R15 Understanding Business Cycles

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 Introduction
This reading is organized into the following sections:
• What is a business cycle; what are the different phases in a business cycle?
• Introduction to business cycle theory, and the different economic schools of thought.
• Unemployment and inflation, and how they affect economic policy.
• Economic indicators that are useful in predicting the future of an economy.

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 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.”

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 Some Important Points
• Business cycles occur in economies where there are a large number of private companies, and
not just agriculture economies.
• The economic activity shows a cyclical behavior between expansion and recession.
• They are pervasive, i.e., the cycle includes many economic activities and not just one sector.
And the phases of expansion or contraction occur at the same time throughout the economy.
For example, banking and real estate both may be in an expansion stage.
• They are recurrent but not periodic, i.e., the cycles repeat. To say they are not periodic means
that the intensity and the duration differs. For instance, if an economic boom lasted for five
years from 2002-07, it does not mean that the expansion phase will last for five years in the
next cycle. Each cycle lasts about 1 to 12 years.

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 Types of Cycles
• Classical cycle refers to fluctuations in the level of economic activity (e.g.,
measured by GDP in volume terms). The contraction phases between peaks
and troughs are often short, while expansion phases are much longer.

• Growth cycle refers to fluctuations in economic activity around the long-

term potential or trend growth level. The focus is on how much actual
economic activity is below or above trend growth in economic activity.
• Compared to the classical view of business cycles, peaks are generally
reached earlier and troughs later in time. The time periods below and above
trend growth are of similar length.

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 Types of Cycles
• Growth rate cycle refers to fluctuations in the growth rate of
economic activity (e.g., GDP growth rate). Peaks and troughs are
mostly recognized earlier than when using the other two definitions.

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 Types of Cycles

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 Phases of the Business Cycle
• There are four stages of a business cycle:
1. Expansion: The period between a trough and
peak where real GDP is increasing. It is
further divided into:
• Early expansion
• Late expansion
2. Peak: Real GDP stops increasing.
3. Contraction/Recession: The period after the
peak where real GDP is decreasing.
4. Recovery: Real GDP stops decreasing.

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 Phases of the Business Cycle
• When the business cycle is at its peak after
expansion, the intersection of AD and SRAS
curves occurs to the right of the LRAS curve.
The GDP is greater than potential GDP, and
it results in expansionary gap.

• When the business cycle is at its trough

after contraction, the intersection of AD and
SRAS curves occurs to the left of the LRAS
curve. The GDP is below the potential GDP,
and the gap is known as recessionary gap.

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 Characteristics of Business Cycles
Recovery Expansion Peak Contraction
(Recession)
Economic Gross domestic Activity Activity Activity
Activity product (GDP), measures show measures show measures
industrial an accelerating decelerating show outright
production, rate of growth. rate of growth. declines.
and other measures
of economic
activity
turn from decline
to
expansion.

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 Characteristics of Business Cycles
Recovery Late Expansion Peak Contraction
(Recession)
Employment Layoffs slow (and net Business begins Business slows Business first
employment turns full time its rate of cuts hours and
positive), but new rehiring as hiring. freezes hiring,
hiring does not yet overtime hours However, the followed by
occur and the rise. The unemployment outright
unemployment rate unemployment rate continues layoffs. The
remains high. At first, rate falls to low to fall. unemployment
business turns to levels. rate rises.
overtime and
temporary employees
to meet rising
product demands.

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 Characteristics of Business Cycles
Recovery Late Expansion Peak Contraction
(Recession)
Consumer and Upturn often most Upturn Capital Cutback appear most in
Business pronounced in becomes more spending Industrial production,
Spending housing, durable broad-based. expands Housing consumer
consumer items, and Business begins rapidly, but the durable items and orders for
orders for light to order heavy growth rate of new business equipment,
producer equipment. equipment and spending starts followed, wit a lag, by
engage in to slow down. cutbacks in other forms of
construction. Capital spending.

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 Characteristics of Business Cycles
Recovery Late Expansion Peak Contraction
(Recession)
Inflation Inflation remains Inflation picks Inflation further Inflation
moderate and may up modestly. accelerates. decelerates
continue to fall. but with a lag.

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 Example
• A simple and commonly referred to rule is the following: A recession has started when a
country or region experiences two consecutive quarters of negative real GDP growth. Real
GDP growth is a measure of the “real” or “inflation-adjusted” growth of the overall economy.
This rule can be misleading because it does not indicate a recession if real GDP growth is
negative in one quarter, slightly positive the next quarter, and again negative in the next
quarter. Many analysts question this result. This issue is why some countries have statistical
and economic committees that apply the principles stated by Burns and Mitchell to several
macroeconomic variables—not just real GDP growth—as a basis to identify business cycle
peaks and troughs.

