1.

An economy is experiencing accelerated GDP growth and businesses have started hiring full-time workers and ordering heavy equipment. This
economy is most likely in the:

A. peak phase.

 B. late expansion phase.

C. early expansion phase.

Explanation

Economies experience business cycle phases of trough, expansion, peak, and contraction. Each phase is associated with certain characteristics
regarding GDP growth and inflation. Expansion is divided into early (ie, recovery) and late phases (ie, boom).

During an early expansion phase, consumers begin to spend more, and GDP growth becomes moderately positive. Businesses begin to
purchase inventory but are hesitant to hire new employees until there is evidence of further economic growth (Choice C).

During the late expansion phase, consumer spending increases even further, and GDP growth becomes accelerated. Businesses rehire
full time employees and invest in heavy capital equipment.

(Choice A) The peak phase follows late expansion and is characterized by decelerating GDP growth and a slowdown in hiring.

Things to remember:
Economies experience business cycle phases of trough, expansion (early and late), peak, and contraction. In the late expansion phase GDP
growth is accelerated, and businesses begin to rehire employees and invest in capital equipment.

Describe the business cycle and its phases

LOS

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2. Which of the following best describes a characteristic of the early expansion phase of the business cycle?

A. Inflation accelerates, leading economic growth

B. Capital spending by businesses expands rapidly

 C. Consumers accelerate spending on housing and durable goods

Explanation

The phases of the business cycle are expansion, peak, contraction (ie, recession), and trough. The length of a business cycle, or any specific
phase, is not predictable. However, each phase is associated with certain characteristics regarding GDP growth and inflation.

Expansions are divided into early (ie, initial recovery) and late phases. The early expansion phase occurs after the economy has been in a trough,
which is considered a turning point in the cycle, when economic activities begin to expand. Characteristics of the early expansion phase
include the following:

Businesses begin to replenish inventories.

Consumers start spending more, particularly on housing and durable goods, as incomes stabilize.
GDP moves from negative to moderately positive.
Central banks generally keep interest rates low to support the expanding economy.
Unemployment levels decline but remain high. Layoffs slow, but employers are reluctant to hire new staff without evidence of sustained
economic growth.

(Choice A) Inflation tends to lag other variables, exhibiting slow growth or even deflation. Inflation catches up to economic growth during the later
expansion phase.

(Choice B) Early in the expansion, businesses are not yet willing or able to commit to large capital spending plans (eg, new manufacturing
facilities, expanding production capabilities). It is during the peak phase that business capital spending expands rapidly since confidence in the
business cycle is high.

Things to remember:
The early expansion phase occurs after the economy has been in a trough, when economic activities begin to expand. GDP growth moves from
negative to moderately positive. Consumers start spending more, particularly on housing and durable goods.

Describe the business cycle and its phases

LOS

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3. Loose private sector credit conditions occurring at the peak of a credit cycle are most likely to:

 A. contribute to financial asset price bubbles.

B. result in a stronger recovery during the early part of the next economic expansion.

C. moderate the economic downturn associated with a contraction of the business cycle.

Explanation

Business cycles measure changes in economic activity. Financial cycles measure changes in financing and credit conditions. Credit cycles are a
subset of financial cycles and describe changes in availability and pricing (ie, interest rates/yields) of private sector credit, which has direct
implications for the business cycle.

The credit cycle tends to be longer and more extreme than the business cycle. Credit cycle peaks are often a precursor to the peak of the
business cycle. They are characterized by loose credit conditions (ie, easily available credit) that contribute to bubbles (ie, unsustainable
valuations) in financial assets such as stocks and real estate.

Therefore, investors monitor the credit cycle to better understand and anticipate:

its alignment with the business cycle,

the valuation of financial assets,
changes in real estate markets (eg, housing, construction), and
government policy actions.

Monetary and fiscal policymakers have increasingly focused on the management of financial market stability. This focus is influenced by their
recognition that credit cycle peaks are often associated with subsequent banking crises.

