Macroeconomics Policy and Practice 2nd Edition Mishkin Solutions Manual

Macroeconomics Policy and Practice 2nd Edition

Mishkin Solutions Manual

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Chapter 8
Business Cycles: An Introduction

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline
Business Cycle Basics
Business Cycle Illustration
An Alternative View of the Business Cycle
Co-Movement and Timing of Economic Variables
Macroeconomic Variables and the Business Cycle
Real GDP and Its Components
Macroeconomics in the News: Leading Economic Indicators
Unemployment
Inflation
Financial Variables
International Business Cycles
A Brief History of U.S. Business Cycles
Pre–World War I
The Interwar Period and the Great Depression
Post–World War II
The “Great Moderation”
The Great Recession of 2007–2009
Time Horizons in Macroeconomics
Keynesian and Classical Views on Economic Fluctuations
The Short Run Versus the Long Run
Price Stickiness
Perfect Competition Versus Monopolistic Competition
Sources of Price Stickiness
Empirical Evidence on Price Stickiness
Road Map for Our Study of Business Cycles

Chapter Overview and Teaching Tips

This chapter provides an introduction to Part Four of the book by first discussing the basic features of business
cycles and how key macroeconomic variables—real GDP and its components, unemployment, inflation,
interest rates, stock prices, and term and credit spreads—vary over the business cycle. Discussing the cyclical
movements of these variables with Figures 8.2 to 8.9 lets students know what data the aggregate demand-

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82 Mishkin • Macroeconomics: Policy and Practice, Second Edition

aggregate supply (AD/AS) model developed in the coming chapters is intended to explain. Taking students
through a brief history of U.S. business cycle episodes, what I like to describe as the “greatest hits of U.S.
business cycle history,” is a way of getting them excited about the study of business cycles.

The chapter ends by discussing two key issues in business cycle analysis. First is the distinction between
the short and the long run, and how long it takes to get to the long run, which separates Keynesian versus
classical views of economic fluctuations. It then goes on to discuss price stickiness, an essential feature of
short-run business cycle models. Because the degree of price stickiness is also important in differentiating
Keynesian and classic views of business cycle analysis, it is worth discussing what the empirical evidence
tells us about the degree of price stickiness in the economy.

◼ Answers to End of Chapter Review Questions and Problems

Answers to Review Questions
Business Cycle Basics
1. Business cycles are fluctuations in aggregate economic activity that follow a sequence of expansion,
peak, contraction, and trough. The period between a peak and a trough is a business cycle contraction
(commonly referred to as a recession), and the period between a trough and a peak is a business cycle
expansion (or boom). Peaks and troughs are referred to as the turning points in the business cycle.
Although each business cycle follows this peak-recession-trough-expansion sequence, the lengths of
expansions and recessions vary from one cycle to another.
Macroeconomic Variables and the Business Cycle
2. The distinction is based on the direction of change in a variable’s value relative to changes in the
overall level of aggregate economic activity. Procyclical variables move in the same direction as
aggregate economic activity, so they rise during business cycle expansions and fall during recessions.
Countercyclical variables move in the opposite direction from aggregate economic activity, falling
during expansions and rising during recessions.

3. The distinction is based on the timing of directional changes in a variable’s value relative to business
cycle peaks and troughs. A variable whose value starts to rise before a business cycle trough and to
fall before a business cycle peak is a leading variable: Changes in its value lead (occur before) the
turning points in the business cycle. The value of a lagging variable peaks after a business cycle peak
occurs and likewise reaches a trough after the business cycle does. Variables whose values peak and
trough at the same time as business cycle turning points are coincident variables.

4. Real consumer spending: procyclical, coincident; real investment spending: procyclical, coincident;
unemployment: countercyclical, timing is uncertain; inflation: procyclical, lagging; S&P 500 Index:
procyclical, leading; spread between long- and short-term interest rates on U.S. government bonds:
procyclical, leading; spread between interest rates on corporate bonds and government bonds:
procyclical, coincidental.
A Brief History of U.S. Business Cycles
5. The “Great Inflation” was the period from the mid-1960s to the early 1980s when annual inflation
rates rose from an average of less than 2 percent to more than 15 percent and exhibited extremely
high variability before settling down to a narrower range of 4–5 percent. During this time span, the
inflation rate rose during both expansionary and recessionary periods of the business cycle. The
“Great Moderation” occurred during the 1990s when the volatility of real GDP and inflation
narrowed considerably.

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 Chapter 8 Business Cycles: An Introduction 83

Time Horizons in Macroeconomics

6. Flexible prices and wages rise and fall in response to demand and supply shocks and move to new
long-run equilibrium values following these shocks. Sticky prices may rise and fall some but do not
move to new long-run equilibrium values when these shocks occur.

