Bruce Domazlicky

II. Business Cycles in the United States

From 1960 to 1998, the United States has experienced very impressive growth in GDP. The overall increase in real GDP during this period was 261.3%, or an average annual increase of 3.43%. The last figure is an average annual growth rate; it represents the yearly percentage growth rate in GDP if growth were smooth over the 39-year period. However, the reality is that GDP has not grown evenly over the period, but has, in fact, exhibited periods of rapid growth as well as periods of actual decline in GDP.

Figure 11.1 is a graph of real GDP from 1960 to 1998. The periods of rapid growth are evident: first half of the 1960s and the first 8 years of the 1980s. It is also easy to spot the periods of decline: 1973-75, 1980-82 and most recently, 1991. The concept of the business cycle can be used to aid in understanding the periodic movements in real GDP. A somewhat exaggerated picture of business cycles is given in Figure 11.2. It can be seen that there are four stages to a typical business cycle: peak, recession, trough and expansion/recovery.

The peak of a business cycle signals the end of the economy's expansion and a slide into a recession. The official definition of a recession is when real GDP declines for two consecutive quarters (i.e., six months) or more. During the recession stage, unemployment will rise as real GDP falls. In addition, the actual real GDP of the economy will be less than the potential real GDP, which is defined as the output of the economy at full employment.

Eventually, the recession will end when a trough is reached in real GDP. After the trough occurs, real GDP starts to increase. This is the expansion stage of the business cycle. The expansion in the economy will continue until another peak in real GDP is reached and the economy slides into a new recession. During the latter parts of the expansion phase as the new peak is approached, it is quite common for inflation to increase due to tight labor markets, which constrain the ability of the economy to increase output further. Shortages in other resource markets can also occur near the peak of the business cycle.

Since World War II, the economy has gone through the four stages of the business cycle several times. One fact that is clear from a study of postwar cycles is how different they tend to be in terms of length and severity. The 1973-75 recession was especially severe in terms of length and the decline in real GDP while the 1961 recession was relatively short with only a modest increase in unemployment. We also find expansion stages that last for over eight years (late 1982 to the middle of 1991) and some that last barely a year (1981). Clearly, there is no such thing as a "typical' business cycle beyond the four stages that we identified earlier.

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Go to the following website for the Bureau of Economic Analysis:

http://www.bea.doc.gov

Click on 'Overview of the Economy.'  What has been happening to GDP in the last few quarters? Are we in a recession?  Does it look like we might be going into a recession?  How does the growth of GDP compare to a year ago?  

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It would be very desirable if we could forecast real GDP, especially the turning points (peaks and troughs). For example, if we knew that a peak was near, we might be able to implement appropriate changes in government policy to reduce the severity of or even prevent the coming recession. Forecasting the business cycle is a difficult task, and is not for the fainthearted. There are several methods that are used to try to gauge the future movements in real GDP, some that are rather simple and others that are quite sophisticated. One method that is widely reported in the news media is the Index of Leading Indicators.

The Index of Leading Indicators is an historical method that depends on past relationships between various economic variables and real GDP. There are monthly data available on many different economic variables: employment, new orders for durable goods, the Dow-Jones Industrial average, average workweek, the money supply, etc. Each of these variables fluctuates over time and exhibits cycles. However, some of these variables have been found to consistently lead the business cycle in that they tend to reach their peak first and turn down before real GDP. Similarly, they will reach their trough and turn upward before real GDP does. If we were to graph them together with real GDP over time (they obviously do not have the same vertical scale), they would look something like Figure 11.3. The darker curve represents the leading indicators over the course of time. Note how they reach a peak (and a trough) before real GDP.

The U.S. Department of Commerce has constructed an index of the leading indicators and tracks that index on a monthly basis. Monthly movements in the Index of Leading Indicators are not as important as overall trend. A three-month change in the Index in the same direction is usually taken to be indicative of future movements in real GDP. Therefore, if the economy is expanding and the Index turns down for three consecutive months, this is perceived as an indication that a peak is near and the economy will slide in to a recession. Similarly, if the economy is in a recession and the Index turns upward for three consecutive months, that is interpreted to mean the recession will soon end and the expansion phase will start.

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The current value of the Index of Leading Indicators can be found at the following website:

http://www.conference-board.org

On the right click on 'Economic Indicators' for a definition of the indictors.  Near the bottom is a link to the latest report.
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