Level I – Economics

Understanding Business Cycles

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1
 Contents and Introduction
This reading focuses on short-term
1. Introduction movements in economic activity

2. Overview of the Business Cycle

3. Theories of the Business Cycle

4. Unemployment and Inflation

5. Economic Indicators

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 2. Overview of the Business Cycle
Business cycles are a type of fluctuation found in the aggregate economic activity of
nations that organize their work mainly in business enterprises: a cycle consists of
expansions occurring at about the same time in many economic activities, followed by
similarly general recessions, contractions, and revivals which merge into the
expansion phase of the next cycle; this sequence of events is recurrent but not
periodic; in duration, business cycles vary from more than one year to 10 or 12 years.

Burns and Mitchell (1946)

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 2.1 Phases of the Business Cycle

Level of National
Economic Activity

Four stages of the business cycle:

1. Expansion: real GDP is increasing
▪ Early Expansion
▪ Late Expansion
2. Peak: real GDP stops increasing
3. Contraction/recession: real GDP is
decreasing
4. Trough: real GDP stops decreasing
Time

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 Exhibit 1: Business Cycle Characteristics
Early Expansion (Recovery) Late Expansion Peak Contraction (Recession)

At what stage of the cycle is labor productivity likely to

be the highest?

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 Exhibit 1: Business Cycle Characteristics
Early Expansion (Recovery) Late Expansion Peak Contraction (Recession)

Example 1

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2.2 Resource Use through the Business Cycle
Economic downturn starts → AD down/left →
Capital Inventories accumulate → production down (low
Spending
utilization) → idling workers (less overtime)

If downturn is severe companies may take

External aggressive measures
Trade Inventory
Sector
Economic Draw the recessionary output gap using the SRAS,
fluctuations LRAS and AD curves.

Housing Consumer
Sector Behavior

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 Fluctuations in Capital Spending
Spending on new capital equipment is sensitive to the business cycle. Shifts in capital
spending affect economic cycle in three stages:

Stage 1: Businesses see Stage 2: Economy begins initial Stage 3: Late in the cyclic
demand falling recovery upturn

Reduce/cut maintenance cost;

halt new orders; cancel Capital spending rises
Capital spending focused on
existing orders if possible because:
capacity expansion: complex
Small orders easily cancelled; 1) Growth in earnings
equipment, warehouses,
cutbacks on large orders take 2) Some cancelled orders are
factories
longer reinstated
Negative impact on economy

Major indicator: orders for capital equipment

Example 2
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 Fluctuations in Inventory Levels
Inventory increase and decrease happens very rapidly and has a major effect on
economic growth despite small size. Inventory/sales (I/S) ratio is an important
indicator.

Stage 1: top of economic cycle; Stage 2: Production rate less Stage 3: Sales begin cyclic
sales fall or slow than sales rate upturn

Takes a while to cut back on

production; inventory I/S ratio falls Initially production does not
accumulates → I/S ratio up keep pace with sales → I/S
Cut production to reduce Once I/S is at a normal level falls
inventory production is increased even Surge in production
Layoffs and cancelled orders though sales might not be up Turn in hiring patterns
might exaggerate downturn

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 Consumer Behavior
• 70% of U.S. economy
• Patterns of household consumption determine overall economic direction of
economy more than any other sector
• Major indicator of household consumption: retail sales
▪ Some indicators make a distinction between durable goods, non-durable goods, services
• Durables are more sensitive to the economic cycle (why?)
• Growth in income provides an indication of consumption prospects
▪ Some analysts focus on ‘permanent’ income

• Example 4

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 2.3 Housing Sector Behavior
• Smaller part of overall economy compared with consumer spending, but can move
up and down quickly; hence can count more in overall economic movements than
the sector’s relatively small size might suggest

• Generally statistics on housing are easily available in developed countries

• Sector is particularly sensitive to interest rates

• Housing sector might follow its own internal cycle

• Sector is sensitive to demographics

• Example 5

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 2.4 External Trade Sector Behavior
• This sector varies in size and importance from one country to another

• Imports rise with domestic GDP growth

• Exports rise with growth in the rest of world

• Currency value has a major impact on imports/exports

• Example 6

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 3. Theories of the Business Cycle

Until the 1930s economists believed that business cycles were a natural feature of the
economy and recessions were temporary. The Great Depression changed that view
and gave rise to new schools of economic thought.

