Part 4. Understanding Business Cycles

Question 1

Business cycle

Answer 1

The fluctuations in economic activity; with key variables being GDP and the rate of unemployment being used to determine the current phase of the cycle.

Question 2

4 phases of a business cycle:

Answer 2

1. Expansion - real GDP is increasing.
2. Peak - real GDP stops increasing and begins decreasing.
3. Contraction/recession - real GDP is decreasing.
4. Trough - real GDP stops decreasing and begins increasing.

Question 3

Resource Use Fluctuation

Answer 3

1. Expansion - sales growth slows, and unsold inventories accumulate, shown by an increase in the inventory-sales ratio above normal level. Firms reduce production, causing contraction.
2. Contraction (at the trough) - reduced production levels adjust for lower sales demand, firms find inventories depleting more quickly as sale growth begins to accelerate, causing inventory sales ratio to decrease below the normal level. To meet the increase in demand, firms will increase output.
   - Firms react to fluctuations by changing how they utilize their current workers, producing less or more output per hour, or adjusting the hours they work by adding or removing overtime. If expansion/contraction persists they will hire or lay off workers.
   - Firms react to fluctuations by buying and selling plants and equipment, firms adjust to production levels using their existing physical capital more or less intensively.

i.e. expansion - firms increase production capacity by investing more in plants and equipment.
contractions - firms won’t sell plant and equipment outright but can reduce physical capacity by spending less on maintenance or delaying equipment replacement.

Question 4

Housing Sector Activity

Answer 4

1. Mortgage rates
   - low IR increases home buying and construction, but high-interest rates reduce home buying and construction.
2. Housing costs relative to income

• when incomes are cyclical high (low) relative to home costs, including mortgage financing costs, home buying and construction tend to increase (decrease).
• housing activity can decrease when incomes rise late in the cycle, if home prices rise faster than incomes, this leads to a decrease in purchase and construction activity.

3. Speculative activity

• Housing sector in 2007/8 meant rising home prices led to purchases based on expectations of further gains.
• Higher prices led to more construction, and excess building resulted in falling prices decreased/eliminated speculative demand, and a dramatic decrease in housing activity overall.

4. Demographic factors
   - Proportion of the population in the 25 to 40-year-old segment is positively related to activity in the housing sector as are the ages of greatest household formation.
   e. g. China had a strong population shift from rural to city areas due to manufacturing growth required large increases in the construction of new housing to accommodate needs.

Question 5

Neoclassical school

Answer 5

Beliefs:

• shifts in AD and AS are primarily driven by changes in technology over time.
• the economy has a strong tendency toward full-employment equilibrium, as recession puts downward pressure on the money wage rate or over full employment puts upward pressure on the money wage rate.
• the business cycles result from temporary deviations from LR equilibrium.

BUT: The Great Depression of the 1930s did not support the beliefs of neoclassical economists.

Question 6

Keynesian School

Answer 6

Beliefs:

• These fluctuations are primarily due to swings in the level of optimism of those who run businesses.
• They overinvest and overproduce when too optimistic about future growth in potential GDP, and underinvest and underproduce when too pessimistic or fearful about future growth in potential GDP.
• Wages are downward sticky reducing the ability of decrease in money wages to increase SRAS, and move economy from recession back to full employment.
• Increase AD directly, through monetary policy (increase MS) or fiscal policy (increase G, or decrease T)

Question 7

New Keynesian school

Answer 7

Thsi added the assertion that the prices of productive inputs other than labor are also downward sticky presenting additional barriers to the restoration of full-employment equilbrium.

Question 8

Monetarist School

Answer 8

Belief:

• The variations in AD that cause business cycles are due to variations in the rate of growth of the money supply, likely from inappropriate decisions by the monetary authorities.
• The recessions can be caused by external shocks or by inappropriate decreases in money supply.
• To keep AD stable and growing, the central bank should follow a policy of steady and predictable increases in money supply.

Question 9

Austrian school

Answer 9

Belief:

• The business cycles are caused by government intervention in the economy.
• With policymakers forcing interest rates down to artificially low levels, firms invest too much capital in the long-term, and speculative lines of production compared to actual consumer demand.
• If investments turn out poorly, firms must decrease output in those lines, which causes contraction.

Question 10

New Classical School

Answer 10

Introduced as real business cycle theory (RBC):

• This emphasises the effect of real economic variable such as changes in technology and external shocks, opposed to monetary variables causing business cycles.
• This applies utility theory, which individuals and firms maximise expected utility.
• The policymakers should not try to counteract business cycles as expansions and contractions are efficient market responses to real external shocks.

Question 11

3 categories of unemployment:

Answer 11

1. Frictional unemployment
2. Structural unemployment
3. Cyclical unemployment

Question 12

Frictional unemployment

Answer 12

This results from the time lag necessary to match employees who seek work with employers needing their skills.

This is always with us as employers expand or contract their businesses and workers move are fired or quit to seek others opportunities.

Question 13

Structural unemployment

Answer 13

This is caused by long rune changes in the economy that eliminate some jobs while generating others for which unemployed workers are not qualified.

Differs from frictional where unemployed workers do not currently have the skills needed to perform the jobs that are available.