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 Example
• The National Bureau of Economic Research (NBER) is an organization that dates business
cycles in the United States. Interestingly, the economists and statisticians on NBER’s Business
Cycle Dating Committee analyze numerous time series of data focusing on employment,
industrial production, and sales. Because the data are available with a delay (preliminary data
releases can be revised even several years after the period they refer to), it also means that
the Committee’s determinations may take place well after the business cycle turning points
have occurred. As we will see later in the reading, there are practical indicators that may help
economists understand in advance if a cyclical turning point is about to happen.

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 Example
• Which of the following rules is most likely to be used to determine whether the economy is in
a recession?
A The central bank has run out of foreign reserves.
B Real GDP has two consecutive quarters of negative growth.
C Economic activity experiences a significant decline in two business sectors.

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 Example
• Suppose you are interested in forecasting earnings growth for a company active in a country
where no official business cycle dating committee (such as the NBER) exists. The variables
you are most likely to consider to identify peaks and troughs of a country’s business cycle are:
A Inflation, interest rates, and unemployment.
B Stock market values and money supply.
C Unemployment, GDP growth, industrial production, and inflation.

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 CREDIT CYCLES AND THEIR RELATIONSHIP TO
BUSINESS CYCLES
• Credit cycles describe the changing availability—and pricing—of credit.

• They describe growth in private sector credit (availability and usage of loans), which is essential for
business investments and household purchases of real estate. They are therefore connected to real
economic activity captured by business cycles that describe fluctuations in real GDP.

• When the economy is strong or improving, the willingness of lenders to extend credit, and on
favorable terms, is high. Conversely, when the economy is weak or weakening, lenders pull back, or
“tighten” credit, by making it less available and more expensive. This frequently contributes to the
decline of such asset values as real estate, causing further economic weakness and higher defaults.
This is because of the importance of credit in the financing of construction and the purchase of
property.

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 CREDIT CYCLES AND THEIR RELATIONSHIP TO
BUSINESS CYCLES

• Investors pay attention to the stage in the credit cycle because

(1) It helps them understand developments in the housing and construction markets
(2) It helps them assess the extent of business cycle expansions as well as contractions,
particularly the severity of a recession if it coincides with the contraction phase of the credit
cycle; and
(3) It helps them better anticipate policy makers’ actions. Whereas monetary and fiscal policy
traditionally concentrate on reducing the volatility of business cycles, macro-prudential
stabilization policies that aim to dampen financial booms have gained importance. This is further
stressed by findings that strong peaks in credit cycles are closely associated with subsequent
systemic banking crises

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 Example

• A senior portfolio manager at Carnara Asset Management explains her analysis of business
cycles to a junior analyst. She makes two statements:
Statement I Business cycles measure activity by GDP, whereas credit cycles combine a range of
financial variables, such as the amount of and pricing of credit.
Statement II Credit cycles and business cycles are unrelated and serve different purposes.

A Only Statement I is true.

B Only Statement II is true
C Both statements are true

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 Resource Use through the Business Cycle

• Fluctuations in the following variables are linked to economic fluctuations:

• Capital spending
• Inventory
• Consumer Behaviour
• Housing sector
• External trade sector

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 Resource Use through the Business Cycle

Fluctuations in Capital Spending:

• Spending on new capital equipment is sensitive to the business cycle. When the business cycle
slows down, cash flows and profitability come down and companies defer spending on capital
equipment. Shifts in capital spending affect the economic cycle in three stages:

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 Resource Use through the Business Cycle

• Stage 1: Businesses see demand falling

• Decline in sales.
• Reduce/cut maintenance cost; halt new orders; cancel existing orders if
• possible;
• small orders easily cancelled; cutbacks on large orders take longer.
• Reduction on capital : investment  negative
• impact on economy.

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 Resource Use through the Business Cycle

• Stage 2: Economy begins : Initial recovery

• Capacity utilization low.
• Capital spending rises because of:
• Growth in earnings.
• Some cancelled orders are reinstated.

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 Resource Use through the Business Cycle

• Stage 3: Late in the : Cyclic upturn

• Productive capacity strained.
• Capital spending focused on capacity expansion: complex equipment, warehouses, and factories.

• A major indicator of capital spending is the orders for capital equipment. This excludes orders
from the defense sector and military aircraft because these orders are infrequent and large, and
cannot be treated as regular business cycle indicators.