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 3.1 Neoclassical and Austrian Schools
• Basic premise of the neoclassical school: markets will reach equilibrium because of
the “invisible hand or free markets”
▪ All resources used efficiently based on MR = MC
▪ If an economic shocks shifts the AD or SRAS curve, the economy will quickly readjust and reach
equilibrium via lower interest rates and lower wages

• The Austrian school largely agreed with the neoclassical model but is more focused
on role of low interest rates and the resulting excessive credit growth
▪ Business cycles are the outcome of overinvestment in projects with low return; when interest
rates rise these investments fail
▪ Government’s interference should be minimal because markets are self-stabilizing;

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 3.2 Keynesian and Monetarist Schools
• Keynesian School
▪ Focus on AD fluctuations
▪ Wages are downward sticky, but even if lower wages accepted, consumption and hence AD will
be lower
▪ Simply lowering interest rates would not ignite growth because of low business confidence and
‘animal instincts’
▪ Government should use monetary AND fiscal policy to keep capital and labor employed even if
this means a large fiscal deficit
▪ Agreed with Neoclassical and Austrian schools about economy self-correcting but ‘in the long-
run we are all dead’

Example 7
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 Monetarist School
• Monetarist school objected to Keynesian intervention for four reasons
▪ Keynesian model does not recognize importance of money supply
▪ Keynesian model lacks complete representation of utility-maximizing agents
▪ Keynesian model fails to consider long term costs of government intervention
▪ Timing of government’s economic policy response is uncertain

• What do the monetarists say?

▪ Monetary and fiscal policy should be clear and consistent; limited role of government
▪ Grow money supply at steady predictable rate
▪ Business cycles occur because of exogenous shocks and government intervention
▪ Let AD and AS find own equilibrium rather than risking further economic fluctuation

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 3.3 The New Classical School
• New classical macroeconomics models emphasize that economic agents should be
represented with a utility function and a budget constraint
▪ Assume that all agents are roughly alike
▪ Two flavors: models without money and models with money

• Models without Money: Real Business Cycle Theory

▪ Emphasizes effect of real economic variables such as changes in technology and external shocks
▪ Aggregate supply is an important part of the model
▪ Expansions and contractions represent efficient operation of the economy in response to
external real shocks → government should not intervene with monetary and fiscal policy

• Models with Money

▪ Build on RBC models but recognizing the role of monetary policy
▪ Neo-Keynesians (or New Keynesians) build models on microeconomic principles but say that
frictions in the economy may prevent convergence and government intervention necessary
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Example 8 17
 Summary of Business Cycle Schools
School of Thought Comment Recommended Policy
Neoclassical Invisible hand Do nothing

Austrian Fluctuations caused by misguided Do nothing

government intervention

Keynesian Focus on the AD curve Use fiscal and/or monetary policy because
Economy does not automatically correct in “in the long-run we are all dead”
the short-run

Monetarist Monetary policy Steady, predictable growth of money

supply

New Classical: RBC Expansions and contractions represent Do nothing

efficient operation of the economy in
response to external real shocks

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Example 9 18
 4. Unemployment and Inflation
Most governments try to limit unemployment and contain price inflation

Unemployment
at lowest level
(tight labor Downturn
market)

Generally inflation
is pro-cyclical

Unemployment
at highest level

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 4.1 Unemployment
• Employed • Activity (participation) ratio

• Labor force • Underemployed

• Discouraged worker
• Unemployed
▪ Long-term Unemployed
• Voluntarily unemployed
▪ Frictionally Unemployed
▪ Structurally Unemployed

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 Unemployment (Cont…)
• Unemployment rate = ratio of unemployed to labor force
▪ Most quoted measure of unemployment
▪ Measured differently in different countries
▪ Inaccurate at predicting direction of economy (lags the business cycle)
➢ Businesses reluctant to lay off people
➢ In difficult economic times discouraged workers stop looking for jobs (hence not counted as
unemployed)

• Overall Payroll Employment and Productivity Indicators

▪ To get a sense for the employment cycle analysts often look at payroll growth
▪ Other measures include overtime hours and number of temporary workers
▪ Drop in productivity precedes decrease in full-time payrolls
▪ Increase in productivity precedes increase in full-time payrolls

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Example 10 21
 4.2 Inflation
• Generally inflation is pro-cyclical (it goes up and down with the business cycle)

• Inflation is the sustained rise in overall prices in an economy

• Inflation rate is the percentage change in a price index

• Inflation rates allow us to infer the state of the economy

• Unexpected change in inflation my trigger a change in monetary policy which can

impact asset prices

• High inflation, fast economic growth and low unemployment indicate the economy
is overheating

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 Deflation, Hyperinflation and Disinflation
• Deflation: A sustained decrease in aggregate price level

