[An updated version of this article can be found at Business Cycles in the 2nd edition.]
The United States and all other modern industrial economies experience significant swings in economic activity. In some years most industries are booming and unemployment is low; in other years most industries are operating well below capacity and unemployment is high. Periods of economic expansion are typically called booms; periods of economic decline are called recessions or depressions. The combination of booms and recessions, the ebb and flow of economic activity, is called the business cycle.
Business cycles as we know them today were first identified and analyzed by Arthur Burns and Wesley Mitchell in their 1946 book, Measuring Business Cycles. One of their key insights was that many economic indicators move together. During a boom, or expansion, not only does output rise, but also employment rises and unemployment falls. New construction and prices typically rise during a boom as well. Conversely, during a downturn, or depression, not only does the output of goods and services decline, but employment falls and unemployment rises as well. New construction also declines. In the era before World War II, prices also typically fell during a recession; since the fifties, prices have risen during downturns, though usually more slowly than during booms.
Business cycles are dated according to when the direction of economic activity changes. The peak of the cycle refers to the last month before several key economic indicators, such as employment, output, and new housing starts, begin to fall. The trough of the cycle refers to the last month before the same economic indicators begin to rise. Because key economic indicators often change direction at slightly different times, the dating of peaks and troughs necessarily involves a certain amount of subjective judgment. The National Bureau of Economic Research, an independent research institution, determines the official dates of peaks and troughs in U.S. business cycles. Table 1 shows the NBER monthly dates for peaks and troughs of U.S. business cycles since 1890.
In many ways the term business cycle is misleading. "Cycle" seems to imply that there is some regularity in the timing and duration of upswings and downswings in economic activity. Most economists, however, believe otherwise. Booms and recessions occur at irregular intervals and last for varying lengths of time. For example, economic activity hit low points in 1975, 1980, and 1982. The 1982 trough was then followed by eight years of uninterrupted expansion. For describing the swings in economic activity, therefore, most modern economists prefer the term economic fluctuations.
Just as there is no regularity in the timing of business cycles, there is no reason why cycles have to occur at all. The prevailing view among economists is that there is a level of economic activity, often referred to as full employment, at which the economy theoretically could stay forever. Full employment refers to a level of production at which all the inputs to the production process are being used, but not so intensively that they wear out, break down, or insist on higher wages and more vacations. If nothing disturbs the economy, the full-employment level of output, which naturally tends to grow as the population increases and new technologies are discovered, can be maintained forever. There is no reason why a time of full employment has to give way to either a full-fledged boom or a recession.
Business cycles do occur, however, because there are disturbances to the economy of one sort or another. Booms can be generated by surges in private or public spending. For example, if the government spends a lot of money to fight a war but does not raise taxes, the increased demand will cause not only an increase in the output of war materiel, but also an increase in the take-home pay of government plant workers. The output of all the goods and services that these workers want to buy with their wages will also increase. Similarly, a wave of optimism that causes consumers to spend more than usual and firms to build new factories will cause the economy to expand. Recessions or depressions can be caused by these same forces working in reverse. A substantial cut in government spending or a wave of pessimism among consumers and firms may cause the output of all types of goods to fall.
Another cause of recessions and booms is monetary policy. The Federal Reserve System determines the size and growth rate of the money stock and, thus, the level of interest rates in the economy. Interest rates, in turn, are a crucial determinant of how much firms and consumers want to spend. A firm faced with high interest rates may decide to postpone building a new factory because the cost of borrowing is so high. Conversely, a consumer may be lured into buying a new home if interest rates are low and mortgage payments are, therefore, more affordable. Thus, by raising or lowering interest rates, the Federal Reserve is able to generate recessions or booms.
This description of what causes business cycles reflects the Keynesian or New Keynesian view that cycles are the result of imperfections in the economy. Only when prices and expectations are not fully flexible can fluctuations in government spending or the money stock cause large swings in real output. An alternative framework, referred to as the New Classical view, holds that modern industrial economies are quite flexible. As a result a change in government policy does not necessarily affect real output and employment. In the New Classical view, for example, a change in the stock of money will change only prices; it will have no effect on real interest rates and thus on people's willingness to invest. According to this view business cycles are largely the result of disturbances in productivity and tastes, not of changes in government economic policy. One implication of this view would be that there is nothing inherently wrong with an economic downturn.
