The Business Cycle

1
The Business Cycle

• What are recessions? Expansions?
• POTENTIAL GDP, Actual GDP and the GDP GAP
• Unemployment and the NAIRU
• Okuns Law

2
National Bureau of Economic Researchand the
dating of the business cycle

• The NBER (a private organization in Boston)
  produces the most widely accepted business cycle
  dates.
• It looks at several indicators
• industrial production
• employment
• real income
• wholesale/retail trade
• Recessions are the period from PEAK to TROUGH
• Expansions are the period from TROUGH to PEAK
• Web site http//www.nber.org/cycles.html

3
The Congressional Budget Office

• Estimates POTENTIAL GDP on basis of available
  capital, labor force and technology.
• Uses those estimates in long-run planning -- for
  example, can we still fund Social Security and
  have a tax cut?
• Permits a definition of RECESSION as a period in
  which the economy is BELOW POTENTIAL.
• GDP GAP (POTENTIAL GDP - ACTUAL GDP)
  divided by POTENTIAL GDP.
• Textbook notation (Y - Y) / Y

4
Actual GDP and Potential GDP 1953.Q1 to
2000.Q2 Source Congressional Budget Office
5
GDP gap (potential - actual) / potential Gap
greater than 0 gt RECESSION
6
GDP gap 1953 - 2000 Gap lt 0 indicates EXPANSION
7
The NAIRU (Natural Rate of Unemployment)

• NAIRU literally stands for The Non-Accelerating
  Inflation Rate of Unemployment -- the level of
  unemployment which cannot be reduced by monetary
  policy without a higher and accelerating
  inflation rate.
• The Natural Rate non-cyclical rate
• Estimates of the NAIRU have changed
• because of the changing composition of the labor
  force
• new entrants into the labor force change jobs
  more frequently, and therefore have higher rates
  of unemployment

8
The NAIRU estimated by the CBO
NAIRU Non-Accelerating Inflation Rate of
Unemployment
9
Percentage composition of the labor forceYEAR
Under 24 Over 24 Female

• 1960 19.5 80.5 36.8
• 1970 23.2 76.8 38.7
• 1980 23.7 76.3 42.5
• 1990 16.2 83.8 45.2
• 2000 16.1 83.9 46.5

10
Unemployment rate and the NAIRU 1953.1 to 2000.2
11
GDP gap and unemployment gap Note that they move
together, but GDP moves more
12
Okuns Law -- scatterplot Unemployment gap on
X-axis GDP gap on Y-axis
13
Okuns Law - regression line GDP GAP 1.77
UGAP