7. In the long run, prices and wages are completely flexible and fully adjust to their long-run
equilibrium values. In the short run, prices and wages are sticky and do not fully adjust to long-run
equilibrium. Macroeconomists make the distinction between the two time horizons because only in
the long run, when all price and wage adjustments have taken place, will the classical dichotomy
hold. In the short run, before all price and wage adjustments occur, monetary neutrality does not hold,
and thus, changes in the money supply affect the values of real variables as well as nominal ones in
the short run.

8. Classical macroeconomists hold that prices and wages are flexible so that the economy adjusts
quickly to long-run equilibrium following demand and supply shocks. (In other words, the short run
is a very short period of time.) They advise that government policymakers, therefore, should focus
more on promoting the economy’s long-run economic growth than on reacting to its short-run ups
and downs. Keynesians hold opposing views. They think that because of sticky prices and wages the
economy adjusts slowly to long-run equilibrium (the short run is a very long period of time) and,
therefore, believe government can and should play an important role in countering economic
fluctuations.
Price Stickiness
9. Classical macroeconomists treat economic actors as price takers who buy or sell standardized
products at prices determined in perfectly competitive markets. Given this market structure, prices
and wages adjust rapidly to changes in demand and supply conditions. Keynesians think it is more
realistic to assume that firms have some market power and that they are able to set prices even if
there is competition in markets. This means that if firms find it advantageous to do so, they can keep
their prices fixed even when market demand and supply conditions are changing, which will slow the
speed of price and wage adjustment.

10. Menu costs refer to the costs a firm incurs when it changes its prices. These costs may include
printing new catalogs, price lists, or menus, informing salespeople of new prices, advertising to
inform customers of the new prices, and re-marking the prices of goods on shelves and in inventories.
Also, a firm may be concerned that price changes will anger its customers. Because of menu costs,
changing prices is not costless, and a firm will only change its prices if it believes the benefits of
adopting new prices will exceed the costs of changing them. Given the menu costs it faces, a firm
likely will change prices less frequently than it would if it ignored these costs. Thus, menu costs slow
the pace of price adjustments following changes in market demand and supply conditions.

Answers to Problems
Business Cycle Basics
1. a. There are two expansions according to this graph: (1) from January 1912 to January 1913, which
lasted 12 months, and (2) from December 1914 to August 1918, which lasted 44 months, or 3
years and 8 months.
b. There are two contractions according to this graph: (1) from January 1913 to December 1914,
which lasted 23 months, and (2) from August 1918 to March 1919, which lasted 7 months.
2. This statement is not entirely correct. A contraction is a decrease in aggregate economic activity,
measured by changes in many economic indicators. The NBER Business Cycle Dating Committee
uses many sources of information to determine when the economy is experiencing a contraction or

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84 Mishkin • Macroeconomics: Policy and Practice, Second Edition

expansion. Changes in real GDP receive a lot of media attention, but that does not mean it is the only
indicator used to determine expansions or contractions. As many indicators of economic activity
move together, it might be the case that an economy is experiencing a contraction when its real GDP
decreases for a couple of periods, but this would only be true if the other indicators tell the same story
about the economy.

3. a. Although home prices declined slightly before aggregate economic activity declined, home prices
decreased during the current contraction, suggesting this could be a cyclical variable. As of May
2009, home prices stabilized and even started to increase, while broad economic conditions did
not improve by much, which might suggest that this could be an a cyclical variable.
b. Because home prices reached a peak in April 2006, we can assert that home prices are a leading
indicator of the business cycle. Note that this is only one example and that more evidence is
needed to properly state the timing of an indicator.

4. a. Considering only changes in real GDP, the economy reached its peak in February and reached its
trough in April.
b. The inflation rate seems to be a lagging variable. The economy reached its peak in February, but
the inflation rate kept increasing for a few more periods. Inflation began its decrease after the
economy reached its trough in April. The stock price index seems to be a leading (by one month)
indicator of the business cycle. It peaked one month before real GDP, and it reached its trough
one month before (March) real GDP (April).

