Question

We know from our key business cycle facts that employment N is procyclical. Therefore, in a boom (recession), output Y and N would typically both increase (decrease). However, since output is more variable than employment, Y/N is procyclical since Y will typically increase (decrease) proportionately more than N during a boom (recession).

Could you please explain the answer to this

Answer 1

Business cycle :

Business cycles are a type of fluctuation found in the aggregate economic activity of nations…a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions…this sequence of changes is recurrent but not periodic." That description, from the 1946 magnum opus by Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles, remains definitive today.

Real business cycles

The most well known paper in the Real Business Cycles (RBC) literature isKydland and Prescott (1982). That paper introduces both a specific theory ofbusiness cycles, and a methodology for testing competing theories of business
cycles.

The RBC theory of business cycles has two principles:-
1. Money is of little importance in business cycles.
2. Business cycles are created by rational agents responding optimally to
real (not nominal) shocks - mostly fluctuations in productivity growth,
but also fluctuations in government purchases, import prices, or preferences

The “RBC” methodology also comes down to two principles:
1. The economy should always be modeled using dynamic general equilibrium models (with rational expectations).
2. The quantitative implications of a proposed model should be taken seriously. In particular, a model’s suitability for describing reality should
be evaluated using a quantitative technique known as “calibration”. I the model “fits” the data, its quantitative policy implications should be taken seriously.

Some facts about business cycles:

Business cycles are the reason why macroeconomics exists as a field of study,
and they’re the primary consideration of many macroeconomists. What characterizes business cycles? The two obvious characteristics are fluctuations in
unemployment and output. A few definitions:

• Procyclical: a variable that usually increases in booms, decreases in recessions. For example, productivity is procyclical.
• Countercyclical: a variable that usually decreases in booms, increases in recessions. For example, unemployment is countercyclical.
• Acyclical: a variable that shows no systematic relationship to the business cycle.
• Fiscal policy: the government’s policy for taxes and spending.
• Monetary policy: the government’s policy for how much money to put into the economy

Before we go into the details of an RBC model, let’s establish some stylized facts about business cycles. Most of these are outlined in the beginning of Chapter 4 in Romer.

1. Labor input varies considerably and procyclically (goes up in booms, down in recessions). Most of this variation is variation in employment rates, though some is in average weekly hours.
2. The capital stock varies little at business cycle frequencies (1-3 years).
3. Productivity growth (as measured by the Solow residual) is procyclical, though not nearly as much as labor input. In other words, most of the output loss in recessions can be traced to unemployment.
4. Wages vary less than productivity, and have low correlation with output.
5. All major expenditure categories are procyclical. Investment in consumer and producer durables is quite volatile, while consumption of nondurables and services varies much less than output. The most volatile expenditure category is inventory investment.

Stages of the Business Cycle :
In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:

1 Expansion
The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues as long as economic conditions are favorable for expansion.

2 Peak :
The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal point in the trend of economic growth. Consumers tend to restructure their budgets at this point.

3 Recession :
The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc., consequently start to fall.

4 Depression :
There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line, the stage is called depression.

5 Trough :
In the depression stage, the economy’s growth rate becomes negative. There is further decline until the prices of factors, as well as the demand and supply of goods and services, reach their lowest point. The economy eventually reaches the trough. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.

6 Recovery :
After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and, consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and production starts increasing.

Employment begins to rise and, due to accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investments in the production process.

Recovery continues until the economy returns to steady growth levels. It completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.