Business Cycle Measurement

(Chapter 3)
Measurement and Macroeconomic Theory

• Observation is a
foundation of scientific
exploration in
macroeconomics

• Business cycle regularities, the “stylized facts”

of business cycles, provide us with the first
clues about the nature of the typical cycle.

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Learning objectives

• Define business cycles

• Explain regularities and irregularities in GDP
fluctuations
• Define the comovement properties of economic series
• Describe a set of key business cycle facts concerning
comovement in Canadian macroeconomic data
• Introduction to Money and Banking

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References

• Required readings: Chapter 3 in Williamson (2021)

• Additional resources:
• Sarah Hansen (2020) U-Shape? V-Shape? Recovery Shapes
Explained And What They Mean For America’s Economy, Forbes
• IMF (2009) World Economic Outlook: Recessions and Recoveries,
Chapter III, From Recession to Recovery: How Soon and How
Strong?
• IMF (June 2020) World Economic Outlook
• A podcast “The Business Cycle” from the Federal Reserve Bank
of St. Louis
• All references are posted in BrightSpace

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Real GDP grows over time, but its growth
sporadic

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Business cycles are defined as fluctuations about
trend in real GDP.

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Several key definitions

• A peak is a relatively large positive deviation from

trend in real GDP.
• A trough is a relatively large negative deviation from
trend in real GDP.
• The turning points in the deviations of real GDP from
trend are peaks and troughs.
• Persistent positive deviations from trend that
culminate in a peak is a boom.
• Persistent negative deviations that culminate in a
trough is a recession.

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The trend and the cycle in the Canadian data

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The growth rate of Canadian GDP (1961-2020)

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There are different methods of constructing a
trend of a growing series
• Fit a straight line through the series
• Construct a moving average of observations of the
actual series in a specified “window” around each
date
• Example: if the data are quarterly, a two-sided one year
moving average measure of the trend would be
lnYttrend =average(Yt-4,Yt-3,Yt-2,Yt-1,Yt,Yt+1,Yt+2,Yt+3,Yt+4)

• Apply the Hodrick-Prescott (HP) filter

• Very similar to a two-sided moving average filter

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Trend-cycle decomposition
• Given the trend Yttrend, a “cyclical component” or a
“cycle”, Ytcycle is defined as the residual
lnYtcycle= lnYt - lnYttrend

• The cyclical component is not invariant to how the

trend component is computed.
• The trend-cycle decomposition is not accurate for the
end of the sample

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 There are other approaches to defining
recessions and expansions
• Media: a period of at least two consecutive quarters of
negative growth in real gross domestic product for Canada
• The National Bureau of Economic Research (NBER) in the U.S.
defines a recession is a significant decline in economic activity
spread across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment,
industrial production, and wholesale-retail
• The C.D. Howe institute applies the NBER approach to Canada.
• Chauvet (2011) uses a non-linear probability model
• IMF (2009) defines turning points as local maximums and
minimums of the logarithm of real GDP that meet the
conditions for a minimal duration of a cycle and of each phase.

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Canadian recessions - Business Cycle Council

Monthly Peak (Quarterly) Monthly Trough (Quarterly)

April 1929 (1929:Q2) February 1933 (1933:Q1)
November 1937 (1937:Q3) June 1938 (1938:Q2)
August 1947 (1947:Q2) March 1948 (1948:Q1)
April 1951 (1951:Q1) December 1951 (1951:Q4)
July 1953 (1953:Q2) July 1954 (1954:Q2)
March 1957 (1957:Q1) January 1958 (1958:Q1)
March 1960 (1960:Q1) March 1961 (1961:Q1)
October 1974 (1974:Q3) March 1975 (1975:Q1)
June 1981 (1981:Q2) October 1982 (1982:Q4)
March 1990 (1990:Q1) May 1992 (1992:Q2)
October 2008 (2008:Q3) May 2009 (2009:Q2)
February 2020 (2019:Q4) Present

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Business cycles in the international content

• IMF (2009) examines recessions and recoveries in 21

advanced economies, including Canada
• The study evaluates whether recessions and recoveries
associated with financial crises are different from
others
• On average, advanced economies have experienced six
complete cycles of recessions and expansions since
1960, with variations in numbers among the countries
• Advanced economies are in a recession phase of the
cycle only 10 percent of the time

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Key facts about deviations from trend in real GDP

• The fluctuations in GDP about trend are quite choppy.