• Hyperinflation: An extremely fast increase in aggregate price level

• Disinflation: A decline in the inflation rate

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 Measuring Inflation: The Construction of Price Indices
• A price index represents the average prices of a basket of goods and services

• Laspeyres index is the most common type of index and is created by holding
consumption basket constant; this strategy introduces a few biases
▪ Substitution bias
▪ Quality bias
▪ New product bias

• Paasche index allows for the composition of the basket to change

• Fisher index uses the geometric mean of the above two indices

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 Example
Date January 2012 February 2012
Goods Quantity Price Quantity Price
Sugar 7 kg 90/kg 9 kg 110/kg
Milk 10 Liters 100/Liter 12 Liters 120/Liter

Assume the base period is January 2012. The price level for the base period is
set to 100. Calculate the December price index as a:
1) Laspeyres index
2) Paasche index
3) Fisher index

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 Price Indices and Their Usage
• Most countries use their own CPI to track inflation in the domestic economy
• Weights of different categories vary across countries (Exhibit 6)
• Scope of each index is different
▪ CPI-U
▪ PCE
▪ PPI
• Many economic activities are indexed to a certain price index
▪ Treasury Inflation Protected Securities (TIPS) adjust bond’s par value based on CPI-U
• Central banks use CPI to monitor inflation
• Example 11 – Headline and Core Inflation
• Example 12 – Sub-Indices and Relative Prices
• Example 13 - Inflation

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 Explaining Inflation
Cost-push inflation results from a decrease in aggregate supply caused by an increase in the real price
of an important factor of production, such as labor or energy
• Commodity prices
• Non-accelerating inflation rate of unemployment
• Natural rate of unemployment
• Productivity and unit labor cost
• Example 14

Demand-pull inflation results from persistent increases in aggregate demand that increase the price
level and temporarily increase economic output above its potential or full-employment level
• If actual GDP is close to potential → shortages and bottlenecks → prices rise
• Monetarist perspective: inflation is a monetary phenomenon
▪ Compare money growth with growth of nominal economy
• Example 15

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 Inflation Expectations
• Inflation expectations can be self-sustaining

• Some analysts gauge inflation expectations based on past trends

• Example 16

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 5. Economic Indicators
We use economic indicators to assess the current state of the economy and for insights into future
economic activity

• Leading indicators have turning points that tend to precede those of the business cycle
▪ Weekly hours in manufacturing, S&P 500 return, private building permits

• Coincident indicators have turning points that tend to coincide with those of the business cycle and
are used to indicate the current phase of the business cycle
▪ Manufacturing activity, personal income, number of non-agricultural employees

• Lagging indicators have turning points that tend to occur after those of the business cycle
▪ Bank prime lending rate, inventory-to-sales ratio, average duration of unemployment

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 Leading Indicators
Leading Indicators

1. Average weekly hours, manufacturing In the U.S. the composite leading

2. Average weekly initial claims for unemployment insurance indicator is called the Index of
Leading Economic Indicators (LEI)
3. Manufacturers’ new orders for consumer goods and
materials
Different countries will have
4. Vendor performance, slower deliveries diffusion index different composite indices
5. Manufacturers’ new orders for non-defense capital goods
6. Building permits for new private housing units Diffusion index reflects the
7. S&P 500 Stock Index proportion of the index’s
components that are moving in a
8. Money supply, real M2
pattern consistent with the overall
9. Interest rate spread between 10-year treasury yields and index
overnight borrowing rates
10. Index of Consumer Expectations, University of Michigan

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 Coincident and Lagging Indicators
Coincident Indicators Lagging Indicators

1. Employees on non-agricultural payrolls 1. Average duration of unemployment

2. Aggregate real personal income 2. Inventory–sales ratio
3. Industrial Production Index 3. Change in unit labor costs
4. Manufacturing and trade sales 4. Average bank prime lending rate
5. Commercial and industrial loans
outstanding
Coincident and lagging indicators can help 6. Ratio of consumer installment debt to
confirm what leading indicators are telling us income
7. Change in consumer price index for
services
Trade associations and public agencies also
provide aggregate cyclical measures

Examples 17, 18, 19

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 Summary
• Business cycle and its phases
▪ Inventory levels, labor and capital utilization at different phases of
the cycle
• Classical, Keynesian, Monetarist and RBC theories
• Types and measures of unemployment
• Price levels and inflation
• Economic indicators

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 Conclusion
• Read summary

• Review learning objectives

• Examples

• Practice problems

• Practice questions from other sources

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