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 Resource Use through the Business Cycle

• Fluctuations in Inventory Levels:

• Increase and decrease in inventory happens very rapidly, and has a major effect on economic
growth despite the small size.

• Inventory/Sales (I/S) is important ratio.

• Final sales numbers better reveal the reality of the economic situation than inventory
numbers because the inventory may accumulate or companies may want to dispose obsolete
inventory before starting production; it depends on the stage of the business cycle.

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 Resource Use through the Business Cycle

Fluctuations in Inventory Levels:

• The different stages are below:
Stage 1: Top of the economic cycle; sales fall or slow.
• Takes a while to cut back on production; inventory accumulates  I/S ratio increases.
• Businesses cut production to reduce inventory below sales levels.
• Layoffs and cancelled orders might exaggerate downturn.

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 Resource Use through the Business Cycle

Fluctuations in Inventory Levels:

• Stage 2: Production rate less than sales rate.

• I/S ratio starts falling toward normal levels.

• Once I/S is at a normal level, production is increased, even though sales might not be up, to
reduce the decline in inventory levels.

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 Resource Use through the Business Cycle

Fluctuations in Inventory Levels:

• Stage 3: Sales begin cyclic upturn.
• Initially production does not keep pace with sales  I/S falls as sales increase.
• Surge in production.
• Turn in hiring patterns.

• Inventories tend to rise when the I/S ratio is low. During recovery, inventory will be less than
sales and companies start production to increase inventory.

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 Resource Use through the Business Cycle

Consumer Behaviour

• Major points related to consumer behavior are shown below:

• Represents 70% of the U.S. economy.
• Patterns of household consumption determine the overall economic direction more than any other
sector.
Two measures of household consumption
o retail sales.
o broad-based indicator of consumer spending.

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 Resource Use through the Business Cycle

Consumer Behaviour

• Some indicators make a distinction between durable goods (autos, appliances), nondurable
goods (food, medicine), and services (medical treatment, entertainment etc.)

• Durables are more sensitive to the economic cycle; these have a longer useful life.
• Example of a durable good is a car. During a downturn, if consumers are not too confident
about their jobs (uncertainty), then they will defer purchases of such goods.

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 Resource Use through the Business Cycle

Consumer Behaviour
• Growth in income provides an indication of consumption prospects. It is a better indicator
than surveys.
• Some analysts focus on permanent income than gross or after-tax income to determine
spending behavior. Overall income can be divided into temporary and permanent income.
Temporary income is loss or gains from sources such as stocks that are not sustainable.
Permanent income is reliable income.
• Increases in permanent income is a good indicator of basic consumption spending.

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 Resource Use through the Business Cycle

Consumer Behaviour
• But, consumer spending varies according to income. So analysts use savings rate to judge the
willingness of consumers to spend from current income in the short run. Savings rate varies
with country and reflects income uncertainties as perceived by households. Greater savings
rate indicates that consumers anticipate more uncertainty.

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 Resource Use through the Business Cycle

Housing Sector Behaviour.

• The housing sector is a smaller part of the overall economy compared

to consumer spending, but it can move up and down quickly; hence
can count more in overall economic movements than the sector’s
relatively small size might suggest.

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 Resource Use through the Business Cycle

Housing Sector Behaviour.

Other points related to the housing sector are listed below:
• Generally, statistics on housing are easily available in developed countries. The sector is particularly
sensitive to interest rates. Lower mortgage rates can lead to expansion in housing activity.
• The housing sector might follow its own internal cycle. Low housing prices and low rates relative to
average incomes can lead to an increase in demand for housing.
• The sector is sensitive to demographics such as: are many new people moving into a region (influx
of people into the IT sector in the San Francisco area over the past decade), how quickly new
families are formed, or if older people are vacating existing homes, etc. This buying is based on a
need.
• People may also buy real estate for speculative purposes.

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 Resource Use through the Business Cycle

External Trade Sector Behaviour

• This sector varies in size and importance from one country to another. It is significant for
countries like Japan, where most of domestic produce is exported, but is a small amount for
U.S. Major points related to the external trade sector are listed below:
• Imports rise with domestic GDP growth. They are a reflection of the domestic cycle.
• Exports rise with growth in the rest of the world. They do not reflect domestic cycle and rise
even if domestic economy is slowing down. Exports increase if foreign demands for domestic
output increase. Currency value has a major impact on imports/exports:
o Stronger domestic currency  increase in imports, decline in exports.
o Weaker domestic currency  decrease in imports, increase in exports.

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 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. All these theories attempt to explain the fluctuations
in an economic cycle, and what must/must not be done to restore equilibrium.

• Neoclassical and Austrian Schools

• Keynesian and Monetarist Schools
• The New Classical School

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 Neoclassical and Austrian Schools

• Basic premise of the neo-classical school is: markets will reach equilibrium because
of the invisible hand or free markets. No government intervention is needed for
equilibrium.
• All resources are used efficiently based on MR = MC.
• If an economic shock shifts the AD or SRAS curve, the economy will quickly adjust
and reach equilibrium via lower interest rates and lower wages. This is the self-
correcting adjustment mechanism for unemployment and excess supply of goods.
• It relies on Say’s law: All that is produced will be sold because supply creates its own
demand.

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 Neoclassical and Austrian Schools

• However, Neo-classical theory could not explain:

• Unemployment during the Great Depression. According to the theory,
unemployment was not possible, yet it happened. And many countries that
were affected could not come out of this situation without any intervention.
• Fluctuations in GDP. If an economy has the power to reach equilibrium on its
own accord (invisible hand), how can the situation in the Great Depression
be explained? Lowering wages and interest rates did not help.

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 Neoclassical and Austrian Schools

• Austrian School
• The Austrian school, largely agreed with the neoclassical model, but focused on two more aspects:
money and government.
• Money was not important in the neo-classical model because the exchange of goods and services
could be done through a barter system.
• The government’s role is important since expansionary policies (lower interest rates) to improve
GDP and employment cause fluctuations in the economy, first as an inflationary gap and then as a
recessionary gap. According to this school of thought, misguided government intervention causes
the business cycle.
• This theory says the government’s interference should be minimal because markets are self-
stabilizing.

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 Keynesian and Monetarist Schools

Keynesian School
• Key points related to the Keynesian school of thought are as follows:
• There is no quick adjustment mechanism for markets as advocated by neoclassicals. The focus is on AD
fluctuations.
• The theory believes that it would be hard to restore equilibrium in the event of a crisis by wage and
price reduction alone. Wages are downward sticky, but even if lower wages are accepted, consumption,
and hence AD will be lower because workers would cut their spending.
• Simply lowering interest rates would not ignite growth because business confidence (or animal
instincts) was low.
• The government’s intervention is needed during a severe crisis. The government should use monetary
and fiscal policy to keep capital and labor employed even if this means a large fiscal deficit.

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 Keynesian and Monetarist Schools

Keynesian School
• The fiscal policy tools are government spending and taxes. The government can either reduce taxes or
increase spending to increase AD.
• Monetary policy tools are money supply and interest rates. The government can either increase money
supply or lower interest rates to increase AD.
• Agreed with neoclassical and Austrian schools about the economy self-correcting in the long run, but
states that by that point we will all be dead.

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 Keynesian and Monetarist Schools

Keynesian School
• Why is the Keynesian policy criticized?
• Fiscal deficit leads to more government debt.
• It focuses on the short term. In the long run, the impact of low interest rates could be inflationary.
• Takes time to implement fiscal policy. By then the economy is already recovering.

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 Keynesian and Monetarist Schools

• Monetarist School
• The Monetarist school objected to Keynesian intervention for four reasons:
• The Keynesian model does not recognize the importance of the money supply. If the supply is too fast, the
boom will be unsustainable. If the supply is low, it will lead to recession.
• The Keynesian model lacks complete representation of utility-maximizing agents. The major agents in the
economy are households and firms. Households try to maximize their utility while firms try to maximize
their profit.
• The Keynesian model fails to consider long-term costs of government intervention. Reducing taxes or
increasing government spending can have a detrimental effect in the long run, which the Keynesian model
does not consider.
• The timing of the government’s economic policy response is uncertain.

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 Keynesian and Monetarist Schools

• Monetarist School
• What do the Monetarists say?
• Monetary and fiscal policy should be clear and consistent.
• Minimal intervention from the government.
• Steady money supply, i.e., money supply must grow at a steady 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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 The New Classical School

• The basis of this school of thought is that macro outcomes are based on microeconomic principles of
utility maximization and profit maximization. A worker may choose to enjoy leisure (give up
consumption) or consume more (give up leisure).
• New classical macroeconomic models emphasize that economic agents should be represented by a
utility function and a budget constraint. These models assume that all agents are roughly alike. There
are two major flavors: models without money and models with money Models without Money: Real
Business Cycle (RBC) Theory
• The initial new classical models did not include money just like neo-classical models. These were
called the real business cycle (RBC) models. Cycles are caused by real economic variables such as
changes in technology and external shocks. According to this model, monetary variables such as
inflation have no effect on GDP and unemployment.

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 The New Classical School

• Unlike the Keynesian model, aggregate supply is an important part of the model. It shows that new
technology can improve GDP and move LRAS to the right. Similarly, high input prices may move LRAS
to the left.
• Expansions and contractions are natural responses of the economy in response to external real shocks
the government should not intervene with monetary and fiscal policy. The level of economic activity is
consistent with maximizing utility.
• RBC models rely on efficient markets and believes that unemployment can only be short term: apart
from frictional unemployment, according to RBC, a person who does not have a job can only be a
person who does not want to work or is asking for a higher wage. Criticism: If markets are efficient as
the model suggests, then there should be no unemployment unless a person does not want to work or
is asking for a higher wage.

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 The New Classical School

• Models with money

• Builds on RBC models, but recognizes the role of monetary policy. Inflation is seen as a cause of the
business cycle.
• When inflation is high, central banks intervene by increasing rate; or, lower rates to boost growth.
• So, this model includes money to explain economic growth.
• Two models: one model says that shocks can come from technology, input prices, and monetary policy.

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 The New Classical School

• Another model: Neo-Keynesians (or New Keynesians) build models on microeconomic principles, but
say that frictions (sticky wages and prices) in the economy may prevent it from reaching equilibrium
and government intervention is necessary.
• A key difference between New Classical (RBC) and New Keynesian theories is that the RBC model
assumes that prices adjust quickly to changes in supply and demand.

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 Summary of Theories

School of Thought Comment Recommended Policy

Neo-classical Invisible hand. Do nothing.
Austrian Fluctuations caused by misguided Do nothing.
government intervention.
Keynesian Focus on the AD curve. Economy does not Use fiscal/monetary policy
automatically correct in the short-run. because in the “long run, we
are all dead”.
Monetarist Monetary policy. Steady, predictable growth of
money supply.
New Classical: RBC Expansions and contractions Do nothing.
represent efficient operation of the economy in
response to externa real shocks.

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 Unemployment and Inflation

• Most governments try to limit

unemployment and contain inflation
because these conditions can lead to
social and political unrest. The
graph shows the relationship
between these variables and the
business cycle.

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 Unemployment and Inflation

Interpretation of the graph:

• Unemployment is at its lowest at the peak of the
business cycle. This is also indicative of a tight
labor market.
• This situation may also trigger a downturn in
the economy, because the bargaining power of
labor increases. Workers demand high wages as
inflation is at its peak now and they expect
prices of goods to further go up.
• Labor costs account for a significant part of a
firm’s costs. When wages are up, the SRAS shifts
to the left, causing a decrease in real GDP.

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 Unemployment and Inflation

Interpretation of the graph:

• If central banks act to tame inflation, it may
result in recession.
• Unemployment is at its highest level at the
trough of the economic cycle.
• Unemployment numbers lag the cycle as we will
see shortly, but they are closely related to the
cycle.
• Inflation numbers move along with the business
cycle. So, it is said to be pro-cyclical

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 Important Terms for Unemployment

Terms Meaning
Employed Number of people with a job. Excludes informal
workers such as illegal workers.
Working age Those between 16 and 64 years of age.
Labour force Includes unemployed and employed i.e. working age
population who are either working or looking for
work. Discourage workers are not included here.
Unemployed People who are actively seeking employment, but
currently without a job. To be considered
unemployed, one must have been looking for work
in the past 4 weeks.

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 Important Terms for Unemployment
Terms Meaning
Long-term Unemployed People who have not been working for a long-time
(3- 4 months).
Frictionally Unemployed People who are between jobs. They are not working
at the time of filling the survey. But, they are not
100 percent unemployed. They have another job
waiting and are yet to start.
Structurally unemployed Unemployment that arises because the demand for
certain skills has reduced while employers are
looking for a different set of skills. Ex: need for
typists decreased because of computers/public
telephone operators decreased in developing
countries because of mobile phones. It can also be
due to changes in business, technology, etc.
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 Important Terms for Unemployment
Terms Meaning
Activity (participation) ratio Labour force
Total population of working age
Underemployed A person who has a job that pays significantly less
for the qualifications they possess. Ex: a person out
of work with a CFA charter working in a grocery
store.
Discouraged worker A person who has stopped looking for a job
probably because of a weak economy. They are not
included in the unemployment rate. If they stop
looking for work, then unemployment rate may
decrease in a recession.

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 Important Terms for Unemployment

Terms Meaning
Voluntarily unemployed Person voluntarily outside the labor force. Ex: early
retirees, a 22-year old who is pursuing a Master’s
degree and hence not looking for work.

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 Important Terms for Unemployment

• Unemployment rate = Unemployed / Labour Force

• Most quoted measure of employment.
• Measured differently in different countries, which makes international
comparisons difficult. Some countries may include even people of working
age who are not willing to work, or underemployed.
• Unemployment rate is inaccurate in predicting the direction of an economy.
It lags the economic cycle because it is the economic environment that forces
people to look actively for jobs or drop out of it.

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 Important Terms for Unemployment

• The following two reasons elaborate on why it is an inaccurate indicator:

o Businesses are reluctant to lay off people as it is more expensive to hire and
train new workers.
o In difficult economic times, discouraged workers stop looking for jobs
(hence not counted as unemployed). So the unemployed number becomes low.
But, when the economy recovers, these people start looking for jobs again
pushing the unemployed number up undermining recovery.

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 Important Terms for Unemployment

Overall payroll employment and productivity indicators:

• To get a sense of the employment cycle and address the issue of discouraged workers,
analysts often look at payroll growth. Most companies publish their payroll data. If payroll
numbers are increasing, then unemployment is decreasing.
• Two other measures used to understand the employment situation: overtime hours and the
number of temporary workers. During a recovery, the first step taken by firms is to increase
overtime hours instead of hiring new workers. Then, they increase the number of temporary
workers. The opposite happens at the peak of a business cycle. Instead of laying off workers
immediately, firms first reduce overtime hours, and then reduce temporary workers.

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 Important Terms for Unemployment

Overall payroll employment and productivity indicators:

• Productivity is output/ hours worked). A drop in productivity (idling workers) precedes

decrease in full-time payrolls. There is a decrease in full-time payrolls once the economy
moves fully into recession.

• Conversely, an increase in productivity precedes an increase in full-time payrolls.

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 Inflation

Key points related to inflation are as follows:

• Generally, inflation is pro-cyclical (it goes up and down with the business cycle).
• Inflation is the sustained rise in the overall level of prices in an economy.
• It must be a steady rise in the price level. In simple terms, inflation means the same amount of
money can purchase a lesser amount of goods and services in the future.
• Inflation rate is the percentage change in a price index.
• Inflation rates allow us to infer the state of the economy. High inflation is the sign of an overheated
economy.
• Unexpected change in inflation may trigger a change in monetary policy that can impact asset
prices.

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 Inflation

Key points related to inflation are as follows:

• High inflation, fast economic growth, and low unemployment indicate the economy is
overheating. This may trigger some policy movements to tame inflation. Equilibrium GDP is
above potential GDP.
• High inflation, high unemployment, and slow economic growth results in a situation called
stagflation (stagnation + inflation).

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 Inflation

Deflation, Hyperinflation, and Disinflation

Deflation: A sustained decrease in aggregate price level. For example, price level comes down from
100 to 99 and then 98 and so on.
Hyperinflation: An extremely fast increase in aggregate price level. Over a three-year time period if
the price level doubles, then it is called hyperinflation.
o Occurs when government spending is greater than real tax revenue and there is unlimited money
supply.
o Occurs usually after a war when the supply of goods and services is limited and there is too much
money supply.
Disinflation: A decline in the inflation rate, or a decelerating inflation. Prices are still going up over
time, but at a slower rate than earlier. For example, two years ago, the inflation rate was 15%, last year
it was 12%, and this year it is 9%.

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 Inflation

What’s the difference between deflation and disinflation?

• With deflation, the price levels are going down, whereas with disinflation price
levels are going up (positive inflation) but not at the same pace as before.
• The preferred inflation is 2% for developed economies. Otherwise, there is a risk of
slipping into deflation. Value of money increases in deflation. Falling prices 
lower revenues for the company  real debt borrowed by companies increases 
cut in spending and investment  economy declines further. So, deflation is not
good as was seen during the Great Depression.

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 Inflation

• Measuring Inflation: The Construction of Price Indices

• Inflation rate is measured as the percentage change of a price index.
• A price index represents the average prices of a basket of goods and services. It determines the
price change in one period relative to another.
• Base year/period is the period with which prices are being compared to for the current period.
• Laspeyres index is the most common type of index; it is created by holding the consumption basket
constant. For instance, the consumption basket last year could have been 5 loaves of bread and 10
liters of milk. If it changes this year to 6 loaves of bread and 12 liters of milk, then when calculating
the index we take the initial quantities of the consumption basket and not the recent ones.
• Laspeyres index is a base-weighted index because the price increases are weighted using the
quantities in the base period. This index number can then be used to calculate the inflation rate.