5. a. Real GDP and stock prices index:

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 Chapter 8 Business Cycles: An Introduction 85

b. Unemployment and inflation rates:

c. Considering real GDP and the unemployment rate, it is not clear that the economy reached its
trough in April because the unemployment rate kept increasing after that period. Using other
indicators, the trough would probably be determined at some date between April and May (when
unemployment peaks).
d. By considering these four indicators, it is clear that no single indicator can be used to determine
the business cycle. The problem is that even if the timing of some variables can be assessed, this
relationship can change over time. A leading variable might predict a peak in the next month, or
the next quarter, depending on the ever changing economic environment.
Macroeconomic Variables and the Business Cycle
6. Real GDP is procyclical and coincident. Consumer and investment spending also appear to be
procyclical and coincident. Unemployment is countercyclical and its timing is uncertain. Inflation is
procyclical and lagging. Stock prices are procyclical and leading. Interest rates are procyclical and
their timing is uncertain. The spread between interest rates on long- and short-term government bonds
is procyclical and leading. The spread between interest rates on corporate and government bonds is
procyclical and coincident.
A Brief History of U.S. Business Cycles
7. The longest expansion took place between March 1991 and March 2001 and lasted 120 months. The
shortest expansion took place between March 1919 and January 1920 and lasted 10 months only. The
longest contraction took place between October 1873 and March 1879 and lasted 65 months. The
shortest contraction took place between August 1918 and March 1919 and lasted 7 months only.
Table 1 data shows that U.S. business cycles are quite difficult to predict, as their lengths vary
substantially. It is not correct to say that there is a contraction coming because we are living through
an expansion that lasted 20 months and the last five recessions came after 20 months of expansion.
Business cycles are unpredictable by nature, and so is their persistence. They might last for more or
fewer months than their previous episodes would lead one to believe.
Time Horizons in Macroeconomics
8. This statement is not correct. Keynes stated that we should primarily focus on short-run fluctuations
because it takes a long time for the economy to reach its long-run equilibrium. Waiting for such a
long time would be useless, Keynes argued, because there are policy tools that can be used to reduce
the pervasiveness of business cycle contractions. Instead of waiting for prices to adjust, which takes a
long time, Keynes argued for an approach that would make use of policy tools to stimulate the

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86 Mishkin • Macroeconomics: Policy and Practice, Second Edition

economy. Keynes was also worried about the long-run consequences of policy actions, however, and
it is not correct to interpret his famous statement as irresponsible.
Price Stickiness
9. a. Dairy products are considered to be quite standardized. The market for dairy products is,
therefore, a pretty competitive market, in which buyers and sellers are price takers.
b. The production of motor vehicles in the United States is dominated by a few big manufacturers.
Although competition is fierce in this market, it cannot be considered a perfectly competitive
market. Car manufacturers, through advertising, encourage consumers to develop a preference
for their brand (e.g., associate a Corvette with a given lifestyle), which enables them to have
some control over prices. This market is better described as a monopolistically competitive market.

10. If an economy is composed of only competitive markets, then prices would be more flexible than in
an economy in which firms have some market power. In this particular case, the classical assumption
of flexible prices holds and would, therefore, be a better representation of that economy.

11. There are a few aspects of wage determination that contribute to their relative stickiness, in particular
in the downward direction. Wages are usually set for a year or maybe more. Employers and employees
decide on a given wage and benefits for some time, and this contributes to wage rigidity. On the other
hand, wages are mostly determined in competitive markets and, therefore, respond to supply and
demand conditions in the labor market. During contractions, when the demand for labor decreases,
wages usually decrease as well. Because wages are such an important price in the economy, there is
an ongoing debate about their relative rigidity or flexibility.

◼ Answers to Data Analysis Problems

1. a. The most recent recession, according to the National Bureau of Economic Research (NBER)
spanned 2008:Q1 through 2009:Q2.
b. See table below, for averages from 2008:Q1 through 2013:Q1.
c. All three variables are procyclical because they have negative growth rates during the recession
and positive growth rates during the expansion phase.
Real
Real Consumption Real GDP Growth Investment
Growth Rate Rate Growth Rate
Recession Average, 2008:Q1 to 2009:Q2 –2.3 –3.2 –26.5
Post-Recession Average, 2009:Q3 to
2013:Q1 2.1 2.1 9.4

2. a. The most recent recession, according to the NBER spanned January 2008 through June 2009.
b. From January 2008 to June 2009, the unemployment rate increased from 5.0 percent to 9.5
percent, an increase of 4.5 percentage points. From July 2009 through June 2013, the
unemployment rate fell from 9.5 percent to 7.6 percent, a decline of 1.9 percentage points. The
unemployment rate is countercyclical.
c. For the period from January 2008 through June 2009, nonfarm payrolls declined from
138,056,000 to 130,578,000, a net loss of 7,478,000 jobs during the recessionary period. In the
post-recession period from July 2009 to June 2013, nonfarm payrolls increased from 130,227,000
to 135,902,000, a net gain of 5,675,000 jobs. Nonfarm payroll employment is procyclical,
declining during recessions and increasing in expansions.
d. Although the lowest part of UNEMPMEAN occurs in September 2007 at 16.3 weeks, the data
does not start increasing substantially until July 2008, when it increases from 17.0 weeks, to 17.7

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 Chapter 8 Business Cycles: An Introduction 87

the following month. After that, the average duration of unemployment rises substantially. At its
peak, it tops out at 40.7 weeks in December 2011, long after the recession officially ends.
Because of the delayed timing, the average duration of unemployment lags the business cycle and
is countercyclical because it rises during recessions and falls during expansions.

