1. Definitions and Fundamentals

Business cycle = cyclical change in business activities

length of phase

amplitude

t

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Cycle-types (Josef Schumpeter, Business Cycles, 1939)

• Kitchins (3 years storage-cycles)

• Juglars (10 years investment-cycles)

• Kondratieffs (50 – 60 years construction and innovation-cycles)

GDPreal

time t

GDPreal

time t

Reality: Cycle-types overlap

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Theory: ideal types

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Previous classification of cycle-phases(Gottfried Haberler, Prosperity and Depression, 1937)

GDPreal

GDPtrend

time t

1. boom 2. recession

3. crisis 4. recovery

• today: rising trend => growth rates of GDP are relevant

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Business Cycle vs. Economic Growth

Definition I: • growth = trend of GDP• cycles = cyclical deviations from trend

Definition II:• growth = rise in potential output• cycles = cyclical change of capacity utilization

t

ln BIPPP

ln BIP

t

Trend

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Definitions

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Capacity utilization:

Output-Gap:

(PO = potential output)

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Alternative definitions of a recession (cf. SVR JG 2008, S. 78)

• Common definition: recession = real GDP (seasonally adjusted) declines for several (mostly: three) quarters

shortcomings: lagged publication of GDP, frequent revisions

• National Bureau of Economic Research: recession = substantial decline in several indicators (GDP, industrial production, sales…) for more than a few months

shortcomings: lagged publication, not very precise

• SVR: recession = decline of a (negative) relative output-gap of at least 2/3 of potential growth rate

shortcomings: different calculations of potential output, definition sophisticated

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Example for SVR-definition of a recession(cf. JG 2008/09, S. 80)

• Relative Output-gap 2008: + 0,9%

• Relative Output-gap 2009: - 0,5%

=>decline of output-gap -1,4 percentage points

• potential output growth 2008: 1,6%

• Two thirds from that: 1,1%

• Difference > 0? 1,4 > 1,1

• Output-gap 2009 <0? -0,5 < 0recession

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Cycle phases according to German Council of Economic Advisors

(capacity utilization)

GDPreal/PO

Upper turning point

lower turning point

Normal level of CU

timeupswing downswing

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Concept of anticyclical business cycle policy (Keynes 1936)

• General Idea: Smoothing of cycles

• upswing: Budget-surplus, contractionary policy

• downswing/recession: Budget-deficits, expansionary policy

• on average (long run): balanced budget

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Classification of cycle indicators

• leading (e.g. orders)• coinciding (e.g. industrial production)• lagging (e.g. employment)

• „hard“(e.g. retail sales)• „weak“ (e.g. consumer confidence)

• single (e.g. quantity of money)• composite (e.g. FAZ-Indikator)

• real (e.g. orders, production)• monetary (e.g. interest rates, prices)

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gGDP

t

(leading indicators) (coinciding indicators) (lagging indicators)

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• orders• business climate• consumer confidence• stocks• monetary growth• interest rate spread

Leading indicators

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• industrial production• GDP • capacity utilization• output gap• retail sales

Coinciding indicators

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• inflation rate• unemployment rate• employment growth• interest rates

Lagging indicators

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Confidence indicators in Germany

Ifo-business expectations industrieZEW-business cycle expectations

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GDP

gBIP

t

t

0

Turning points: Level vs. Growth rate

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Why cycle forecast is principally limited*)

*) Source: S. Klein, Alles Zufall, Hamburg 2004, S. 50 f.

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Small inexactness...

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...amounts to total ignorance!

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GDP-forecast and reality

2001 2002 2003 2004

reality in year t

1,0% 0,2% -0,1% 1,8%

SVR in autumn t-1

2,8% 0,7% 1,0% 1,5%

Institutesin spring t

0,7% 0,9% 0,5% 1,5%

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%

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SVR-forecast vs naive forecast

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Digression: continuous vs. discrete growth

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discrete:

continuous:

• discrete rates are both better applicable in empirical research and more easily accessible• continuous rates are both better applicable in theoretical research and more elegant

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Digression (continued): calculus using growth rates

discrete:

continuous:

Only with small growth rates are the differences negligible!

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Exercise (I)

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Exercise (II)

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Learning goals / review questions

• How do we classify the business cycle?

• How do we define capacity utilization and the output gap

• Which indicators are leading, lagging, coincident?

• What are the differences and comparative advantages of discrete vs. continuous growth rates?

• How do we calculate them?

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