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IFT Notes for Level I CFA® Program

R15 Understanding Business Cycles

Part 1


 

1.  Introduction

The focus of our previous reading was GDP, the goods and services produced in an economy, and the factors that affect it in the long run. In this reading, we look at the factors causing short-term movements in the economy, such as money, inflation, population, technology, and capital.

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.

2.  Overview of the Business Cycle

The curriculum defines business cycle as: “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.”

Some important points to be noted from the definition:

  • 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.

2.1. 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
  1. Peak: Real GDP stops increasing.
  2. Contraction/Recession: The period after the peak where real GDP is decreasing.
  3. Trough: Real GDP stops decreasing.

The four stages are illustrated below (this exhibit is reproduced from the curriculum):

Schematic of Business Cycle Phases

econ r16 4 1

This connection between aggregate demand and phases of a business cycle is not explicitly given in the curriculum. But, let us tie the concepts we covered in the previous reading to this one:

  • Aggregate demand plots price level (y-axis) vs real GDP (x-axis).
  • 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.

Some of the important characteristics of each phase in a business cycle are presented in the exhibit (reproduced from the curriculum):

Characteristics:

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

 

Activity measures show outright declines.

 

Employment Layoffs slow (and net employment turns positive), but new hiring does not yet occur and the unemployment rate remains high. At first, business turns to overtime and temporary employees to meet rising product demands. Business begins full time rehiring as overtime hours rise. The unemployment rate falls to low levels. Business slows its rate of hiring. However, the unemployment rate continues to fall.

 

Business first cuts hours and freezes hiring, followed by outright layoffs. The unemployment rate rises.

 

Consumer and Business Spending Upturn often most pronounced in housing, durable consumer items, and orders for light producer equipment. Upturn becomes more broad-based. Business begins to order heavy equipment and engage in construction. 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, with a lag, by 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.

Some key points:

  • Upturn is pronounced in the early expansion (recovery) stage because consumers put off expensive purchases such as a new house, or car as they are not sure of employment during a recession. Once the economy starts recovering, confidence returns and purchases in these discretionary items go high.
  • Recession starts when there are two consecutive quarters of negative real GDP growth.

At what stage of the business cycle is labor productivity likely to be the highest?

Labor productivity is \rm \frac{output \ or \ real \ GDP}{aggregate \ hours}. This ratio is likely to the highest at the trough. At the trough, labor is low. Output though low is not as low compared to labor, making the ratio comparatively higher at this point.

2.2. Resource Use through the Business Cycle

Fluctuations in the following variables are linked to economic fluctuations:

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

Policy-Triggered Recession:

econ r17 2.2 1

Interpretation of the graph:

  • AD1 is the initial aggregate demand. Equilibrium GDP is GDPa which is above potential GDP.
  • When there is an economic downturn, aggregate demand shifts down to the left to AD2. At this point, inventories start to accumulate because demand is low, but the companies continued producing at the same level. Finished final products also start accumulating.
  • Eventually, companies cut production, and there is a low utilization of labor (idling workers) and physical equipment. Initially, companies do not lay off people, but cut down on overtime.
  • The AD curve shifts further to the left to AD3. Equilibrium moves from GDPa to GDPb. The new equilibrium is below the potential GDP.
  • If the downturn is severe, companies may take drastic cost-cutting measures such as downsizing. It is expensive to hire and train new workers, so companies do not fire workers at the beginning of a slowdown but eventually will if the condition deteriorates. They may also liquidate inventories and AD falls further to the left.

Recessionary Output Gap

econ r17 2.2 1

Interpretation of the graph:

  • Existing inventory is now sold below the cost of production.
  • Unemployment increases.
  • Short-run equilibrium (GDPR, PriceR) is not on the LRAS curve. The unemployment level is below the natural level and the GDP level is below the potential GDP.
  • The gap between equilibrium GDP and potential GDP is called the recessionary gap.
  • Decrease in AD is likely to impact (decrease) wages and prices of input.
  • To revive the economy, monetary authority may slash interest rates.
  • When prices are low, consumers purchase more. Demand increases. Companies may increase production as inventories are low.
  • Low interest rate makes companies invest more in warehouse/equipment as it is relatively cheap. This is the turning point for revival. AD starts shifting to the right.
  • Companies start inventory rebuilding to support aggregate demand in the short run. This may later be followed by capital expenditure as overall demand increases.

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:

 

Stage 1: Businesses see demand falling Stage 2: Economy begins initial recovery Stage 3: Late in the cyclic upturn
  • Decline in sales.
  • Reduce/cut maintenance cost; halt new orders; cancel existing orders if possible; small orders easily canceled; cutbacks on large orders take longer.
  • Reduction on capital investment à negative impact on economy.
  • Capacity utilization low.

Capital spending rises because of:

  • Growth in earnings.
  • Some cancelled orders are reinstated.
  • 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.

Fluctuations in Inventory Levels:

Increase and decrease in inventory happens very rapidly, and has a major effect on economic growth despite the small size. \rm \frac{Inventory}{Sales} (I/S) ratio is an important indicator. 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.

The different stages are tabulated below:

Stage 1: Top of the economic cycle; sales fall or slow. Stage 2: Production rate less than sales rate. Stage 3: Sales begin cyclic upturn.
Takes a while to cut back on production; inventory accumulates à I/S ratio increases.

Businesses cut production to reduce inventory below sales levels.

Layoffs and cancelled orders might exaggerate downturn.

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.

Initially production does not keep pace with sales à 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.

Consumer Behavior

 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
    • retail sales.
    • broad-based indicator of consumer spending.
  • Some indicators make a distinction between durable goods (autos, appliances), non-durable 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.
  • 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.
    • 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.

2.3. Housing Sector Behavior

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. 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.

2.4. External Trade Sector Behavior

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:
  • Stronger domestic currency → increase in imports, decline in exports.
  • Weaker domestic currency → decrease in imports, increase in exports.


Economics Understanding Business Cycles Part 1