2.4 understanding business cycles

Question 1

Types of Cycles

Answer 1

The classical cycle

The growth cycle

The growth rate cycle

Question 2

The classical cycle

Answer 2

refers to fluctuations in the level of economic activity, which can be measured by GDP in volume terms

Usually, the contraction phases are short and the expansion phases are long. The classical cycle is rarely used because it does not allow the breakdown of movements between short-term fluctuations and long-run trends.

Question 3

The growth cycle

Answer 3

refers to fluctuations in economic activity around the long-term potential or trend growth level

Question 4

The peak of the growth cycle corresponds to what?

Answer 4

corresponds to the largest positive gap between actual GDP and the trend GDP

Question 5

The trough of the growth cycle corresponds to what?

Answer 5

to the largest negative gap between actual GDP and trend GDP

Question 6

The growth cycle is most commonly used by economists because of what?

Answer 6

because it captures both the changes driven by long-run trends and changes due to short-term fluctuations

Question 7

The growth rate cycle

Answer 7

refers to fluctuations in the growth rate of economic activity

Question 8

An advantage of the growth rate cycle is…?

Answer 8

there is no need to first estimate a long-run trend

Question 9

Phases of the Business Cycle

Answer 9

Recovery (end of through)

Expansion (mid to end of Peak)

Slowdown (end of peak to mid though)

contraction (mid through to end of through)

Question 10

Market Conditions and Investor Behavior

Recovery Phase

Answer 10

When an expansion is expected, risky assets will be repriced upward as the markets start incorporating higher profit expectations into the prices of corporate bonds and stocks.

Equity values typically bottom out three to six months before the overall economy reaches its trough.

Question 11

Market Conditions and Investor Behavior

Expansion Phase

Answer 11

The later part of an economic expansion is called the boom phase, during which the economy is operating at above full capacity and is at risk of overheating

Companies compete for qualified workers by raising wages and continue to expand capacity through strong cash flows and borrowing.

Question 12

Market Conditions and Investor Behavior

Slowdown phase

Answer 12

During the boom, prices for risky assets increase while prices for safe assets, such as government bonds, decrease.

Concern over higher inflation drives higher nominal yields.

Question 13

Market Conditions and Investor Behavior

contraction phase

Answer 13

investors turn to safer assets and shares of companies with steady positive cash flows

The marginal utility of a safe income stream increases when employment is falling.

Question 13

Which of the following statements is most accurate? Once the economy moves into the contraction phase of a typical business cycle, inflation:

A
eventually decelerates, but with a lag.

B
remains moderate and may continue to fall.

C
continues the decelerating trend that began in the slowdown phase.

Answer 13

B
remains moderate and may continue to fall.

Question 14

The reason analysts follow developments in the availability of credit is that:

A
credit cycles are of same length and depth as business cycles.

B
loose credit helps reduce the extent of asset price and real estate bubbles.

C
loose private sector credit may contribute to the extent of asset price and real estate bubbles and subsequent crises.

Answer 14

C
loose private sector credit may contribute to the extent of asset price and real estate bubbles and subsequent crises.

Question 15

Recovery
Business conditions and expectations:

Answer 15

Low utilization of capacity results in excess capacity and little need for capacity expansion

Low interest rates support investment

Question 16

Recovery
Capital spending

Answer 16

Low but increasing, with a focus on efficiency rather than capacity

Light producer equipment and equipment with a high rate of obsolescence are reinstated first

Question 17

Expansion
Business conditions and expectations:

Answer 17

Favorable conditions

Utilization of capacity increases and may begin to limit the ability to respond to demand

Increased investment spending supported by growth in earnings and cash flow

Question 18

Expansion
Capital spending

Answer 18

Focused on capacity expansion

New types of equipment needed to meet demand

Purchase of heavy and complex equipment

Companies expand warehouse space to new locations

Question 19

Slowdown
Business conditions and expectations:

