The business cycle

Let's make a plot of real GDP as a function of time. This axis right over here is going to be real GDP, so it's an actual measure, not just nominal GDP. It's an actual measure of the goods and services produced by an economy or the productivity of an economy. Over here let's have time. In our little country or whatever economy we're studying here, let's assume that over time its population is growing. Let me write these things down. So, population is growing over time, and this is not an unrealistic assumption, this is true of most countries. Population is growing over time. Also, let's assume that productivity is improving. Productivity ... Productivity is just essentially how much can each individual person produce? Productivity. Productivity is going up. Productivity goes up due to technology, probably mainly technology, technology Mainly technology, but there could be discoveries of resources. Discovery of resources ... Or it could be new business processes. People wouldn't even consider that maybe technology, so new processes. On a per person basis, they're able to produce more and more over time. Because of these trends, and these are trends that do take place over long periods of time in many, many economies, you would expect the real productivity of that economy to increase. If you were to just do the long-term trend just based on these two things, the population growing and productivity improving, over time, real GDP should have a trend something like that. That is the long-term trend of most properly functioning economies. When you look at it on the short-term, it doesn't look like a nice, smooth trend line like this. When you study any major economy in the world, or any economy, any normal economy, instead of going this nice, smooth trend line, it tends to look something more like this. Real GDP will be going really fast, maybe higher than trend line, and then all of a sudden, it will essentially recede, or it will essentially shrink. Then it'll start growing again, maybe go above the trend line, then it'll recede ... Go below the trend line. Then it'll go above the trend line, it'll just keep fluxuating around a trend line like that. This fluxuation around this trend line, this is called the business cycle. This right over here ... And you could maybe call one cycle, you could say it's from one peak to one peak or one trough to one trough, or whatever you want to call it, it's this idea that the economy isn't just a nice, steady-as-you-go growth, you have periods of fast growth going maybe above the trend line, and then it recedes, then it expands, then it recedes. This is the business cycle. Business cycle. The term "cycle" is a little bit misleading. Whenever you think of a cycle, even the way I drew it, it kind of looks like a nice well-defined pattern and every the same amount of years you're going up and down, it kind of implies that it's predictable. The reality is that the business cycle is very unpredictable. And economists more than anyone have trouble predicting the business cycle. When you think of a cycle, it's not this nice, sinusoid pattern, it's much, much more unpredictable. It does fluxuate up and down above a trend, but it's hard to predict. Hard to predict. In general, you don't have the same period of time between every peak and every trough. That is why it is so hard to predict. There are different terms for different phases of the business cycle. I kind of used it just in describing what was happening. Over here, where the economy is growing, so the economy is growing from there to there, from there to there, we would call this phase of the business cycle, I'll highlight that in green, we would call that expansion because the economy is literally expanding. There's more goods and services being produced in that economy. Then when, and we'll talk about the reasons why this is happening, and then when it starts to shrink, the economy starts to shrink, this right over here, or you could call it "recedes", if you think of it in a title analogy, this right over here is called a "recession". This right over here is a ... So that purple part right over there, is a recession. If a recession is bad enough, it is sometimes categorized as a "depression", and there's different categories for a depression; there's the famous joke,' "When your neighbor loses his job, it's a recession. When you lose your job, it is a depression." The interesting thing is we see this pattern happening, whether it's every 8 years, 7 years, every 10 years, but we don't fully understand exactly why it's happening. What we're going to try to attempt to do in the next few videos is look at models that do attempt to explain it. That's actually the whole purpose why we're going to study aggregate demand and aggregate supply. With that said, I want you to view those models with a huge grain of salt because those are, I would argue, overly simplified economic models that don't take into consideration probably the most important factor in the economic cycle or any type of market cycle, and that is human emotions. Human emotions. You might notice in most of our studies of economics so far, we haven't really talked a lot about human emotions or human's tendencies to extrapolate the recent past, or human's greed or risk of fear and greed, and all of these things, that are very real things because in traditional economics, they don't fit neatly into the models. There are new fields in behavioral economics and behavioral finance that do try to take into account things like human emotions, but it's not going to make its way into the models that we're going to study in aggregate supply and aggregate demand. The reason why I say human emotions, and because just based on, I spent I think it was six or seven years in markets while I was an analyst at an investment firm, it was very clear to me that what drove market cycles and economic cycles to a large degree, was based on human emotions. That what you