(Choice B) Since the credit cycle is usually longer than the business cycle, credit tends to be an economic headwind early in the expansion
phase of the business cycle. It is not uncommon for credit to still be contracting (tight, not loose) during this first stage of an economic recovery.

(Choice C) A peaking credit cycle would intensify (not moderate) the economic downturn associated with a contraction of the business cycle.
Typically, credit contraction and the associated reduction in asset values is well underway by the time the business cycle begins its downturn.

Things to remember:
Loose credit conditions, which often occur at the peak of a credit cycle, contribute to bubbles in financial assets such as stocks and real estate.

Describe the business cycle and its phases

LOS

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4. Credit cycles are least likely to:

A. peak prior to recessions.

 B. be countercyclical to business cycles.

C. amplify the duration and magnitude of business cycles.

Explanation

Business cycles measure changes in economic activity. Financial cycles measure changes in financing and credit conditions (eg, pricing,
availability, risk attitudes). Credit cycles are a subset of financial cycles and describe changes in availability and pricing (ie, interest
rates/yields) of private sector credit, which has direct implications for the business cycle. Credit cycles tend to be procyclical, not
countercyclical, to business cycles since credit availability expands during economic expansions and contracts sharply during economic
downturns.

(Choice A) The credit cycle tends to peak prior to the onset of a recession and is often a precursor to the peak of the economic cycle. As the
business cycle slows/contracts, lending institutions often severely restrict credit availability while increasing the cost of credit.

(Choice C) Credit cycles tend to amplify the duration and magnitude of the business cycle: when the economy is expanding (contracting),
creditors are more (less) willing to lend, so the supply of credit increases (decreases) and its price decreases (increases), accelerating the trend of
the business cycle.

Things to remember:
Credit cycles are a subset of financial cycles and describe the change in availability and pricing of private sector credit, which has direct
implications for the business cycle. Credit cycles are procyclical since credit availability expands during economic expansions and contracts
sharply during economic downturns.

Describe credit cycles

LOS

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5. If an economy is in the early expansion phase of the business cycle, this most likely indicates that:

A. both inventory-to-sales ratios and labor utilization are increasing.

B. both inventory-to-sales ratios and labor utilization are decreasing.

 C. inventory-to-sales ratios are decreasing, and labor utilization is increasing.

Explanation

Business cycle impact on inventory-to-sales ratios and labor utilization

Inventory-to-sales ratio Labor utilization

Decreases Increases
Early expansion
Production ramp-up lags sales growth Existing labor force used to meet demand; additional hiring postponed

Increases Decreases
Contraction
Production cuts lag sales decline Minimum employment level to maintain operations

Economies experience business cycle phases of expansion, peak, and contraction (ie, recession). Expansions are divided into early (ie, recovery)
and late phases. Both the inventory-to-sales ratio and labor utilization rates are sensitive to stages of the business cycle, and changes in these
areas often lag an economy's move from one phase to another.

The inventory-to-sales ratio measures the inventory available for sale relative to the level of sales. In the early phase of an expansion, as
consumer spending and sales begin to increase, companies may hold off on increasing production out of concern that the expansion is not yet
underway. This lag means that the rate of increase in sales typically outpaces the rate of increase in inventory, and the inventory-to-sales
ratio declines. During or soon after a peak, the inventory-to-sales ratio tends to increase as production cutbacks lag the slowdown in sales
(Choice A).

Labor utilization refers to how companies manage workforce productivity through hiring and firing practices. Companies tend to retain a certain
workforce strength during a downturn, even if not fully utilized. In the early expansion phase of the business cycle, companies meet increased
product demand primarily by more fully utilizing the existing workforce and tend to postpone new hiring until later in the recovery (Choice B).

Things to remember:
In the early expansion phase of the business cycle, the inventory-to-sales ratio tends to decline as production fails to keep pace with increased
sales demand. Labor utilization increases as companies more fully utilize workers who were retained during the downturn.