Answer 19

Peak business conditions with healthy cash flows

Higher interest rates avoid overheating of the economy

Question 20

Slowdown
Capital spending

Answer 20

new orders continue to be placed as companies operate at or near capacity

Question 21

contraction
Business conditions and expectations:

Answer 21

Fall in demand, profits, and cash flows

Question 22

contraction
Capital spending

Answer 22

Existing orders are canceled and companies stop placing new orders

Technology and light equipment with short lead times get cut first, then cutbacks in heavy equipment and construction follow

Scale back on maintenance

Question 23

The inventory-sales ratio

Answer 23

key indicator

Sales slow faster than production when the economy is in the slowdown phase, causing a spike in inventory-sales ratio

When the economy is in contraction, companies often reduce prices to unload surplus inventories. The inventory-sales ratio begins to fall back to normal.

When demand bounces back, inventories will often drop because production cannot keep pace with sales. The drop in the inventory-to-sales ratios will encourage companies to ramp up production even more.

The expansion phase is the stage of inventory rebuilding or restocking.

Question 24

In a recession, companies are most likely to adjust their stock of physical capital by:

A
selling it at fire sale prices.

B
not maintaining equipment.

C
quickly canceling orders for new construction equipment.

Answer 24

B
not maintaining equipment.

Physical capital adjustments to downturns come through aging of equipment plus lack of maintenance.

Question 25

Based on typical labor utilization patterns across the business cycle, productivity (output per hours worked) is most likely to be highest:

A
at the peak of a boom.

B
into a maturing expansion.

C
at the bottom of a recession.

Answer 25

C
at the bottom of a recession.

At the end of a recession, firms will run “lean production” to generate maximum output with the fewest number of workers.

Question 26

Home sales are sensitive to interest rates because?

Answer 26

most people finance purchases

The internal cycle of the housing sector is seen as part of the credit cycle. Demand for housing increases when housing prices are low relative to average incomes

As the expansionary cycles mature, housing prices and mortgage rates become disproportionately high, resulting in higher housing costs.

When house sales slow down, there will be a downturn first in buying, followed by actual construction activity.

Question 27

Neoclassical economists, particularly the Real Business Cycle (RBC) advocates, conclude that expansions and contractions are a result of efficient responses of the economy to external real shocks that shift the supply curve. The economy is always at a level that maximizes expected utility.

Based on this model, governments should not intervene with fiscal or monetary policy because these policies affect the economy with substantial lags, including:

Answer 27

A lag between when policymakers realize what is happening and when they develop a plan

A lag between when policymakers develop a plan and when they implement it

A lag between when a policy is implemented and when it actually impacts the economy

Question 28

Schumpeterian “creative destruction”

Answer 28

the creation of a better product may drive producers of existing goods out of business.

Question 29

The Austrian School

Answer 29

closely aligned with the neoclassical school

emphasizes the role of money

Economists from the Austrian school argue that low interest rates and excessive credit growth during boom times result in over-investment in projects with low returns.

–> Eventually, firms realize that they have overinvested, and economic activity slows as the aggregate demand curve moves sharply to the left.

According to this school of thought, governments and central banks must refrain from intervening and allow prices and wages to adjust to the new equilibrium

Question 30

Monetarism

Answer 30

steady growth in the money supply

Government intervention should be minimal as it likely causes more economic fluctuations

Fiscal and monetary policy should be clear and consistent over time.

Question 31

Monetarists also see business cycles stemming from movements in the aggregate demand curve, but they object to the intervention prescribed by Keynesian economists on three grounds:

Answer 31

The Keynesian model does not recognize the importance of the money supply.

The short-term focus misses the long-term consequences of government intervention.

The timing of fiscal policy is uncertain, and a stimulus may not take effect until the economy has started to recover.

Question 32

Keynesianism

Answer 32

advocate government intervention in the form of managing the aggregate demand rather than the aggregate supply.

Prices are viewed as sticky in the short run, which leads to a relatively flat AS curve.

The Keynesian theory agrees with the neoclassical theory that long-run equilibrium may be achieved by the market without external intervention. However, this is a very long process due to sticky wages. The society will be severely impacted financially and mentally while waiting for prices to naturally adjust.

According to Keynes, the government should intervene during an economic recession by increasing its fiscal deficit

Question 33

Criticisms about the Keynesian theory include:

Answer 33

Government debt needs to be serviced and repaid eventually.

Expansionary policy may cause the economy to overheat in the long term due to unsustainable growth.

Implementation of fiscal policy can take a long time.

Question 34

Economic indicators

Answer 34

variables that provide information on the state of the overall economy.

They help policymakers and analysts understand the position of an economy in a cycle and they are used by policymakers and analysts to predict the future performance of the market.

Question 35

types of indicator

Answer 35

Leading indicators

coincident indicators

Lagging indicators

Question 36

Leading indicators

Answer 36

useful for predicting the future state of the economy.

Question 37

Coincident indicators

Answer 37

help identify the current economic state.

Question 38

Lagging indicators

Answer 38

help identify past economic conditions.

Question 39

Key Leading indicators include:

Answer 39

Stock Market

Retail Sales

Building Permits

Average weekly hours (manufacturing)

Manufacturer’s new orders

Interest spread

Question 40

Key Coincident indicators include:

Answer 40

Industrial protection index

real personal income

Manufacturing and trade sales

Manufacturing sales

Question 41

Key Lagging indicators include:

Answer 41

inventory-sales ratio

average duration of employment

average bank prime lending rate

commercial and industrial loans outstanding

change in unit labor costs

inflation

Question 42

Composite indicators

Answer 42

Composite include several different variables that tend to move together.

–> For example, a composite indicator may measure the financial stability of a company using variables such as its total asset value, debt ratio, and other important metrics.

–> The indicator will then issue a stable/unstable rating based on the different variables.

In economics, composite indicators often measure the economic cycle using variables published by organizations like the OECD. The variables may differ for different economies.

Question 43

In the US, the Conference Board Leading Economic Index (LEI) uses 10 components to predict the business cycle:

Leading indicator + reason for use

Answer 43

1 Average weekly hours (manufacturing)

–> Businesses cut hours before laying off workers in a downturn and increase it before rehiring in an upturn

2 Average weekly initial claims for unemployment insurance

–> High unemployment rate indicates economic downturn

3 Manufacturers’ new orders for consumer goods and materials

–> Change in orders captures business sentiment

4 Institute of Supply Management (ISM) new order index

–> Change in orders captures business sentiment

5 Manufacturers’ new orders for non-defense capital goods excluding aircraft

–> Change in orders captures business sentiment

6 Building permits for new private housing units

–> Increase in permits may signal new construction activity

7 S&P 500 Index

–> Stock movements anticipate economic turning points

8 Leading Credit Index

–> Recession is more likely with a vulnerable financial system

9 Spread between 10-year treasury yields and federal funds rates

–> Change in interest rates indicates economic cycle

10 Average consumer expectations for business conditions

–> Consumer sentiment drives spending and economy

Question 44

Nowcasting

Answer 44

the process of estimating the current state (think “now” + “forecasting”), and the produced estimate is known as a nowcast

important because certain data are subject to publications delays. Policy makers need to use a huge amount of real-time data from different sources (e.g., internet searches) to estimate low frequency economic indicators.

Nowcasting is commonly used to estimate the current GDP growth, inflation rate, and unemployment rate.

Question 45

GDPNow

Answer 45

While different nowcasts are produced by different institutions, the Atlanta Fed publishes a running estimate of real GDP growth for the current quarter known as GDPNow

useful because the current GDP data is usually not available until the end of the quarter.

The GDP growth forecast is updated throughout the quarter when different data become available

Question 46

the diffusion index

Answer 46

consists of different leading, coincident, and lagging indicators

This index shows the components that are moving consistently with the overall index

It allows analysts to measure the breadth of change in a composite index.

