2.4 understanding business cycles Flashcards
Types of Cycles
The classical cycle
The growth cycle
The growth rate cycle
The classical cycle
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.
The growth cycle
refers to fluctuations in economic activity around the long-term potential or trend growth level
The peak of the growth cycle corresponds to what?
corresponds to the largest positive gap between actual GDP and the trend GDP
The trough of the growth cycle corresponds to what?
to the largest negative gap between actual GDP and trend GDP
The growth cycle is most commonly used by economists because of what?
because it captures both the changes driven by long-run trends and changes due to short-term fluctuations
The growth rate cycle
refers to fluctuations in the growth rate of economic activity
An advantage of the growth rate cycle is…?
there is no need to first estimate a long-run trend
Phases of the Business Cycle
Recovery (end of through)
Expansion (mid to end of Peak)
Slowdown (end of peak to mid though)
contraction (mid through to end of through)
Market Conditions and Investor Behavior
Recovery Phase
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.
Market Conditions and Investor Behavior
Expansion Phase
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.
Market Conditions and Investor Behavior
Slowdown phase
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.
Market Conditions and Investor Behavior
contraction phase
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.
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.
B
remains moderate and may continue to fall.
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.
C
loose private sector credit may contribute to the extent of asset price and real estate bubbles and subsequent crises.
Recovery
Business conditions and expectations:
Low utilization of capacity results in excess capacity and little need for capacity expansion
Low interest rates support investment
Recovery
Capital spending
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
Expansion
Business conditions and expectations:
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
Expansion
Capital spending
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
Slowdown
Business conditions and expectations:
Peak business conditions with healthy cash flows
Higher interest rates avoid overheating of the economy
Slowdown
Capital spending
new orders continue to be placed as companies operate at or near capacity
contraction
Business conditions and expectations:
Fall in demand, profits, and cash flows
contraction
Capital spending
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
The inventory-sales ratio
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.
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.
B
not maintaining equipment.
Physical capital adjustments to downturns come through aging of equipment plus lack of maintenance.
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.
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.
Home sales are sensitive to interest rates because?
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.
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:
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
Schumpeterian “creative destruction”
the creation of a better product may drive producers of existing goods out of business.
The Austrian School
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
Monetarism
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.
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:
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.
Keynesianism
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
Criticisms about the Keynesian theory include:
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.
Economic indicators
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.
types of indicator
Leading indicators
coincident indicators
Lagging indicators
Leading indicators
useful for predicting the future state of the economy.
Coincident indicators
help identify the current economic state.
Lagging indicators
help identify past economic conditions.
Key Leading indicators include:
Stock Market
Retail Sales
Building Permits
Average weekly hours (manufacturing)
Manufacturer’s new orders
Interest spread
Key Coincident indicators include:
Industrial protection index
real personal income
Manufacturing and trade sales
Manufacturing sales
Key Lagging indicators include:
inventory-sales ratio
average duration of employment
average bank prime lending rate
commercial and industrial loans outstanding
change in unit labor costs
inflation
Composite indicators
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.
In the US, the Conference Board Leading Economic Index (LEI) uses 10 components to predict the business cycle:
Leading indicator + reason for use
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
Nowcasting
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.
GDPNow
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
the diffusion index
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
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.
A
leading indicators of an economic expansion.
The unemployment rate is which type of economic indicator
lagging economic indicator
Stagflation
high inflation and high unemployment
Deflation
sustained decrease in the price level (negative inflation rate)
Hyperinflation
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.
disinflation
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.
A price index
represents the average prices of a basket of goods and services
a Laspeyres index
An inflation index calculated by holding the composition of the consumption basket constant
The assumption of a constant consumption basket yields three sources of upward bias:
Substitution bias
New product bias
Quality bias
Substitution bias
Rather than consuming the same basket of goods and services, people will choose other goods and services that have a lower price.
New product bias
A constant consumption basket will not include new products unless it is regularly updated.
Quality bias
Prices may rise to reflect the improved quality; this can be accounted for through hedonic pricing.
The Paasche index
uses the current composition of goods
The Fisher index
the geometric mean of the Laspeyres index and the Paasche index
The Treasury Inflation-Protected Securities (TIPS)
are indexed to the CPI-U
Cost-push inflation
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.
Demand-pull inflation
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
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.
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.
An economic peak is most closely associated with:
A
accelerating inflation.
B
stable unemployment.
C
declining capital spending.
A
accelerating inflation.
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.
B
could look for a job but choose not to.
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.
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.