The empirical evidence, I believe, is strongly on the side of the New Keynesian view that cycles are often the result of changes in economic policy. Monetary policy, in particular, appears to have played a crucial role in causing business cycles in the United States since World War II. The severe recessions of both the early seventies and the early eighties, for example, were directly attributable to the Federal Reserve's decisions to raise interest rates. On the positive side, the booms of the midsixties and the mideighties were both at least partly due to monetary ease and falling interest rates.
The role of money in causing business cycles is even stronger if one considers the era before World War II. Many of the worst prewar depressions, including the recessions of 1908, 1921, and the Great Depression, were to a large extent the result of declines in the money supply and the related high real interest rates. In this earlier era, however, most monetary swings were engendered not by conscious monetary policy, but by financial panics and international monetary developments.
If one accepts that cycles are the result of market imperfections and not the result of the optimal adjustment of the economy to productivity shocks, then cycles are costly. Every recession in which workers are involuntarily unemployed results in a loss of output that cannot be regained. This fact naturally leads to the question of what can be done to eliminate swings in economic activity. If government spending and monetary policy can cause booms and recessions, it seems obvious that they could be used to cure economic fluctuations. Indeed, the Employment Act of 1946 mandated that the U.S. government use its control of spending, taxation, and the money supply to stabilize output and employment.
Such policies appear to have reduced the amplitude and duration of recessions. A comparison of the traditional prewar unemployment statistics with the official postwar statistics, for example, suggests that the average rise in the unemployment rate during a recession was twice as large in the years 1900 to 1930 as it has been in the period since 1947. Recessions also appear to have occurred more frequently and lasted longer in the prewar era than in the postwar era.
But appearances are deceiving. The kind of statistics that economists use to measure the severity of business cycles, such as data on the unemployment rate, real gross national product, and industrial production, have been kept carefully and consistently only since World War II. Therefore, the conclusion that government policy has smoothed business cycles is based on a comparison of fragmentary prewar evidence with sophisticated postwar statistics.
In some recent research, I have tried to avoid the problem of inconsistent data by comparing the crude prewar statistics with equally crude postwar statistics. That is, I have compared the existing prewar series with modern data that are constructed using the same assumptions and data fragments that were used to piece together the prewar series. These comparisons show essentially no decline in the severity of cycles between the prewar and postwar eras. They also show little change in the duration and frequency of cycles over time. Thus, much of our apparent success at eliminating the business cycle seems to be a figment of the data.
Why has public policy failed to cure business cycles in the United States? One reason is that monetary and fiscal policy are difficult to use with any precision. There are long lags in the implementation and effect of changes in spending, taxes, and monetary stance. There is also significant uncertainty about how much of a monetary or fiscal stimulus is needed to end a recession of a particular severity. Finally, policymakers also often have conflicting goals. Because inflation tends to slow down in recessions and speed up in booms, policymakers cannot cure the dual problems of inflation and unemployment with the same policy tools. As a result they often seem to adopt the strategy of fighting inflation with tight policy and then reducing unemployment with a switch to loose policy.
While government policy may not have cured the business cycle, the effects of cycles on individuals in the United States and other industrialized countries almost surely have been lessened in recent decades. The advent of unemployment insurance and other social welfare programs means that recessions no longer wreak the havoc on individuals' standards of living that they once did.
Christina D. Romer is the class of 1957-Garff B. Wilson professor of economics at the University of California, Berkeley, and a research associate of the National Bureau of Economic Research. She has served as a member of the Brookings Panel on Economic Activity and has earned the National Science Foundation's Presidential Young Investigator Award.
Burns, Arthur F., and Wesley C. Mitchell. Measuring Business Cycles. 1946.
Friedman, Milton, and Anna J. Schwartz. "Money and Business Cycles." Review of Economics and Statistics 45 (February 1963): 32-64.
Gordon, Robert J., ed. The American Business Cycle: Continuity and Change. 1986.
Romer, Christina D. "Is the Stabilization of the Postwar Economy a Figment of the Data?" American Economic Review 76 (June 1986): 314-34.