A higher diffusion index value signifies a broader movement in the economy

Question 47

An increase in new capital goods orders and a decrease in the weekly number of initial unemployment insurance claims are most accurately characterized as:

A
leading indicators of an economic expansion.

B
coincident indicators of an economic expansion.

C
a leading and a lagging indictor, respectively, of an economic expansion.

Answer 47

A
leading indicators of an economic expansion.

Question 48

The unemployment rate is which type of economic indicator

Answer 48

lagging economic indicator

Question 49

Stagflation

Answer 49

high inflation and high unemployment

Question 50

Deflation

Answer 50

sustained decrease in the price level (negative inflation rate)

Question 51

Hyperinflation

Answer 51

extremely high inflation rate (such as 1000% per year)

typically occurs when government spending is not backed by real tax revenue. It may be caused by the shortage of supply, economic regime transition, or economic distress caused by political instability. Money changes hands quickly because people prefer to hold onto goods that will not lose real value. The basic cause is too much money in circulation.

Question 52

disinflation

Answer 52

decline in the inflation rate, but still positive

often occurs after periods of relatively high inflation. Central banks strive to pull inflation back to normal levels.

Question 53

A price index

Answer 53

represents the average prices of a basket of goods and services

Question 54

a Laspeyres index

Answer 54

An inflation index calculated by holding the composition of the consumption basket constant

Question 55

The assumption of a constant consumption basket yields three sources of upward bias:

Answer 55

Substitution bias

New product bias

Quality bias

Question 56

Substitution bias

Answer 56

Rather than consuming the same basket of goods and services, people will choose other goods and services that have a lower price.

Question 57

New product bias

Answer 57

A constant consumption basket will not include new products unless it is regularly updated.

Question 58

Quality bias

Answer 58

Prices may rise to reflect the improved quality; this can be accounted for through hedonic pricing.

Question 59

The Paasche index

Answer 59

uses the current composition of goods

Question 60

The Fisher index

Answer 60

the geometric mean of the Laspeyres index and the Paasche index

Question 61

The Treasury Inflation-Protected Securities (TIPS)

Answer 61

are indexed to the CPI-U

Question 62

Cost-push inflation

Answer 62

usually triggered by rising wages

This is more likely to occur when the unemployment rate is low (i.e., below the natural rate of unemployment)

Productivity increases can allow for wage increases without putting pressure on corporate costs.

Question 63

Demand-pull inflation

Answer 63

likely to occur if the GDP is close to its potential

Pressure on commodity prices will often come first

This inflation can be analyzed by studying industrial capacity utilization

Question 64

Evidence that a country is experiencing demand-pull inflation is most likely to be found by analyzing the:

A
unemployment rate.

B
capacity utilization rate.

C
hourly wage growth rate.

Answer 64

B
capacity utilization rate.

Demand-pull inflation is observed when businesses raise prices in response to their inability to meet increased demand. In response to such conditions, workers demand higher wages in order to maintain their standard of living. A higher capacity utilization rate indicates that an economy is more likely to experience price increases due to bottlenecks that arise when demand outstrips supply.

The unemployment rate is typically used to assess for the presence of cost-push inflation, which occurs when businesses raise prices due to the higher cost of key inputs such as labor.

Question 65

An economic peak is most closely associated with:

A
accelerating inflation.

B
stable unemployment.

C
declining capital spending.

Answer 65

A
accelerating inflation.

Question 66

The discouraged worker category is most likely defined to include people who:

A
are overqualified for their job.

B
could look for a job but choose not to.

C
currently look for work without finding it.

Answer 66

B
could look for a job but choose not to.

Question 67

A central bank will most likely allow the economy to self-correct in periods of:

A
high inflation, fast economic growth, and low unemployment.

B
low inflation, slow economic growth, and high unemployment.

C
high inflation, slow economic growth, and high unemployment.

Answer 67

C
high inflation, slow economic growth, and high unemployment.

This scenario is often referred to as stagflation. Here, the economy is likely to be left to self-correct because no short-term economic policy is thought to be effective.