Question 14

Cyclical unemployment

Answer 14

This is caused by changes in general level of economic activity.

This is positive when the economy is operating at less than full capacity, and can be negative when expansion leads to employment temporarily over full employment level.

Question 15

Unemployed

Answer 15

A person who is not working but is actively searching for work.

Question 16

Unemployment rate

Answer 16

The percentage of people in the labor force who are unemployed.

Question 17

Labor force

Answer 17

This includes all people who are either employed or unemployed,

Question 18

Voluntarily unemployed

Answer 18

People who choose not to be in the labor force, and are not included in the calculation of the unemployment rate.

Question 19

Underemployed

Answer 19

A person who is employed part time but would prefer to work full time or is employed at a low-paying job, despite being qualified for a significantly higher paying job.

The value is subjective and no easily discernable.

Question 20

Participation ratio

Answer 20

The percentage of working age population who are either employed or actively seeking employment.

Question 21

Discouraged workers

Answer 21

Those who are available to work but are neither employed nor actively seeking employment.

This causes the unemployment rate to be a lagging indicator of the business cycle.

During expansion - when hiring prospects begin to improve, the number of discouraged workers who re-enter the labor force greater than the number who are hired immediately, or firms tend are slow to hire or fire workers. This causes unemployment rate to increase even though employment is expanding.

Question 22

Inflation

Answer 22

• The persistent increase in the price level over time.
• This erodes the purchasing power of a currency.
• This favors borrowers at expense of lenders, as borrower returns the principal to the lender is worth less in terms of g/s (in real terms) than it was worth when borrowed.

Question 23

Hyperinflation

Answer 23

Inflation that accelerates out of control, which can destroy a country’s monetary system and bring about social and political upheavals.

Question 24

Inflation rate

Answer 24

The percentage increase in the price level, typically compared to the prior year.

An objective of central banks is to keep inflation within some target range, thus a business cycle indicator.

Question 25

Disinflation

Answer 25

This refers to inflation rate that is decreasing over time but remains greater than zero.

Question 26

Disinflation

Answer 26

This refers to an inflation rate that is decreasing over time but remains greater than zero.

Question 27

Deflation

Answer 27

A persistently decreasing price level (i.e. a negative inflation rate)

Commonly associated with deep recessions, as consumers delay purchases as they believe the same goods more cheaply in the future, and businesses decrease revenue and increase fixed costs.

Question 28

Price Index

Answer 28

A proxy for price level, measures the average price for a defined basket of goods and service.

Question 29

Consumer price index (CPI)

Answer 29

The basket that represents the purchasing patterns of the typical urban household.

Question 30

Price index for personal consumption expenditures

Answer 30

This index is created by surveying businesses rather than consumers.

Another alt: GDP deflator

Question 31

Producer price index (PPI)

Answer 31

This can be observed for different stages of processing (raw material, intermediate goods, and finished goods) to watch for emerging price pressure.

Sub-indexes of PPI are useful for identifying changes in relative prices of producers inputs, indicating shifts in demand among industries.

Question 32

Headline inflation

Answer 32

The price index of all goods.

Question 33

Core inflation

Answer 33

The price indexes that exclude food and other goods; thus a more useful measure of underlying trend in prices.

Question 34

Laspeyres index

Answer 34

3 factors that cause this index to be a biased upward as measure of cost of living:

1. New goods
   - older products are often replaced by newer, nut initially more expensive.
   - new goods added periodically to market, with older goods they replace are reduced in weight.
2. Quality changes
   - if price of product increases as product has improved, this is not due to inflation but increase in price index.
3. Substitution
   - in an inflation-free economy, prices of goods relative to each other change all the time.
   - 2 goods being substitutes to each other mean consumers increase purchases of relatively cheaper good and buy less of more expensive good, overtime making Laspeyres index less accurate measure.

Question 35

Hedonic pricing

Answer 35

This can be used to adjust a price index for product quality

Question 36

Fisher Index

Answer 36

To address the bias from substitution, reporting agencies can use a chained or chain-weighted price index.

Question 37

Unit labor costs

Answer 37

An indicator of wages and benefits in terms of productivity, the ratio of total labour compensation per hour to output units per hour.

(wage increases are not inflationary as long as the remain in line with gains in productivity).

Question 38

Expected inflation

Answer 38

The difference in yield between inflation-indexed bonds, such as Treasury Inflation-Protected Securities and similar non-indexed Treasury bonds.

(If workers expect inflation to increase, they will increase wage demands accordingly).

Question 39

Economic indicators can be classified into 3 different categories:

Answer 39

1. Leading indicator - known to change directions before peak and troughs.
2. Coincident indicators - known to change direction at roughly same time as peak and troughs.
3. Lagging indicators - known to not change direction until after expansion or contraction is already underway.

Question 40

Indexes for US (the Conference Board) include:

Answer 40

1. Leading indicators - S&P 500 equity price index, Leading Credit index, consumer expectations, 10 year Treasury to Fed funds interest rate spread.
2. Coincident indicators - real personal income, index of industrial production.
3. Lagging indicators - average duration of unemployment, average prime lending rate change in unit labor costs, inventory-sales ratio.

other sources: OECD, Economic Cycle Research Institute (ECRI)