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS

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6. An economic diffusion index is most appropriately used to identify:

 A. trend change.

B. rate of change.

C. magnitude of change.

Explanation

A diffusion index measures the dispersion of change among its components by calculating the proportion of components that are increasing
or decreasing in a period. Diffusion indexes are often used in economics to identify trends (ie, consecutive changes in the same direction) and
potential turning points for metrics such as new orders, pricing, and employment. An index is usually based at 50 or zero, at which point activity is
deemed to be roughly unchanged from the prior period, with higher (or lower) values indicating increasing (or decreasing) levels of activity.

For example, one widely followed diffusion index is a monthly purchasing manager index (PMI). To create this index, national surveys are
conducted in many countries to ask manufacturing and service purchasing managers about the current state of business in their organizations.
The new orders component of these surveys is considered a leading indicator; a reading above (or below) 50 indicates more firms are reporting
improvement (or deterioration) in orders compared to the previous month.

(Choices B and C) Diffusion indexes capture trends (ie, direction of change), not the magnitude (ie, size) or rate (ie, speed) of change.

Things to remember:
A diffusion index measures the dispersion of change among components by calculating the proportion of components that are increasing or
decreasing in a period. Diffusion indexes capture trends, not magnitude or rates of change.

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS

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7. If an economy has stabilized GDP growth and moderate inflation, it is most likely in which of the following phases of the business cycle?

A. Peak

B. Contraction

 C. Early expansion

Explanation

Economies experience three business cycle phases: expansion, peak, and contraction (ie, recession). Expansion is divided into the early (ie,
recovery) and late phases. The length of a full cycle, or any phase of the cycle, is unpredictable. However, each phase is associated with certain
characteristics regarding GDP growth and inflation.

The early phase of expansion occurs after the end of contraction. Characteristics of this phase include:

Businesses begin to recover and build up inventories.

GDP moves from negative to positive (with moderate growth).

Consumers start spending more, particularly on housing and durable goods.

Central banks tend to keep interest rates low to spur the economy.

Inflation tends to lag other variables; therefore, it is moderate in growth and may continue to fall. Inflation catches up to economic growth
during the later expansion phase.

Unemployment levels decline but remain high because employers tend to halt layoffs but are slow to hire additional staff.

(Choice A) During the peak phase, the GDP growth rate decelerates, possibly as a result of the shock to the economy or restrictive policies put in
place during expansion. Inflation tends to accelerate, which is a lagged reaction to the rising wages and input prices during the late expansion
phase.

(Choice B) Contraction is defined by negative GDP growth (ie, declining economic output) and is usually accompanied by a falling rate of
inflation, which typically lags the decline in GDP.

Things to remember:
The phases of the business cycle are expansion, peak, and contraction (ie, recession). Expansion is divided into the early and late phases. The
early phase of expansion occurs after the end of contraction. GDP moves from negative to positive, although it is moderate in growth. Inflation
tends to be moderate in growth and may continue to fall.

Describe the business cycle and its phases

LOS

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8. The business cycle phase typically characterized by decelerating GDP growth and accelerating inflation is most likely a:

 A. peak.

B. contraction.

C. late expansion.

Explanation

The phases of the business cycle are expansion, peak, contraction (ie, recession), and trough. Expansions are divided into early (ie, recovery)
and late phases. The length of a cycle or any phase is not predictable. However, each type of phase shares certain characteristics regarding
GDP growth and inflation across cycles.

Peaks occur after expansions have been ongoing for some time. There is often a lack of available labor and capital to fuel further growth. Most
who want to work have already found employment; capacity utilization is likely quite high. The lack of resources to expand production results in a
deceleration of growth. At the same time, tight labor markets and lack of excess capacity result in wages and prices being bid up, leading to an
acceleration of inflation.

(Choice B) A contraction is defined by negative GDP growth (ie, declining economic output). This is usually accompanied by falling rates of
inflation, although the inflation decline typically lags the decline in GDP.

(Choice C) The late expansion phase is characterized by an acceleration of both growth and inflation above the moderate rates typical for each in
the early expansion phase.

