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Business Cycle

The NBER’s business cycle dating committee follows nism of the economy when affected by outside shocks.
standard procedures by using economy-wide measures of Many theories have been advanced over the years to
economic activity. The primary measure it looks at is the explain these cumulative up-and-down movements.
real GDP, which it considers to be the single best measure One set of theories developed around the turn of the
of aggregate economic activity. It also looks at other meas- twentieth century focused on such factors as innovations,
ures such as real personal-transfer payments, employment, variations in funds flow, and overinvestment as the initiat-
and industrial production. According to the dating com- ing causes of cyclical movements in the economy. Internal
mittee, the decline of real GDP for two or more consecu- dynamics of the economy also played a key role in the var-
tive quarters is the criterion for determining the beginning ious phases of the cycle in these theories. Theories devel-
of a recession. Table 1 provides the NBER’s chronology of oped during the interwar and immediate postwar period
U.S. business cycles since 1854. focused more on internal instability to explain how cycli-
The most recent turning point identified by the cal fluctuations in economic activity are created and sus-
NBER was November 2001, marking the end of the tained.
recession that started in March 2001 and inaugurating an In 1917 an eminent American economist, J. M.
expansion. As of December 2005, the U.S. economy con- Clark (1884–1963), published an article titled “Business
tinued to expand. The expansion that began in March Acceleration and the Law of Demand: A Technical Factor
1991 and ended in March 2001, lasting exactly ten years, in Economic Cycles.” His technical factor was the obser-
was the longest in the NBER’s chronology. Notice from vation that with a fixed capital-output ratio, a small per-
the table that all that is established with regard to “the” centage change in final sales would give rise to a large
business cycle is the peak and trough of each cycle. This percentage change in investment. Each innovation gener-
determination tells readers absolutely nothing about the ates a temporary demand for the required investment
rate of rise or fall in the general level of economic activity, goods. Once the initial investment has been made, the
nothing about the magnitude of the boom or the severity replacement market requires a lower rate of investment.
of the recession. This is referred to as the principle of acceleration. If it
takes $10 worth of steel mills to produce $1 worth of steel
THEORIES OF THE BUSINESS per year, growth in demand for steel by $1 will temporar-
CYCLE ily generate $10 worth of demand for steel mills.
The first lecture in an introductory economics course usu- Another early business cycle theorist, Joseph Schum-
ally makes the point that the expenditures of one eco- peter (1883–1950), noted that nothing is constant over
nomic unit are the incomes of other economic units. This the business cycle and nothing ever really returns to its
provides a fairly firm basis for expecting sympathetic starting place. That is what makes each business cycle
movements in many sectors of the economy. A good the- unique. The economy grows and changes with each
oretical basis and substantial empirical support exist for cycle—new products, new firms, new consumers. As
cumulative upward and downward movement in the Schumpeter observed in 1939, “As a matter of history, it
economy. One sector’s expansion is the basis for another is to physiology and zoology, not to mechanics, that our
sector’s expansion, general prosperity lowers risk and science is indebted for an analogous distinction which is
makes credit more readily available, and so on; but the at the threshold of all clear thinking about economic mat-
weakest part of business cycle theory and the toughest ters” (p. 37). The economy grows and changes. He
problem in forecasting is turning points. Why does the referred to this as the process of “creative destruction.”
general upward or downward movement end? Sometimes Schumpeter concluded that what most people con-
it is obvious. When, for example, a war begins or ends sider “progress” is at the source of the problem. He
with a commensurate and dramatic change in military believed that as entrepreneurs come up with new ways of
expenditures, the cause of the beginning or end of an eco- doing things, this disturbs the equilibrium and creates
nomic boom is fairly unambiguous. fluctuations. Schumpeter distinguished between inven-
Historically, however, only a small minority of the tions, which may gather dust for years, and innovations,
turning points are the result of specific, identifiable events which are commercial applications of previous inventions.
such as wars, changes in population, and advances in tech- Inventions occur randomly through time. Innovations
nology. Even when exogenous events initiate a business tend to be bunched, thereby creating cycles of economic
cycle, what generates cumulative up-and-down move- activity.
ments in the economy is the internal mechanism of the Many business cycle theorists give a prominent role
economy responding to the external stimuli. A satisfactory to the monetary system and interest rates. Early in the
theory of business cycle, therefore, must explain how twentieth century, a Swedish economist, Knut Wicksell
cyclical movements are generated by the internal mecha- (1851–1926), argued that if the “natural” rate of interest

64 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION