CHAPTER 6 UNDERSTANDING BUSINESS CYCLES Presenter’s name Presenter’s title dd Month yyyy

CHAPTER 6UNDERSTANDING BUSINESS CYCLESPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2014 CFA Institute 2

INTRODUCTION

• The study of business cycles is the study of short-term economic fluctuations.

• Factors that may affect business cycles are some of the same factors that affect economic growth (e.g., labor productivity, money supply, inflation, and technology).


OVERVIEW OF THE BUSINESS CYCLE

• A business cycle consists of an expansionary period and a contractionary period.

• Characteristics of a business cycle:

- They are typical in economies that rely on business enterprises.

- There are alternating phases of expansion and contraction.

- Phases occur throughout the economy, most often simultaneously.

- Phases reoccur, but vary in duration and intensity.

• An expansion occurs after a low point (the trough) and a contraction occurs after the highest point (the peak).

• A contraction

- is also referred to as a recession.

- is referred to as a depression if severe and if aggregate activity declines.


TYPICAL SCENARIO: RECESSION

Aggregate demand declines

Inventories begin to

accumulate

Companies slow production

Companies cut nonessential expenditures

Lower GDP


TYPICAL SCENARIO: EXPANSION

Wages grow and wages decline

Input prices fall

Consumers and companies

purchase more

Companies increase capital

spending

Increase GDP


BUSINESS CYCLE SUMMARY

CharacteristicEarly Expansion (Recovery)

Late Expansion Peak Contraction (Recession)

Economic activity

Economic activity changes from decline to expansion.

Accelerating rate of growth

Decelerating rate of growth

Declines

Employment Layoffs slow, but new hiring does not yet occur and the unemployment rate remains high.

Unemployment rate falls to low levels.

Unemployment rate continues to fall.

Unemployment rate rises.

Consumer and business spending

Upturn is often most pronounced in housing, durable consumer items, and orders for light producer equipment.

Upturn becomes more broad based.

Capital spending expands rapidly, but the growth rate of spending starts to slow down.

Cutbacks appear most in industrial production, housing, consumer durable items, and orders for new business equipment, followed by a lag via cutbacks in other forms of capital spending.

Inflation Inflation remains moderate and may continue to fall.

Inflation picks up modestly.

Inflation further accelerates.

Inflation decelerates but with a lag.


THEORIES OF BUSINESS CYCLES

• Different schools of economic thought are used to explain the causes of business cycles.

• These schools of thought offer different prescriptions with regard to government actions that may affect the economy.

• Schools of thought:

- Neoclassical

- Austrian

- Keynesian

- Monetarists

- New classical

- Real business cycle theory

- Neo-Keynesian


NEOCLASSICAL AND AUSTRIAN

• Neoclassical school of economic thought:

- The “invisible hand” (that is, free market) will result in a price for every good for which there is supply and demand.

- Says’s law: All that is produced will sell because supply creates its own demand.

- This school cannot explain a prolonged depression. Any declines in aggregate demand would be temporary.

• Austrian school of economic thought:

- This school is similar to neoclassical but considers the role of the money supply and government actions.

- Government intervention may cause a boom-and-bust cycle.


KEYNESIAN THEORY OF BUSINESS CYCLES

• In the event of lower aggregate demand, lower wages result in lower spending, hence affecting demand further.

• Very low interest rates would not stimulate the economy because confidence would be too low.

• Government should intervene in a crisis, running a deficit.

• Criticisms of this theory:

- Government debt could get out of control.

- Expansionary policy may cause the economy to grow too fast, resulting in inflation and other ills.

- It takes time for fiscal policies to work, so they may be ill timed for a short-term crisis.


MONETARISTS

• Those following the monetarist school of thought object to the Keynesian approach because Keynesian theory

- does not consider the role of the money supply.

- is not logical in light of utility-maximizing market participants.

- ignores the long-term cost of government intervention.

- does not consider the unpredictability of the timing of fiscal policy changes on the economy.

• Monetarists advocate for a steady increase in the money supply and a limited role of government.


NEW CLASSICAL SCHOOL

• The new classical school uses the idea that utility-maximizing agents will seek to maximize profits.

• Real business cycle (RBC) theory:

- Business cycles are the result of the efficient operation of the economy in response to real shocks.

- The RBC theory considers unemployment the result of persons wanting wages that are too high.

- It is criticized as being an unrealistic assumption.

• Neo-Keynesians (new Keynesians):

- Neo-Keynesians assume slow-to-adjust wages and prices.

- Government intervention is needed in the event of disequilibrium.


UNEMPLOYMENT AND INFLATION

• Types of unemployment:

- Unemployed: People who are actively seeking a job but do not have a job.

- Frictionally unemployed are in the process of changing jobs.

- Long-term unemployed have been out of work for a long time, but are still looking.

- Underemployed: Employed people who have the qualifications to work a higher-paying job.

- Discouraged worker: Unemployed person who stopped looking for a job.

- Voluntarily unemployed: Person who is outside of the labor force voluntarily.

• Measures describing the labor market:

- Employed: Number of people with a job.

- Labor force: Number of people with a job or actively seeking a job.

- Unemployment rate: Ratio of the number of unemployed persons to the labor force.

- Activity ratio (participation ratio): Ratio of labor force to total population of working age persons.


PRODUCTIVITY MEASURES

Labor force indicators:

• The unemployment rate (the ratio of the number of unemployed persons to the labor force) lags the current environment.

• Issues:

- Distortions from discouraged workers: The number of unemployed may drop because workers become discouraged and may increase when they rejoin the workforce to resume searching.

