer to this series of expansions and contractions as the business cycle (some economists prefer the term “fluctuation” since “cycle” implies a predictable pattern, which does not exist).

As the workforce and productivity grow, so does the economy’s capacity to produce. This explains why the economy has grown over time. The periods of expansion and contraction are attributed to differences between total spending on output relative to the economy’s long-term capacity to produce. During periods of expansion, spending increases to the point where the economy exceeds its long-run production capacity. Contractions occur as total spending decreases and excess productive capacity remains.

Business Cycle Measurements

Business cycles are measured by looking at both GDP and unemployment. During periods of economic expansion, unemployment is reduced and the GDP grows. The opposite happens in periods of recession.

If you have ever been on a long car trip, you can understand the business cycle. Imagine cruising along a two-lane highway, going with the flow of traffic. This going with the flow is the norm and represents the average rate of economic growth. Occasionally, somebody will be moving a little too slowly, so you scan for oncoming traffic. If it’s clear, you accelerate and pass the slower driver. Passing represents those periods where spending exceeds the productive capacity. Every once in a while, you make a mistake while trying to pass slower traffic. You scan for oncoming traffic and make your move, only to discover that a fully loaded eighteen-wheeler is barreling down the highway in the oncoming lane. You immediately switch back into your lane, shaking violently, and slow to thirty miles per hour, thankful that you are still alive. Events like this are representative of economic contractions. Eventually, you compose yourself and start to travel with the flow of traffic again.

Now, to really understand the business cycle, imagine that you are blindfolded the whole time and relying on an extremely myopic passenger speaking Swahili to provide information about what is happening. To be sure, it would be an interesting ride. Why the blindfold and Swahili? Outside of psychics, prophets, meteorologists, and the rare economist, most Americans have difficulty seeing into the future. The language of economists and financial experts is often difficult to interpret.

The Four Stages of the Business Cycle

Economists generally point to four stages in the business cycle:

1. Expansion, which occurs when the GDP grows month-over-month, and unemployment declines.
2. Peak, which occurs when real GDP spending is at its highest—the period just before unemployment begins to rise and other economic indicators fall.
3. Contraction, which occurs when GDP growth slows or declines. A recession is specifically defined as two consecutive quarters of declining real GDP.
4. Trough, which is the period between contraction and expansion as GDP begins to recover.

As this description makes clear, economists can only determine what stage the economy is in after it has happened.

THEORIES OF BUSINESS CYCLES

Economists disagree on exactly why the economy fluctuates as it does. Is the culprit external causes, such as wars? Or internal factors, such as business innovation? They also disagree on what should be done during downturns. How much should the government meddle? That depends on which economist you talk to.

• Milton Friedman’s monetarists explain the business cycle as being caused by poor management of the money supply. Periods of overexpansion are produced by too much money, and periods of contraction are caused by too little money in circulation.
• Keynes explained the business cycle as being caused by “animal spirits” where businesses are in effect bipolar. Keynes’s animal spirits represent the emotion that clouds rational decision-making. These animal spirits are expressed through businesses’ willingness to invest. When businesses are manic, they invest heavily, only to fall into stages of depression where they are unwilling to invest.
• Most other theories explain the business cycle as ultimately being caused by spending changes, but one referred to as the Real Business Cycle Theory focuses on changes in productivity as being the ultimate cause of the cycle.