• There is no regularity in the amplitude of fluctuations in
real GDP about trend.
• There is no regularity in the frequency of fluctuations in
real GDP about trend.
• Business cycles are persistent: when real GDP is above
trend, it tends to stay above trend, and when it is
below trend, it tends to stay below trend.

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Recession “alphabet soup”

• The two most important questions you will hear during

any recession are
– “When will it end?”
– “How quickly will we recover?”
• The answers to both of these questions can be found
by analyzing the shape of the recession.
• Economists have identified several patterns of
recessions and recoveries in the historical data
– V, U, W, and L shaped recessions
– Swoosh-shaped recession

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V-shaped recession: steep decline, quick recovery
• The economy bounces back
quickly to its baseline before
the crisis.
• Growth continues at the
same rate as before.
• No lasting damage to the
economy.
• This is one of the most
optimistic recovery patterns.
• Example: Canada during the
Great Recession

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U-shaped recession: long period between
decline and recovery
• The economic damage lasts
for a longer period of time
before eventually reaching
the baseline level of growth
again.
• The economy bounces back,
United States but the damage at the
bottom lingers for a while.
• Example: US during the oil
crisis of the 1970s

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W-shaped recession: quick recovery, second
decline
• The economy moves beyond a
recession into a period of
recovery before falling back down
again into another recession.
• The initial recovery is sometimes
known as a bear market rally.
• This pattern is also called a
Germany
double dip recession.
• Example: Germany in the period
Log scale

of Great Recession and the euro

100
crisis
1990
1992
1994
1996
1998
2000
2002
2004
2006

2010

2014
2016
2018
2008

2012

Trend 1990-2006
Real GDP (1990=100)

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L-shaped recession: an extended downturn
• The economy recovers to a
certain degree from a steep
drop, but growth never
reaches pre-crisis levels for
years, if at all.
• A period of economic
United Kingdom stagnation follows. 
950
• This is the most pessimistic
scenario.
Log scale

95
• Example: UK during the Great
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018

recession
Trend 1990-2006
Real GDP (1990=100)

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Swoosh-shaped recession
• A recovery scenario
resembling the Nike
“swoosh” logo is
characterized by a steep drop
and a gradual recovery.
• It takes much longer to return
IMF forecast of quarterly to pre-crisis growth levels
world GDP
than it took to fall into
recession. 
• IMF (2020) expects a swoosh-
shaped recession

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Which shape will the COVID recession take?

• No-one knows yet.

• Examples from the most pessimistic to the most
optimistic scenarios can be found.
• Only the time can tell, as we learn more about the
disease and its impacts on the economy.

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Recession forecasting is challenging

• Knowing the state of the business cycle is important for

economic and policy decisions.
• Economists have developed different models to track
recession probabilities in real time
– Examples for the US economy: https://fred.stlouisfed.org/categories/33120
– Example for Canada: https://www.stevanovic.uqam.ca/DS_forecasts.html
• Macroeconomic theory can provide guidance on the
types of variables that can useful for forecasting.
• However, the ability to forecast future events is not a
litmus test for macroeconomics.

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Forecasting is challenging as shocks represent
unexpected events
• Canadian forecasts of real GDP based on the work of Kotchoni
and Stevanovic

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Behaviour of the key macroeconomic variables
relative to GDP is remarkably similar over time
• Comovement describes how aggregate economic
variables move together over the business cycle

• Three features of comovement are

– Cyclicality
– Volatility
– Lead/lag relations
• The patterns of comovement are useful for model
evaluation

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Comovement: Cyclicality

• A macroeconomic variable can be a

– Procyclical variable, or
– Countercyclical variable, or
– Acyclical variable

• Cyclicality of an economic variable can be determined

from a time-series plot, a scatter plot or a correlation
coefficient between the economic series and real GDP.