Things to remember:
The phases of the business cycle are expansion, peak, contraction (ie, recession), and trough. Peaks are usually characterized by a lack of
available labor and capital resulting in a deceleration of growth. Tight labor markets and lack of excess capacity often result in wages and prices
being bid up, leading to an acceleration of inflation.

Describe the business cycle and its phases

LOS

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9. The following table lists various economic indicators and the trend in each one over the past several months for an economy.

Economic Indicator Trend

Unemployment Record low

Unit labor costs Modestly rising

Industrial production growth Steadily higher

Residential building permits Steady decline

New orders for manufacturing Steady decline

Long-term bond yields Declined 1%

Short-term bond yields Stable

This mix of economic indicators most likely forecasts near-term future economic:

A. stability.

B. acceleration.

 C. deceleration.

Explanation

Certain economic and financial measures have historically exhibited consistent patterns indicating the stage of the business cycle. These
economic indicators are characterized as leading, coincident, or lagging indicators.

Leading indicators provide the most value to investment practitioners since they signal changes in real GDP several months to a year in
advance. Coincident indicators move largely in tandem with the economy, and lagging indicators trail changes in the economy by several months
or quarters. How specific indicators are classified will vary from country to country, but leading indicators that are consistent across most
economies include:

Interest rate spread

Residential building permits/construction
Stock market performance
New manufacturing/machinery orders
Business confidence/expectations

In this scenario, all three leading indicators are indicating a period of economic deceleration or slowing growth in the coming quarters.
Residential building permits and new orders for manufacturing have been in steady decline. The interest rate spread is the difference
between short-term rates and long-term rates. A narrowing of the spread, as is the case here (ie, the yield curve flattened by 1%), implies
economic deceleration.

Things to remember:
Leading indicators provide the most value to investment practitioners since they signal changes in real GDP several months to a year in advance.
Residential building permits, new orders for manufacturing, and interest rate spread are all leading indicators.

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS
10. After a prolonged recession, a developed economy has experienced several quarters of rapid GDP growth and strong increases in average
hourly earnings. The most likely impacts on housing sector activity and an existing trade deficit are that:

 A. both increase.

B. both decrease.

C. housing sector activity increases and the trade deficit decreases.

Explanation

Rapid GDP growth after a prolonged recession implies an economy in the early expansion phase of the business cycle. The housing and external
trade sectors are sensitive to business cycle changes.

Housing sector activity, such as existing home sales and new construction, is sensitive to affordability (ie, housing prices versus income). In the
early expansion phase, home prices are relatively low, a carryover from the preceding contraction. Low home prices, in addition to rising
incomes due to the expansion, drive demand. Consumers reinforce the effect by buying in anticipation of housing appreciation fueled by a
strengthening economy.

Trade deficits occur when imports exceed exports. Imports are directly related to domestic income (ie, GDP). As incomes rise, demand
increases, which consequently increases the purchasing of domestic products and foreign goods (ie, increased imports). Domestic exports are a
function of income in foreign countries; therefore, the state of the domestic business cycle has no direct impact on a country's exports. The
result is an increase in the trade deficit.

Things to remember:
Both housing sector activity and trade deficits are likely to increase during the early expansion phase. Housing sector activity improves due to
improved affordability (ie, relatively low prices and rising incomes) and anticipated housing appreciation. The trade deficit worsens since rising
domestic income leads to increased imports.

