Economic Fluctuations

Three Key Facts About Economic Fluctuations

Short-run fluctuations Opens in new window in economic activity have occurred in all countries throughout history. As a starting point for understanding these year-to-year fluctuations, we will focus on some of their most important properties.

Fact #1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy Opens in new window are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions.

When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing.

When real GDP falls during recessions Opens in new window, businesses have trouble. During such periods of economic contraction, most firms experience declining sales and dwindling profits.

The term business cycle Opens in new window is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern.

In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy. Panel (a) of Figure 1.1 shows the real GDP of the U.S. economy since 1972.

Figure 1.1, Panel (a) Figure 1.1, Panel (a)
Figure 1.1, Panel (b) Figure 1.1, Panel (b)
Figure 1.1, Panel (c) Figure 1.1, Panel (c)

The shaded areas represent times of recessions. As the figure shows, recessions do not come at regular intervals.

Sometimes recessions are close together, such as the recessions of 1980 and 1982.

Sometimes the economy goes many years without a recession. The longest period in U. S. history without a recession was the economic expansion from 1991 to 2001.

Fact #2: Most Macroeconomic Quantities Fluctuate Together

Real GDP  Opens in new windowis the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity.

Real GDP measures the value of all final goods and services produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy Opens in new window.

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together.

When real GDP Opens in new window falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data.

Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

In particular, as panel (b) of Figure 1 shows, investment spending varies greatly over the business cycle.

Even though investment averages about one-sixth of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions.

In other words, when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories.

Fact #3: As Output Falls, Unemployment Rises

Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises.

This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

Panel (c) of Figure 1 shows the unemployment rate in the U.S. economy since 1972. Once again, the shaded areas in the figure indicate periods of recession.

The figure shows clearly the impact of recessions on unemployment. In each of the recessions, the unemployment rate rises substantially.

When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. Because there are always some workers between jobs, the unemployment rate never approaches zero. Instead, it fluctuates around its natural rate of about 5 or 6 percent.