- Reluctance of employers to lay off workers when business slows and to hire when business increases.

• Payroll growth does not fully cover employment at small businesses.

• Hours worked (including overtime) and use of temporary workers are indicators of slowing and recovering businesses.


INFLATION

• Inflation is an increase in the level of prices in the economy.

- The inflation rate is the percentage change in a price index.

- The purchasing power of money decreases.

- The liability of the borrower decreases if the loan has fixed monetary terms.

• Deflation is a sustained decrease in the aggregate price level (negative inflation rate).

- The purchasing power of money increases.

- The liability of the borrower increases if the loan has fixed monetary terms.

• Hyperinflation is an extremely fast increase in the aggregate price level.

- It generally occurs when government spending is not backed with tax revenues and the money supply is increased (or unlimited).

• Disinflation is a decline in the inflation rate.


MEASURING INFLATION

• A price index reflects the weighted average price of a basket of goods and services, with the index = 100 at a specified period of time (that is, base year).

- A Laspeyres index is a price index in which the basket of goods and services is held constant.

• Biases in an index:

- Substitution bias: People may substitute goods and services as prices change.

- Addressed somewhat using a chained price index formula (e.g., Fisher index and Paasche index).

- Quality bias: The utility of a good may improve over time, but this may be interpreted as a price increase.

- New product bias: Not included in a fixed basket of goods and services.


INFLATION INDICES

• Price indices may differ with respect to scope and weights on goods and services.

• Examples:

- The consumer price index (CPI) is used to track inflation within a given economy.

- In the United States, the CPI covers only urban areas.

- It is used by US Treasury inflation protected securities (TIPS) and other contracts.

- The personal consumption expenditures (PCE) price index covers all consumption using surveys.

- The producer price index (PPI), also known as the wholesale price index (WPI), tracks inflation in prices of goods and services to domestic producers.


SOURCES AND MEASURES OF INFLATION EXPECTATIONS

• Sources of inflation

- Cost-push: Rising costs to businesses result in increased prices to consumers.

- Measure: Unit labor cost (ULC) = Total labor compensation per hour per worker (W) divided by output per hour per worker (O) = W/O

- Demand-pull: Prices increase because of an increase in demand.

- Measures: Money supply indicators and money supply growth compared with growth in the nominal GDP

- The velocity of money is the ratio of nominal GDP to the money supply and is a measure of the likelihood of inflationary pressures.

• Measures of inflation expectations:

- Extrapolation of trends in inflation

- Surveys of inflation expectations

- Comparison of yields on inflation-adjusted securities with non-inflation-adjusted securities


ECONOMIC INDICATORS

An economic indicator is a measure that provides information about the state of the overall economy.

• A leading economic indicator is a measure that has turning points that precede changes in the economy.

• A coincident economic indicator has turning points that coincide with the changes in the economy.

• A lagging economic indicator has turning points that are later than changes in the economy.


ECONOMIC INDICATORS, EXAMPLES

Leading Economic Indicators

• Average weekly hours• Average weekly initial

claims for unemployment insurance

• Manufacturers’ new orders for consumer good and materials

• Vendor performance, slower deliveries diffusion index

• Manufacturers’ new orders for nondefense capital goods

• Building permits for new private housing units

• S&P 500 Index• Money supply, real M2• Interest rate spread

between 10-year Treasury yields and the federal funds rate

• Index of Consumer Expectations

Coincident Economic Indicators

• Aggregate real personal income

• Employees on nonfarm payrolls

• Industrial Production Index• Manufacturing and trade

sales

Lagging Economic Indicators

• Average duration of unemployment

• Inventory-to-sales ratio• Change in unit labor costs• Average bank prime lending

rate• Commercial and industrial

loans outstanding• Ratio of consumer

installment debt to income• Change in consumer price

index for services


ECONOMIC INDICATORS AND THE BUSINESS CYCLE

Increase in weekly hours, manufacturing Leads an expansion

Increase in the Index of Consumer Expectations Leads an expansion

Increase in the money supply not accounted for by inflation Leads an expansion

Increase in the average duration of unemployment Follows contractionary phase

Increase in Industrial Production Index

Coincides with a contractionary phase


CONCLUSIONS AND SUMMARY

• Business cycles are a fundamental feature of market economies and consist of four phases (trough, expansion, peak, and contraction), but their amplitude and length varies considerably.

• Keynesian theories focus on fluctuations of aggregate demand (AD) and advocate for government intervention.

• Monetarists argue that the timing of government policies is uncertain, and it is generally better to let the economy find its new equilibrium unassisted but ensure that the money supply keeps growing at an even pace.

• New classical and real business cycle theories also consider fluctuations of aggregate supply (AS). Government intervention is generally not necessary because it may exacerbate the fluctuation or delay the convergence to equilibrium.

• New Keynesians argue that frictions in the economy may prevent convergence to equilibrium and government policies may be needed.


CONCLUSIONS AND SUMMARY

• The demand for factors of production may change in the short run as a result of changes in all components of GDP: consumption, investment, government, and net exports. Any shifts in AD and AS will affect the demand for the factors of production (capital and labor) that are used to produce the new level of GDP.

• Unemployment has different subcategories, including frictionally unemployed, long-term unemployed, discouraged workers, and voluntarily unemployed.

• There are different types of price-level movements: inflation, disinflation, deflation, and hyperinflation.

• Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle is occurring.

• Price levels are affected by real factors and monetary factors.

• Inflation is measured by many indices, including consumer price indices and producer price indices.

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CHAPTER 6 UNDERSTANDING BUSINESS CYCLES Presenter’s name Presenter’s title dd Month yyyy