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Correlation can be detected in a time series plot

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Comovement: Cyclicality

• Procyclical: describes an economic variable that tends

to be above (below) trend when real GDP is above
(below) trend
• Countercyclical: describes an economic variable that
tends to be below (above) trend when real GDP is
above (below) trend
• Acyclical: describes an economic variable that is neither
procyclical nor countercyclical

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Correlation can also be detected in a scatter plot

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Correlation with real GDP

• If the deviations from trend in a macroeconomic

variable are positively correlated with the deviations
from trend in real GDP, then that variable is procyclical.
• If the deviations from trend in a macroeconomic
variable are negatively correlated with the deviations
from trend in real GDP, then that variable is
countercyclical.
• If a macroeconomic variable is neither procyclical nor
countercyclical, it is acyclical.

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Example: Real imports are procyclical

The correlation coefficient between the

percentage deviations from trend in real
GDP and real imports is 0.75.

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Comovement: Volatility (Variability)

• The cyclical variability in an economic time series is

measured by the standard deviation of the
percentage deviations from trend
• An economic series can be more volatile than real
GDP, less volatile or have the same volatility.
• Inference on variability can be based on a time
series plot, absolute or relative standard deviations
of a business cycle component of the series in
relation to a business cycle component of real GDP.

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Consumption is less volatile than real GDP

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Investment is more volatile than real GDP

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“Great Moderation”
• From the mid-1980s until 2007, recessions in advanced
economies have become less frequent and milder,
while expansions have become longer lasting .
• This period of relatively low variability in real GDP
around trend has become known as “the Great
Moderation”
• See Macroeconomics in Action 3.3 “The Great
Moderation?”

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Comovement: lag-lead relations

• A leading variable tends to aid in predicting the

future path of real GDP
– Think of how the amber traffic light indicates the coming of the red light.
• A lagging variable tends to be predicted by the past
values of real GDP
– In the traffic light example: the amber light is a lagging indicator for the green
light because amber trails green. 
• A coincident variable is one that neither leads nor
lags real GDP
– In the traffic light example: the green light would be a coincidental indicator of
the associated pedestrian walk signal. 

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Leading-Lagging properties can be detected in a
time series plot

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Importance of the leading indicators

• Data on real GDP are published with a delay

• Leading indicators can sometimes provide useful
information for forecasters in determining the turning
points in aggregate economic activity.

• See also Macroeconomics in Action 3.1 “Economic

Forecasting and the Financial Crisis”

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Stock prices are a leading Indicator

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Employment is a lagging indicator

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Key macroeconomic variables

• Components of GDP
– Consumption and investment.
• Nominal variables:
– Price level and inflation rate.
• Labor market variables:
– Employment, real wage, average labour productivity.

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Table 3.1
Correlation Coefficients and Variability of Percentage Deviations
from Trend

Correlation Std. Dev. (% of S.D. of GDP)

Coefficient (GDP)
Consumption 0.78 83 %
Investment 0.81 509 %
Employment 0.79 80 %
Average labour productivity 0.65 64 %

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 Table 3.2
Summary of Business Cycle Facts

Cyclicality Lead/Lag Variability Relative to GDP

Consumption Procyclical Coincident Smaller

Investment Procyclical Coincident Larger
Employment Procyclical Lagging Smaller
Real wage rate Procyclical ? ?
Average labour productivity Procyclical Coincident Smaller

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Comovement in the international context

• The correlation coefficients among real aggregate

variables are remarkably similar across countries and
over time (Backus and Kehoe, 1992)
• However, the correlation coefficients between the price
level and aggregate output differ across countries and
across time.

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The price level is acyclical – no evidence of the
Phillips curve

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Inflation rate is procyclical, consistent with the
Phillips curve ideas

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Summary

1. Key business cycle facts relate to the deviations of

major macroeconomic variables from their trend and
the comovements in these deviations
2. The most important business cycle fact is that real
GDP fluctuates about the trend in an irregular fashion
3. Business cycles are similar in terms of the
comovement among macroeconomic time series

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What to do for the next class

• Review Chapter 3 of Williamson and answer the

suggested review questions
• Make an empty table similar Table 3.2. Fill it out based
on the figures and empirical statistics discussed in the
text. Check your response with Table 3.1.
• Review the foundations of a consumer choice from
microeconomics courses.
• Start reading Chapter 9

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