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 Inflation

• Measuring Inflation: The Construction of Price Indices

• IL = Σ(P1 * Q) * 100
Σ(P0 * Q)
where,
• P1 = price in current year
• P0 = price in base year
• Q = quantity in base year
• Many countries use the Laspeyres index where the consumption basket is updated once every
5 years.

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 Inflation

• This strategy introduces a few biases (all the biases cause the index to be overstated):
o Substitution bias: As price of a good increases, people substitute the good with a cheaper good.
o Assume you have a consumption basket comprising 5 units of fruits and 5 units of vegetables. If fruits become
expensive, then people will change their consumption basket to 2 units of fruits and 8 units of vegetables. But
the index computes prices based on a fixed consumption basket of 5 units of fruits and 5 units of vegetables.
• Index weighted on these quantities or an inflation rate based on this price index will be biased upward or
overstated.
o Quality bias: Quality of goods and services improves over time. Let us take the example of cars. Even though
cars have become expensive, the improvement in quality is more than the price, which is not reflected in the
index calculation.
o New product bias: New products entering the market are not included in the consumption basket as the
basket is fixed.

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 Inflation

• Paasche index allows for the composition of the basket to change. It uses the consumption in the current
period. It measures the change in the price of consumption basket weighted by using the quantities in the
current period.
• Limitation of Paasche Index: It is difficult to make comparisons on a periodic basis as different weights are
used every time.

Σ(P1 * Q1) * 100

IP =
• where, Σ(P0 * Q1)
• P1 = price in current year
• P0 = price in base year
• Q1 = quantity in current year

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 Inflation

• Fischer index uses the geometric mean of the Laspeyres index and Passche index.

• I = Laspeyres Index Paasche Index

F

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 Example

Goods January 2021 February 2021

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 February price index as a:
• 1. Laspeyres index 2. Paasche index 3. Fischer index

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 Example

• Laspeyres index in February 2012 = (7*110) + (10*120) * 100 = 120.80

(7*90) + (10*100)

• Inflation Rate = 120.80/100 = 20.80%

(9*110) + (12*120) * 100

• Paasche Index in February 2012 = = 120.89
(9*90) + (12*100)

• Fischer Index = √121 121 = 121.

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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 because the constituents of the consumption
basket differ from one country to another (exhibit 6 in the curriculum lists consumption basket of
different CPI). For instance, the weight for food and beverage in CPI for China and India are 34%
and 47.1% respectively. But, it is much lesser for the developed countries.
• Scope of each index is different.
o CPI-U: This CPI for the United States covers only the urban consumers using a household survey.
o PCE: Personal consumption expenditure covers all personal consumption in the United States using
business surveys.
o PPI: Producer price index measures the average change in selling prices experienced by domestic
producers in the country. If PPI goes up, then CPI also goes up as the inputs for firms increases. PPI is
also called the wholesale price index (WPI) in some countries.

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 Price Indices and their Usage

• Many economic activities are indexed to a certain price index.

• o Treasury Inflation Protected Securities (TIPS) adjust the bond’s par value based on CPI-U.

• Central banks use the CPI to monitor inflation.

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 Some important points

• Headline inflation is based on the price index of all goods and services in an economy.
Headline inflation reflects the actual cost of living.
• Core inflation is based on the price index of all goods and services in an economy except food
and energy. In the short-term, prices of food and energy fluctuate a lot, so policy makers focus
on core inflation. But, their long-term goal is to control headline inflation.
• Relative price is the price of a specific good or service in comparison with those of other
goods and services.
• A sub-index is a price index for a specific category of goods and services. For example, a sub-
index for food or energy.

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 Explaining Inflation

• Cost-push inflation:
• Inflation that results from a decrease in
aggregate supply; it is caused by an increase
in the real price of an important factor of
production: wages or any raw material such
as energy. Also known as wage-push
inflation.

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 Explaining Inflation

• Cost-push inflation:
• Interpretation of the graph:
• If there is an increase in the price of an
input or wages, the SRAS curve will shift to
the left.
• Real GDP decreases and the price level
increases.
• This increase in cost creates a one-time rise
in the price level.

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 Explaining Inflation

• Cost-push inflation:
• Interpretation of the graph:
• The signs that analysts look for include:
• Commodity prices because commodities are a
key input to production.
• Unemployment rate: The lower the rate of
unemployment, the greater the likelihood that
shortages will drive up wages. The higher the
rate of unemployment, the lesser the
likelihood of labor shortage. But, it does not
represent the economy’s full labor potential
and participation rate is a better indicator.

