Business Cycles\(:\) Main Problems and Facts

Week 02

Vivaldo Mendes

vivaldo.mendes@iscte-iul.pt

Instituto Universitário de Lisboa (ISCTE-IUL)

February 17, 2025

Table of contents

• 1. A Word of Caution
• 2. The Purpose of Macroeconomics
• 3. The Economy is Very Volatile
• 4. Types of Variables
• 5. Readings

1. A Word of Caution

What is the Nature of Macroeconomics?

• Macroeconomics is a discipline that studies the behavior of the economy as a whole.
• “The economy as a whole” is a very complex system.
• We need to make simplifications (theories) to understand it.
• We need facts to confirm our theories.
• We need data to test our theories.
• We need mathematics to express our theories.
• We need computers to do the calculations.
• We need honesty to interpret and display the results.

A Remarkable Example of Bad Economics

The President of the US, Donald Trump, has recently said the following about the EU trade balance:

“They don’t take our cars, they don’t take our farm products, they take almost nothing, and we take everything from them—millions of cars, tremendous amounts of food and farm products.” \(~~\) Here\(~~,~~\)also here

“The European Union was formed to screw the United States—that’s the purpose of it, and they’ve done a good job of it. But now I’m president.” \(~~\)Here

Facts

Unfortunately, the facts do not support the Donald Trumps’s statements.

More facts

• No, the UE was not created to “screw the United States”
• It was created to screw the …

\(~~~~~~~~~~~~~~~~\)old Soviet Union

• … by the impulse of the US with their Marshall Plan
• … and the adherence of the destroyed European countries

\(~~~~~~~~\)… and everybody knows this historical fact!

2. The Purpose of Macroeconomics

Testing your intuition

• What is more volatile: short-term or long-term interest rates?
• U.S. Treasury Securities Market Yields:
  • 10-Year Maturity
  • 3-Month Maturity

Testing your intuition

The answer is: _______________________________

Main Macroeconomic Variables

• Real GDP (Gross Domestic Product) and its components
• Unemployment, employment, and participation rates
• Inflation rate and interest rates
• Public budgets and public debt

Excellent sources of macroeconomic data:

• For the US economy go here: FRED Economic Data
• For the EU economy go here: EUROSTAT Data
• For World economic data: TED Data

Real GDP

The next figure shows the evolution of Real GDP for the US economy. How helpful is a figure like this one?

Real GDP vs Potential GDP

The previous figure does not provide much information by itself.

• In which periods GDP grew at higher rates?
• In what periods the US economy was performing above/below its potential GDP level?
• This raises to the surface another crucial aggregate:
  • Potential Real GDP

Real GDP vs Potential GDP: USA (1955-2024)

Data source: FRED Economic Data

Real GDP vs Potential Real GDP: USA

A closer view: we can zoom in between 1970 and 1988

Business cycles

Percentage deviations of real GDP from Potential GDP

The Unemployment Rate: USA 1947-2024

The % of the labor force that does not have a job … but is looking for one.

Source: FRED Economic Data

The Participation rate

Total labour force divided by the total working-age population [15,65].

Source: FRED Economic Data

Inflation in the Euro Zone (EZ): 1997-2025

The inflation rate is, normally, taken as the percentage change in the CPI (Consumer Price Index). Central banks have a target level: 2% per year.

The Interest Rate in the USA (FFR)

The Federal Funds Rate (FFR) is the most important short-term interest rate in the US. Source: FRED Economic Data

Target Interest Rate in the USA

The US central bank (The Federal Reserve Board, or simply Fed) sets the target rate range for trading in the federal funds market.

\(~~~~~~~~\)

Source: FRB of New York

Public deficits in the USA

Systematic deficits and highly volatile. Source Fred data

The Size of Public debt

Shocks and the size of public debt. From OECD data: government debt

3. The Economy is Very Volatile

What is Macroeconomic Policy?

• It is the intervention of public institutions (the Government and the Central bank) in the functioning of the economy.

• Why is it necessary? For several reasons:

• The economy may be hit by exogenous shocks that have dramatic impacts on the entire economy (Covid, war in Ukraine, a large increase in oil prices, etc.)

• Some sectors have to be regulated because they are prone to market failures (natural monopolies, collusion, externalities)

• Some private agents may behave dishonestly (moral hazard) and may led to a dramatic collapse of an entire sector in the economy (e.g., bank runs)

• The economy is very volatile … even in the sort term

The Summer 2021’s Big Problem: DEFLATION

• Everybody was concerned about deflation (negative inflation rates)
• One FT’s editorial applauded the move by the ECB to review its policy strategy in July 2021
• Keep interest rates at 0% or even negative if necessary

The Zero Lower Bound (ZLB)

In the US, the fear of deflation was so strong that the Fed kept the interest rate at 0% for a long time.

In Europe, interest rates were negative.

Negative Interest Rates in Europe

The inconceivable become reality in the summer of 2021. Euribor

\(~~~~~~~~~~~\)

Summer 2022’s Big Problem: PACY INFLATION

• Suddenly, in 12 months, inflation increased around 6 or 7 percentage points in most Western economies
• Central banks were forced to increase interest rates very aggressively
• Another FT’s editorial applauded the courage of central banks in July 2022

Galloping Inflation

In the summer of 2022 inflation seemed to be getting out of control.

Financial Crisis and Spread Volatility

Financial crisis lead to large jumps in spreads in the financial markets.

Source: FRED Economic Data

Macroeconomic Instability and Yields

Instability leads to large and abrupt changes in the yields of financial assets.

\(~~~\)

Source: European Central Bank

4. Types of Variables

Business Cycle Variables

From the business cycles, we can obtain information about the relationships among different variables using the following statistical concepts:

• Cross-correlation
  • Pro-cyclical variables
  • Counter-cyclical variables
  • Acyclical variables
• Turning points
  • Leading variables
  • Lagging variables
  • Coincident variables
• Standard deviation: Volatity
• Auto-correlation: Persistence

Pro-cyclical and counter-cyclical variables

A variable is pro-cyclical if it moves in the same direction as the business cycle.

• GDP is the reference variable in the business cycle.

Recall: Cross-Correlation Plots

Time series plots are very bad for detecting the type of correlation. Use the cross-correlation plots.

\(~~~~~~~~\)

Leading and Lagging Variables

A variable is leading if it changes before the change of the business cycle.

• GDP is the reference variable in the business cycle.

Summary 1

Table related to cyclicality and volatility

\(~~~~~~~~~~\)

Stephen D. Williamson, Macroeconomics, 6th Edition, 2018, Pearson. In “Chapter3: Business Cycle Measurement”

Summary 2

Table related to leading/lagging variables

\(~~~~~~~~~~\)

Stephen D. Williamson, Macroeconomics, 6th Edition, 2018, Pearson. In “Chapter3: Business Cycle Measurement”

5. Readings

Readings

• This is an introduction to business cycles. There is no compulsory readings .

• However, if you want to get some further information about business cycles, a good bibliographical reference is “Chapter3: Business Cycle Measurement” in the textbook:

  • Stephen D. Williamson (2018). Macroeconomics, 6th Edition, Pearson.

• If you need more information about macroeconomics in general, you can check the materials available here: modernmacro.org