3.

3 • Business Cycles and Economic Activity 83

is shrinking.

7
Figure 3.13 Quarterly Percentage Change in US Real GDP with Shading Representing Recessions

Figure 3.14 is an illustration of the growth of GDP over time. There has been a definitive long-term upward
trend in GDP, but it has not been in a straight line. Instead, the economy has expanded much like the curve;
periods of quick growth are followed by slower or even negative growth. These alternating growth periods are
known as the business cycle.

Figure 3.14 Growth of GDP and the Business Cycle

Stages of the Business Cycle

The business cycle consists of a period of economic expansion followed by a period of economic contraction.
During the period of economic expansion, GDP rises. Employment expands as businesses produce more;
conversely, unemployment falls. Other measures of economic growth may include increased new business
starts and new home construction. The economy is said to be “heating up.” As the expansion continues,
inflation often becomes a concern.

7 Data from US Bureau of Economic Analysis. “Gross Domestic Product (GDP).” FRED. Federal Reserve Bank of St. Louis, accessed
July 7, 2021. https://fred.stlouisfed.org/series/GDP
84 3 • Economic Foundations: Money and Rates

Fast-paced economic expansion is not sustainable. Eventually, growth slows and unemployment rises. The
economy has moved from expansion to contraction when this occurs. The point at which the business cycle
turns from expansion to contraction is known as the peak. The point at which the contraction ends and the
economy begins to expand again is known as the trough. The length of one business cycle is measured by the
time from one trough to the trough of the next cycle, as shown in Figure 3.15.

Figure 3.15 Stages of the Business Cycle

Often, the contraction is referred to as a recession. A private think tank, the National Bureau of Economic
Research (NBER), tracks the business cycle in the United States. The NBER is the entity that officially declares
recessions in the United States. Historically, a recession was defined as two consecutive quarters of declining
GDP. Today, the NBER defines a recession in a broader, less precise manner; it will declare a recession when
there is a significant decline in economic activity that is spread across the economy and lasts for at least a few
8
months. Measures of real income, employment, industrial production, and wholesale and retail sales are
considered in addition to real GDP.

LINK TO LEARNING

National Bureau of Economic Research

The National Bureau of Economic Research was founded in 1920 to create measures of economic activity
that could be used in public policy discussions. It is a private, nonpartisan organization that conducts
research that is followed by businesses and the public sector. You can find out more about the NBER and
view many of its research papers by visiting its website (https://openstax.org/r/nber-website).

Historical Trends
The NBER has identified business cycle peaks and troughs in data going back to the mid-19th century. Figure
3.16 lists each of these cycles, denoting the months of peaks and troughs. We see a repetition of the economic
behavior—an expansion, a peak, a recession, and a trough, followed by yet another expansion, peak,
recession, and trough. The cycles are events that repeatedly occur in the same order.

8 National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/
research/business-cycle-dating/business-cycle-dating-committee-announcements

Access for free at openstax.org

 3.3 • Business Cycles and Economic Activity 85

Figure 3.16 Peak and Trough Months of Historical Business Cycles (source: National Bureau of Economic Research)

However, the cycles are not identical; the lengths of the cycles vary greatly. On average, the contractions have
lasted about 17 months and expansions have lasted about 41 months. The typical business cycle has been
about 4.5 years long.
9
At the time of this writing, the United States is in an economic recession. The previous trough was in June
2009. From the summer of 2009 through February 2020, the US economy was in the expansionary phase of the
business cycle. This expansion peaked in February 2020, when the economy fell into a contractionary period
associated with the COVID-19 pandemic. This 128-month expansion is the longest expansion in US history.
Only two other expansions have lasted for over 100 months: the 120-month expansion that ran through the
1990s and the 106-month expansion that ran during the 1960s. The longest recessionary period on record is
the 65-month recession that occurred during the 1870s. The recession that began in 1929 was the second-
longest recession in US history. At 43 months long, this recession that ended in 1933 was so severe that it has
10
been called the Great Depression.

9 National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/
research/business-cycle-dating/business-cycle-dating-committee-announcements
86 3 • Economic Foundations: Money and Rates

3.4 Interest Rates

Learning Outcomes
By the end of this section, you will be able to:
• Explain the relationship between the nominal interest rate and inflation.
• Calculate the real rate of interest.
• Explain the relationship between interest rates and risk.

Market for Loanable Funds

An interest rate is the rental price of money. The concepts of supply, demand, and equilibrium apply in this
market just as they do in other markets. This market is referred to as the market for loanable funds.

In the market for loanable funds, the suppliers of funds are economic entities that currently have a surplus in
their budget. In other words, they have more income than they currently want to spend; they would like to
save some of their money and spend it in future time periods. Instead of just putting these savings in a box on
a shelf for safekeeping until they want to spend it, they can let someone else borrow that money. In essence,
they are renting that money to someone else, who pays a rental price called the interest rate.

The suppliers of loanable funds, also known as lenders, are represented by the upward-sloping curve in Figure
3.17. A higher interest rate will encourage these lenders to supply a larger quantity of loanable funds.

The demanders of funds in the loanable funds market are economic entities that currently have a deficit in
their budget. They want to spend more than they currently have in income. For example, a grocery store chain
that wants to expand into new cities and build new grocery stores will need to spend money on land and
buildings. The cost of buying the land and buildings exceeds the chain’s current income. In the long run, its
business expansion will be profitable, and it can pay back the money that it has borrowed.

The downward-sloping curve in Figure 3.17 represents the demanders of loanable funds, also known as
borrowers. Higher interest rates will be associated with lower quantities demanded of loanable funds. At lower
interest rates, more borrowers will be interested in borrowing larger quantities of funds because the price of
renting those funds will be cheaper.

Figure 3.17 Equilibrium in the Loanable Funds Market

The equilibrium interest rate is determined by the intersection of the demand and supply curves. At that
interest rate, the quantity supplied of loanable funds exactly equals the quantity demanded of loanable funds.
There is no shortage of loanable funds, nor is there any surplus.

10 National Bureau of Economic Research. “US Business Cycle Expansions and Contractions.” Last updated July 19, 2021.
https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions

Access for free at openstax.org