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 Explaining Inflation

• Cost-push inflation:
• The two metrics that analysts look for include:
o Non-accelerating inflation rate of unemployment (NAIRU): This is the level of unemployment
where inflation does not rise or fall. If the unemployment rate falls below NAIRU, then there will
be inflationary pressures.
o Natural rate of unemployment (NARU): If the unemployment rate falls below NAIRU, then
there will be upward pressures on wages.
o Both these measures vary from one economy to another, and over time in a single economy.

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 Explaining Inflation

• Cost-push inflation:
o These measures have limitations. One of them is that the appropriate level below which
inflationary wage pressures emerge is not known. Another limitation is that these metrics do not
consider bottlenecks in specific segments of the labor market. For example, if the demand for
skilled analytics engineers is high but the supply is low, then the wages for these workers will
increase. But it may not be represented well in the overall metrics.
o NAIRU and NARU change over time with changes in technology and economic structure.
o NAIRU of an economy can be high if a large number of workers in the labor force do not have
the skills that employers need.

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 Explaining Inflation

• Demand-pull inflation:
• Inflation that results from an increase in
aggregate demand. Increase in aggregate
demand increases the price level and
temporarily increases economic output
above its potential or full-employment level.
It reflects the state of economic activity
relative to potential.

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 Explaining Inflation

• Demand-pull inflation:
• Interpretation of the graph:
• Initially, assume real GDP was below the
potential GDP. If actual GDP is close to
potential, then it leads to shortages and
bottlenecks, and prices rise.
• An increase in aggregate demand shifts the AD
curve to the right.
• Real GDP increases, price level increases. Real
GDP is above potential GDP. There is an
inflationary gap.

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 Explaining Inflation

• Demand-pull inflation:
• Interpretation of the graph:
• This increase in the price level is called
demand-pull inflation.
• Recall what we saw in the previous reading.
The wages rise in response to price rise and
pushes the SRAS left. Real GDP is back on the
LRAS curve equal to potential GDP, but price
has increased even further.
• If the AD continues to increase, then the price
increases too.

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 Explaining Inflation

• Demand-pull inflation:
• Interpretation of the graph:
• An increase in aggregate demand may be
due to any of the following:
• o Increase in money supply.
• o Increase in government spending.
• o Increase in exports.

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 Explaining Inflation

• Demand-pull inflation:
• Monetarist perspective: Inflation is a monetary phenomenon, and they believe the money
supply has a big role to play in determining inflation. If monetary authorities increase the
money supply at a rate higher than the rate of potential GDP, and the money supply is more
than the amount of goods and services available, then the prices tend to rise.
• Analysts compare money growth with the growth of the nominal economy to determine if
there is demand-pull inflation.

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 Explaining Inflation

• Inflation Expectations
• Inflation expectations can be self-sustaining i.e. they persist even after the cause that
triggered the price rise has disappeared.
• Some analysts gauge inflation expectations based on past trends.

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 Economic Indicators

• Economists use these indicators to forecast the prospects of an economy, and

classify them based on whether they lag, lead, or coincide with changes in an
economy’s growth.
• Leading indicators have turning points that tend to precede those of the business
cycle. They help in forecasting the economy in the near term.
o Ex: 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.
o Ex: Manufacturing activity, personal income, number of non-agricultural employees.

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 Economic Indicators

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

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 Leading Indicators

• Following are a few leading indicators

1. Average weekly hours, manufacturing: Firms cut on overtime before a downturn and increase the
overtime before hiring full-time workers during a recovery.
2. Average weekly initial claims for unemployment insurance.
3. Manufacturers’ new orders for consumer goods and materials.
4. Vendor performance, slower deliveries diffusion index.
6. Building permits for new private housing units.
7. S&P 500 stock index.
8. Money supply, real M2: A reduction in money supply will have a contractionary effect.5.
Manufacturers’ new orders for non-defense capital goods

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 Leading Indicators

• Following are a few leading indicators

9. Interest rate spread between 10-year Treasury yields and overnight borrowing rates: Spread
is the difference between long-term yields and short-term yields. If the curve is upward sloping
(a wider spread), then we expect short-term rates in the future to be high and more economic
growth.

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 Coincident Indicators

1. Employees on non-agricultural payrolls.

2. Aggregate real personal income.
3. Industrial production index.
4. Manufacturing and trade sales.

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 Lagging Indicators

1. Average duration of unemployment.

2. Inventory-sales ratio
3. Change in unit labor costs
4. Average bank prime lending rate.
5. Commercial and industrial loans outstanding: Loans are used to build inventory. So, it is a
lagging indicator for the same reason as inventory-sales ratio.
6. Ratio of consumer installment debt to income.
7. Change in consumer price index for services.

Prepared & Presented by Jugal Shah

Prepared & Presented by Jugal Shah