3. a. The most recent recession, according to the NBER, spanned January 2008 through June 2009.
b. The average of the consumer sentiment index is 63.6 during the recessionary period and 71.6
from July 2009 to January 2013. Consumer sentiment is procyclical, declining during recessions
and rising during expansions.
c. Industrial production declined from 100.5 in January 2008 to 83.8 in June 2009, a decrease of
16.6 percent during that period. After that, it increased from 84.5 in July 2009 to 99.0 in June
2013, and increase of 17.2 percent during that time. Industrial production is procyclical, declining
during recessions and rising during expansions.
d. Real retail and food sales declined from $177,022 million in January 2008 to $158,550 million in
June 2009, a decrease of 10.4 percent during that period. After that, it increased from $159,209
million in July 2009 to $181,500 million in June 2013, and increase of 14 percent during that
time. Real retail and food sales are procyclical, declining during recessions and rising during
expansions.
e. All three are fairly closely coincident to the business cycle, although this isn’t all that obvious in
the 2001 recession for (RRSFS), and more generally (UMCSENT) fluctuates quite a bit, so it is
harder to clearly tie major upward or downward movements in consumer sentiment to the exact
business cycle dates.

4. a. See table below.

b. The highest average real GDP growth occurred during the Great Moderation period at 3.3
percent, while the lowest occurred most recently from 2008:Q1 to 2013:Q1, at just 0.7 percent.
Real GDP had its largest swings during the Great Inflation period, as measured by its standard
deviation (which is almost twice as much as during the Great Moderation period).
c. The highest average inflation rate, not surprisingly, was during the Great Inflation period at 7
percent, and the lowest occurred most recently from 2008:Q1 to 2013:Q1, at just 1.7 percent.
Inflation fluctuated the most during the Great Inflation period with a standard deviation more
than twice as much as occurred during the Great Moderation Period.
Real GDP Growth Inflation Rate
Standard Standard
Average Deviation Average Deviation
Great Inflation Period 2.5 2.94 7.0 1.93
Great Moderation Period 3.3 1.61 2.6 0.83
2008:Q1 to 2013:Q1 0.7 0.66 1.7 0.63

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Dating and Measurement of Business Cycles
Data Source
Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/GDPCA?cid=106. Here you
can get access to a chart showing the evolution of real GDP. Note how during the shaded periods (i.e.,
recessions as determined by the NBER) real GDP either stagnated or decreased.

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Macroeconomics Policy and Practice 2nd Edition Mishkin Solutions Manual

88 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article
Business Cycle Dating Committee, NBER: http://www.nber.org/cycles/sept2010.html. This article
explains how the Business Cycle Dating Committee determined the duration of the last contraction in the
U.S. economy.
Discussion Question
What are the consequences of a business cycle contraction for a college graduate?

Answer: The determination of a business cycle contraction depends on many indicators, all of them related
to current economic activity. An important component in that equation is the current situation of the labor
market. Business cycles contractions are associated with increasing unemployment rates, and most of the
time the unemployment rate remains at a relatively high level for an extended period (i.e., even after the
economy has recovered). This has direct negative consequences for recent college graduates, who enter a
depressed labor market and compete with other individuals with more experience and qualifications for
fewer job positions.

B. For Information About the Behavior of Macroeconomic Variables During

the Business Cycle and International Business Cycles
Data Source
The Conference Board: http://www.conference-board.org/data/bcicountry.cfm?cid=1. Follow the “press
release with graph and summary table” link to download a PDF file showing the latest changes in the
index of leading economic indicators (LEI).
Related Article
CNN, “Financial Crisis Dominates G-20 Agenda,” Monday, March 30, 2009:
http://www.cnn.com/2009/WORLD/europe/03/30/g20.summit.explainer/index.html?iref=allsearch. This
press article explains most prominent world leaders’ efforts to deal with the most recent financial crisis. It
also shows how business cycles are highly correlated in a deeply interconnected world.
Discussion Question
Business cycles now have the ability to propagate quite quickly across countries. What are the
implications for policymakers of this relatively new scenario?

Answer: The recent financial crisis that originated in the United States in 2007 reinforced the idea that
business cycles fluctuations in one country can have immediate effects on other countries. This new
scenario makes policymakers around the world very anxious about current economic conditions in other
countries. It also requires a lot of coordination of the type described in the CNN article. World leaders
cannot afford to be out of touch and unaware of potential risks that can turn into contractions affecting
many countries at the same time. This is indeed a by-product of globalization: the need for increased
coordination.

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