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS

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11. An economy has been experiencing decelerating GDP growth rates for several quarters. In the past quarter, short-term interest rates moved
above long-term interest rates and initial claims for unemployment insurance increased more rapidly. Based on these indicators, the most
appropriate forecast for the future of the economy is:

 A. further deceleration of growth, possibly leading to a recession.

B. a reversal of recent trends resulting in an acceleration of GDP growth.

C. difficult to predict due to the conflicting evidence reflected in the indicators

Explanation

Economic indicators

Type Turning point relative to economy Examples

Initial unemployment claims

Stock market indexes
Leading Several months to a year ahead
Consumer expectations
Short/long-term interest rate spread

Real personal income

Industrial production indexes
Coincident Within a few months before or after
Nonagricultural payroll
Manufacturing and trade sales

Average duration of unemployment

Inventory-sales ratio
Lagging Several months to a quarter behind
Bank prime lending rate
Change in unit labor costs

Various statistics drawn from the real economy and the financial markets have historically exhibited stable patterns of change relative to turns in
the business cycle. These economic indicators are characterized as leading, coincident, or lagging indicators.

Leading indicators signal economic change several months to a year in advance of a change in real GDP growth rates. Coincident indicators
move largely in tandem with the economy. Lagging indicators trail changes in the economy by several months or quarters.

The spread between short-term (eg, three-month government security) and long-term (eg, ten-year government bond) interest rates as well as
initial claims for unemployment insurance are leading indicators. A narrowing of the spread of long-term over short-term rates and increases
in new applications for unemployment compensation usually foreshadow a weakening economy. Changes in the opposite direction forecast
economic strengthening.

In this case, both indicators are exhibiting negative signals. Before the specified changes occurred, the indicators had been consistent with a
weakening economy, and both have become even more negative. Initial unemployment claims have increased more rapidly. The spread between
short-term and long-term rates must have previously narrowed since it has recently inverted. Both indicators signify an economy going from bad
to worse.

Based on the information about the indicators, the most appropriate forecast is for further slowing of growth, if not an outright contraction of
economic activity (ie, a recession).

Things to remember:
Changes in leading indicators precede changes in the direction of the economy. The spread between short- and long-term rates and new
applications for unemployment insurance are leading indicators. A narrower spread or an increase in unemployment applications usually precedes
economic weakening.

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS

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12. As an economy moves from an expansion to a contraction phase of the business cycle, which of the following indicators is most likely the last
to signal a turn in the business cycle?

 A. Average duration of unemployment

B. Average weekly hours in manufacturing

C. Building permits for new private housing units

Explanation

Economic indicators

Type Turning point relative to economy Examples

Initial unemployment claims

Stock market indexes
Leading Several months to a year ahead
Consumer expectations
Short/long-term interest rate spread

Real personal income

Industrial production indexes
Coincident Within a few months before or after
Nonagricultural payroll
Manufacturing and trade sales

Average duration of unemployment

Inventory-sales ratio
Lagging Several months to a quarter behind
Bank prime lending rate
Change in unit labor costs

Economic indicators help provide insight on the overall state of the economy and are classified as either leading, coincident, or lagging indicators.
Lagging indicators tend to reflect economic conditions of the previous few months or quarters. Given previous worsening of the leading and
coincident indicators, a worsening of the lagging indicators confirms a business cycle has peaked and is in a contractionary phase.

Average duration of unemployment is a lagging indicator since businesses hesitate to lay off workers due to the high costs of training and low
productivity of new employees. Therefore, businesses typically wait several months to confirm the recession has truly started before laying off
workers. Likewise, when the economy first appears to be coming out of a recession, businesses defer hiring until a recovery is confirmed by
several months or quarters of rising GDP.

(Choice B) Average weekly hours in manufacturing usually decline before a contraction begins since businesses initially reduce overtime rather
than laying off workers when the economy slows. Likewise, companies increase overtime before rehiring workers when a recovery begins.
Average weekly hours is a leading indicator.

(Choice C) Most governments require building permits prior to construction. Since developers plan construction projects long in advance,
building permits is a leading indicator.

Things to remember:
Lagging indicators tend to reflect economic conditions of the previous few months or quarters and are interpreted as confirming signals previously
given by leading and coincident indicators. Average duration of unemployment is a lagging indicator since businesses are slow to fire (hire)
employees until seeing confirmation of a contraction (expansion).

Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business
cycle and describe their measurement using economic indicators
LOS

Copyright © UWorld. Copyright CFA Institute. All rights reserved.