Lecture 9 - Business Cycles
1. From the Long Run to the Short Run
Up to this point in the module, we have analysed the long-run equilibrium of the economy, where prices adjust and markets clear. We developed theoretical accounts of:
- The real interest rate
- The natural rate of unemployment
- The price level
- The level of real income
These were largely determined by real factors such as productivity, savings behaviour, labour supply and institutional structure.
We now shift focus to the short run, where output fluctuates around its long-run trend.
Business cycles are short-run fluctuations in economic activity around long-run trend growth.
This marks a major conceptual transition in macroeconomics: from equilibrium levels to dynamic fluctuations.
2. Basic Concepts of Business Cycles
Economic activity does not grow smoothly. Instead, it alternates between:
- Periods of expansion
- Periods of contraction
These fluctuations define the business cycle.
Recessions and Depressions
A recession is a period of declining real income and rising unemployment, technically defined as two consecutive quarters of negative real GDP growth.
A depression is a particularly severe and prolonged recession.
Phases of the Cycle
- Peak: highest level of activity before output begins to decline
- Trough: lowest level before recovery begins
- Expansion: output rising
- Contraction: output falling
The economy never grows at a constant rate. Investment waves, credit conditions, expectations and policy shifts cause output to overshoot and undershoot its long-run path.
3. Empirical Patterns in GDP
Time series data reveal that GDP:
- Trends upward over decades
- Fluctuates around that trend
- Displays irregular cycles
Long-Run Trend vs Short-Run Fluctuation
This figure shows UK and EU GDP rising over time in current US dollars.
Interpretation:
- There is a clear upward trend in output.
- However, growth is not smooth.
- Shocks such as the oil crises, financial crisis and COVID period generate visible deviations.
The long-run growth trend reflects capital accumulation and technological progress.
Deviations around trend reflect aggregate demand shocks, supply shocks, and institutional rigidities.
Real GDP Growth Rates
This figure shows UK real GDP growth rates (1960–2014).
Interpretation:
- Growth rates oscillate above and below zero.
- Fluctuations are irregular in timing and magnitude.
- Recessions appear as negative spikes.
It is easier to see cycles in growth rates than in GDP levels.
The level always trends upward; growth reveals acceleration and slowdown.
Do not confuse a fall in growth with a fall in output.
If growth slows from 4% to 1%, output is still rising.
4. Procyclical and Countercyclical Variables
Macroeconomists classify variables based on how they move relative to GDP.
A procyclical variable is above trend when GDP is above trend.
Examples:
- Real wages
- Investment
- Consumption
A countercyclical variable is below trend when GDP is above trend.
Example:
- Unemployment
When output rises:
- Firms demand more labour
- Unemployment falls
- Wages tend to increase
- Investment rises due to optimistic expectations
Understanding these relationships is central to diagnosing economic conditions.
5. Leading, Lagging and Coincident Indicators
Policymakers attempt to predict turning points.
The OECD Composite Leading Indicator (CLI) attempts to identify peaks and troughs before they occur.
Interpretation:
- The CLI moves before GDP peaks and troughs.
- Arrows indicate predicted turning points.
- Mid-2007 shows early warning before the global financial crisis.
Leading indicators move before economic activity changes.
Lagging indicators move after.
Coincident indicators move simultaneously.
Forward-looking agents base decisions on expectations.
Financial markets and survey indicators embed expectations, making them leading signals.
6. What Causes Business Cycles?
There is no consensus explanation.
Potential Causes
- Household spending shocks
- Firm investment decisions
- External shocks such as geopolitical crises
- Government policy
- Confidence and expectations
- Technological shocks
- Monetary policy changes
A shock → transmission mechanism → aggregate response framework underlies all models.
The key disagreements concern:
- Source of shocks
- Speed of adjustment
- Role of market imperfections
- Whether policy intervention is stabilising or destabilising
7. Competing Schools of Thought
The debate is ideological as well as analytical.
Keynesian View
- Fluctuations reflect market imperfections.
- Demand failures justify policy intervention.
Hayekian / Austrian View
- Cycles are natural outcomes of market processes.
- Policy intervention distorts signals and worsens instability.
Hard Monetarists
- Monetary instability is central.
- Governments are likely to mismanage intervention.
Marxist View
- Cycles reflect structural contradictions in capitalism.
If asked to compare schools, structure your answer as:
- Source of instability
- View of market clearing
- Role of policy
- Normative implications
8. Real Business Cycle (RBC) Theory
RBC theory attributes fluctuations to technology shocks.
Core Assumptions
- Markets clear
- Agents are rational
- No systematic policy mistakes
- No price rigidities
A negative technology shock:
- Reduces labour productivity
- Lowers labour demand
- Reduces output
- Raises unemployment
- Raises prices
- Raises real interest rate
- Reduces investment
In RBC models, fluctuations are efficient responses to real shocks.
Output falls because the economy becomes less productive, not because demand collapses.
If productivity falls, producing goods becomes more costly.
Firms reduce labour demand.
The fall in supply pushes prices up.
RBC does not claim recessions are “good”.
It claims they are optimal responses to real constraints.
Policy Implication
Since agents have rational expectations:
- No systematic policy can improve outcomes.
- Intervention may distort optimal adjustments.
9. DSGE Models
Modern macroeconomics uses:
Dynamic Stochastic General Equilibrium (DSGE) models
Components
- Dynamic: Intertemporal optimisation
- Stochastic: Random shocks
- General equilibrium: Simultaneous market clearing
These models:
- Microfound macro behaviour
- Incorporate expectations
- Are widely used in central banks
DSGE models unify RBC and New Keynesian approaches by embedding optimisation and expectations within a general equilibrium structure.
Strengths
- Internal consistency
- Policy simulation
- Structural interpretation
Weaknesses
- All models are simplifications
- Financial sector historically underrepresented
- Performed poorly during the global financial crisis
When evaluating DSGE models:
- Mention microfoundations
- Mention expectations
- Mention financial crisis critique
10. Key Takeaways
- Business cycles are short-run fluctuations around trend growth.
- GDP fluctuates irregularly.
- Variables can be procyclical or countercyclical.
- Leading indicators attempt to predict turning points.
- Competing schools disagree on causes and policy responses.
- RBC attributes cycles to technology shocks.
- DSGE models are the modern analytical framework.
Bibliography
Jensen, M.K. (2026) ECON1002: Introduction to Macroeconomics – Week 5, Set 2 Lecture Slides. University of Nottingham.
Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning EMEA.
Mitchell, W.C. and Burns, A.F. (1938) Statistical Indicators of Cyclical Revivals. New York: National Bureau of Economic Research.