The business cycle | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy

The business cycle and how it may be driven by emotion

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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.