have happening over here is that the longer time, once again, this isn't what you would classically learn in your freshman economics class, I'm just going to say this ... Before we start studying the classical one, because I think this does give a better sense of what's probably happening in an economic cycle. Right over here when the expansions phase is starting, people are still skeptical. They've just been through this, people were getting laid off over here, people were losing their jobs, people were having trouble paying the bills, companies had very low profits or maybe no profits at all, bankruptcies were occurring, so even though the economy is starting to expand right over here, people were kind of skeptical. In the recent past, they remember all of this pain so they don't want to go out there and start spending money. They don't want to go out there and start investing. The further and further they go from that point, and I'm just explaining the emotional aspect of the economic cycle which I think is probably the most powerful one, the further and further they go away from this, they say maybe this is for real. Maybe this is really happening. Their memories of that pain are more and more distant. Their memories of all the risk, the memories of all the layoffs and the bankruptcies become more and more distant and then they become more and more confident and more and more eager to invest. They start investing and spending more and more, they start hiring, and because of all of that, they see fewer and fewer bankruptcies, fewer and fewer layoffs, hiring is starting to occur, people are getting more and more and more optimistic, so the economy keeps growing. When you go to points right around here, it's been a long time since anyone really talked about major layoffs and bankruptcies, and foreclosures and all the rest. People over here are feeling super, super confident and they're probably underplaying risk at this point. They're investing money, they're spending money like there's no tomorrow because they think there will always be good growth. They're essentially extrapulating the recent past. They think, and there's actually even been studies that show that even economists, when you ask them at this point, what's the foreseeable future going to look like, they tend to extrapulate the recent past. They say the recent past, we were growing like that, so in the future we will grow like that. At this point, essentially people are being too bullish, they're being too optimistic and they're probably misallocating investment. As soon as things don't grow as people expect, they start getting a little bit fearful, but they're still in denial at this point, they get a little bit more fearful, but here they say, "Oh my God, something is going on." They start panicking, layoffs start happening, economy recedes and then we have the entire cycle again. To kind of understand this emotional aspect of it, this is something I redrew. I redrew a graph that always gets kind of chain mailed around or sent around usually during every bubble when people start becoming skeptical of the growth and economy. It traditionally refers to stock market cycles. Stock market cycles are closely linked to actual economic cycles. I think these words really do capture the emotional sentiment of what's going on in either during the business cycle or during a stock market cycle. Right when we're in the middle of an expansion, people are pretty optimistic. A little bit further into it, people are feeling excitement. They're saying, "Maybe this is a new type of thing. Maybe we're going to be able to grow forever." Then there's a thrill that people, just the last few years, all they do is they remember making money. They say, "I'm going to put all my money in the stock market. I'm going to start buying Pets.com and whatever else." Then there's euphoria. They're just like, "Wow, easy money. I don't have to work for a living. I can just keep flipping houses or buying stocks of Pets.com," or whatever else, day trading. Then all of a sudden, you have some signs that maybe there was some bad investment, that people's investments weren't turning out as good as they expected. People get a little anxious, but then as you still foresee this, they start denying it. Some people say, "Are we in a recession thing?" "No, no, no, no, we're not in a recession. It's been so long since we were in a recession. Things are different this time. The internet changes everything. Housing never goes down." But then as it continues, as the recession really does continue, they start to get fearful, they start saying, "Maybe this is something going on," then desperate, then panic, and that's when people really, if you think of a stock market cycle, really start to sell in the case of a regular business cycle, they start to maybe underspend, they start to really hoard things, then capitulation ... This is when they say, ' "Things are just bad. They're never going to get any better," and then they become despondent and eventually, you could even say, emotionally people start getting depressed because they say it's been so long since we've felt all of these good emotions right over here. As any good investors will tell you, "This is the best time to invest." "This is the worst time to invest." Even though there's maybe a little bit of growth right over here, it's been so long since we've experienced all of these emotions. People are depressed, but then as the growth continues, They start to feel hopeful, a little relieved, they say, "At least we're not getting worse and worse," and then you get back to optimism again. So keep this in mind because in my mind, the emotions really are the main factor that are playing in either stock market cycles or economic cycles. We we study it kind of classically in an economics class, we're going to take human emotions a bit out of the picture, which is a little bit artificial because they might be the most important part of the picture.