The Business Cycle 

The Business Cycle Gross Domestic Product, Real GDP The basic measure of business activity in the U.S. is Gross Domestic Product (GDP). GDP is the sum of all goods and services produced in the country. The GDP measure that is used is termed "real GDP," because any effects of inflation on prices are eliminated to achieve a valid measure. GDP Versus GNP GDP - Gross Domestic Product - measures all output generated within the borders of a country, so it is a "national" measure. GNP - Gross National Product - is an older measure that is no longer used. It measured economic output of U.S. owned entities, whether that production occurred within the country's borders or occurred overseas. GDP consists of consumer spending plus government spending plus business investment. If real GDP is charted over a long time period, the pattern looks as follows:

Business Cycle Business activity tends to expand in a cyclical fashion. Expansion, Prosperity, Recession, Recovery Beginning at a low point, activity expands and real GDP output increases. This is the "expansion" period. As the expansion ages, it tends to reach a peak. This is known as the "prosperity" period. The next phase of the typical economic cycle is a business contraction, known as a "recession." The final phase of the cycle is a "recovery" period, where the business decline bottoms out before starting the next expansion phase. Thus, the order of the economic cycle, which must be known for the exam, is: Expansion, Prosperity, Recession, Recovery. Recession, Depression When GDP drops for 2 consecutive quarters, the economy is said to be in "recession." If the drop continues for at least 18 months, then the downturn has become a "depression."

No one really knows why growth occurs in a cyclical fashion. We do know that growth is affected by: Fiscal Policy Monetary Policy Fiscal Policy Fiscal Policy is government actions (approved by Congress) that influence economic activity. Fiscal policy can be used to increase or decrease the take home pay of the American public - by changing tax rates, changing transfer payments (such as Social Security), or changing Government spending on goods and services. To stimulate the economy, tax rates can be cut, transfer payments increased, and Government spending increased. To slow down the economy, reverse actions can be taken. Monetary Policy Monetary Policy is action taken by the Federal Reserve to influence the growth of the money supply. By expanding the money supply, credit is loosened, and interest rates lowered. This will stimulate the economy. By tightening the money supply, the reverse occurs. Monetary Environment The "monetary environment" is the term used to describe the effect of both fiscal and monetary policy on the level of economic activity. Thus, the "monetary environment" is favorable when the government's economic policies are stimulative; when interest rates are low due to Federal Reserve actions; and when money supply levels are sufficient to support continued growth. The monetary environment is unfavorable when the reverse occurs, that is, when the government's economic policies are restrictive; when interest rates are high due to Federal Reserve actions; and when money supply levels are not sufficient to support continued growth. Economic theories to explain the business cycle and to devise ways to influence the cycle are either Fiscal based or Monetary based. The three theories are Keynesian, Supply-Side and Monetarist. Keynesian Theory John Maynard Keynes is probably the most famous economist of our times. In the 1930s (in the midst of the Great Depression), he developed theories on the economy that basically advocated "Fiscal Policy" as a means of achieving a "full employment" economy. Keynes believed that the economy operates at an "equilibrium" level. Equilibrium is determined by the forces of income and spending. During the depression years, the equilibrium level was very low (with many people out of work), because income (and therefore spending) levels were low. Keynes believed that consumption is the driving force behind growth. To stimulate consumption, Keynes advocated increased Government spending and transfer payments to individuals. This policy appeared to work, since Government spending skyrocketed during World War II, and afterwards, the economy took off. Supply-Side Theory This is really the mirror image of Keynesian theory. "Supply-siders" believe that excessive government meddling and taxation required for all those government programs stifles individual initiative. Thus, by reducing government spending, and reducing taxes, individuals are given the incentive to produce, and this is the key to economic growth.

Monetarist Theory Monetarists such as Milton Friedman argue that fiscal policy is not the main determinant of economic activity - rather monetary policy is the causal factor. They argue that the actions of the Federal Reserve Board are the driving force behind economic cycles.