Understanding Business Cycles Flashcards
The four phases of the business cycle under the “Growth Cycle”:
The more popular method over the “classical cycle”
- recovery
- expansion
- slowdown
- contraction
the growth cycle fluctuates in economic activity around the long-term potential trend growth level
Recovery phase characteristics
- when markets expect the end of a recession and the start of an expansion
- risky assets are repriced upward (investors expect higher corp. profits)
- the equity market typically hit a trough (low point) about 3-6 months before the economy hits the trough
- economy starts at trough and output is below potential
- activity levels are below potential but start to increase
- layoffs slow - businesses rely on overtime v hiring
- unemp remains > than avg
- inflation is moderate
- interest rates tend to be low
- capex is low but increasing
- increased orders for light producer equipment
- usually start with increased orders for new software systems and tech hardware to replace obsolescence
- consumer confidence starts improving
- consumer spending on durables is limited
Inventory/sale ratio: - begins to fall as sales recovery outpaces production
Expansion phase characteristics
boom phase
- firms have difficulty finding qualified labor
- wages rise
- firms borrow a lot to fund capacity expansion
- govt may step in to prevent overheating
- positive output gap opens
- activity measures are above avg growth rts
- firms hire more and rely less on OT and temps
- unemp rt stablezes/ falls
- inflation picks up modestly
- capacity utilization increases from low levels
- firms experience growth in earnings and CF
- firms start increasing investment spending
- orders for capital equipment are widely watched
- consumers experience rising incomes and greater confidence
- consumer spending on durables increases
Inventory/sale ratio:
- ratio is stable
Slowdown phase characteristics
- risk assets will have significant price increases
- rf assets (govt bonds) have lower prices and higher yields
- economy is peaking, positive output gap starts to narrow
- activity measures are > avg, but decelerating
- firms continue to hire, but at a slower pace
- unemp rt continues to fall, but at decreasing rates
- inflation further accelerates
- business conditions at peak with health CF (firms)
- interest rates tend to be higher; to encourage investment slowdown
- new orders intended to increase capacity may be an early indicator of late-stage expansion phase
- companies operate at or near capacity
- consumers remain confident
- consumer spending on durables is above average
Inventory/sale ratio: - ratio increases; signals a weakening economy
- ie sales slow and inventories increase
Contraction phase characteristics
- investors prefer safer assets; govt bonds and defensive companies
- economy weakens and MAY go into a recession
- negative output gap opens
- activity measures are below potential
- growth is lower than normal
- business cut hours, eliminate OT, freeze hiring, then layoff
- unemp rt starts to rise
- inflation decelerates but with a lag
- firms experience decreases in demand, profits, and CF
- new orders are halted, some existing orders are canceled
- starts with technology and light equipment, then on to construction and heavy equipment cuts - consumer confidence weakens
- consumer spending on durables is postponed
Inventory/sale ratio: - ratio begins to fall back to normal
Compared to business cycles, credit cycles tend to be …
- credit cycles tend to be longer, deeper, and sharper than the business cycles
Spending on durable goods is more or less impacted by the business cycle?
is more impacted
- durable goods (long lived items, cars, furniture) are the most cyclical
- non-durable goods are the least cyclical (food/meds)
Which sector of the economy is most sensitive to interest rate changes?
- housing sector
Exports rise with growth ….
- in the ROW
- imports rise with domestic GDP growth
A stronger domestic currency ….
- increases in imports
- decline in exports
A weaker domestic currency ….
- decrease in imports
- increase in exports
Neoclassical and Real Business Cycle (RBC) theory’s characteristics
- focus on fluctuations of aggregate supply
- markets will reach equilibrium because of the invisible hand
- no government intervention is needed as the govt lags
- companies that adopt innovation will survive
- manage expectations and remove information asymmetries
The Austrian School business cycle theory
- believes that business cycles are the outcome of excessive credit growth due to artificially low-interest rates
- largely agrees with neoclassical/RBC model
- low interest rates lead to widespread malinvestment
- govt involvement should be minimal; non-intervention theory
Monetarism theory and what they object to under Keynesian theory
- they focus on the money supply
- minimal govt involvement
- they reject active management of aggregate demand
- emphasize a steady money supply growth rate (in contrast to neoclassical)
- business cycles occur bc of exogenous shocks and govt intervention (shifts in AD)
- let AD and AS find their own equilibrium
objections to Keynesian:
- Keynesian model does not recognize the importance of the money supply
- keynesian model fails to consider long-term costs of govt intervention
- the timing of the govt’s economic policy response is uncertain and could cause more harm than good, because of lag
Keynesianism theory
- focus is on AD fluctuations
- if AD shifts left, the theory believes that it would be hard to restore equilibrium in the event of a crisis by wage and price reduction along
- wages are downward sticky
- even if wages decreased, consumption would decrease and AD would be lower - govt intervention is needed during a severe crisis
- govt monetary and fiscal policy is needed to keep capital and labor employed even if this teams a large fiscal deficit
- think that neoclassical and Austrian theory takes too long
- in the long run, we’re all dead
criticized for:
- fiscal deficit leads to more govt debt
- short term focus
- takes time to implement fiscal policy (lag)
Leading indicators:
- turning points that tend to precede those of the business cycle
- helpful in forecasting the economy in the near term
examples - avg weekly hrs, manufacturing (firms cut OT before a downturn and increase OT before hiring full-time during a recovery)
- avg weekly initial claims for unemp
- manufacturers’ new orders for consumer goods and materials
- ISM new order index (survey)
- manufacturers’ new orders for non-defense capital goods, ex aircraft (survey)
- private building permits
- S&P500 return
- leading credit index
- interest rate spread between 10-yr treasury and overnight borrowing rates.
- consumer expectations (survey)
Coincident indicators:
- turning points that tend to coincide with those of the business cycle
- used to indicate the current phase of the business cycle
examples - manufacturing activity
- personal income
- number of non-agricultural employees
Lagging indicators:
- have turning points that tend to occur after those of the business cycle examples - bank prime lending rate - inventory to sales ratio - average duration of unemployment
Importance of unemployment
- unemployment is at its lowest (tight labor market) at the peak of the business cycle
- workers demand higher wages
- wages are the largest expense to firms
- when wages increase SRAS shifts to the left, causing a decrease in RGDP
- may trigger downturn in economy
- if central banks act to tame inflation, it may result in a recession
- unemployment is at its highest levels at the trough of the economic cycle
- unemployment is a lagging indicator
- inflation is pro-cyclical
Q: a situation where qualified workers are not immediately matched with existing job openings is best described as…
- frictionally unemployment
Structurally unemployed
- employers are looking for a different set of skills
- due to changes in business, technology, etc
Activity (participation) ratio:
= labor force / total population of working age
Unemployment ratio:
= unemployed / labor force
this is a lagging indicator bc
- firms are reluctant to lay off people as it is more expensive to hire and train new employees
- in difficult economic times, discouraged workers stop looking for jobs (so they are not counted as unemp)
- so unemployed number becomes low - as the economic recovers, they start looking for jobs again, and the unemployment number increases
- undermining the recovery
Payroll and productivity
analysts look at payroll growth
- if payroll numbers are increasing, then unemployment is decreasing
- during a recovery, firms increase OT instead of hiring new workers, then increase temps
- at econ cycle peak, OT decreases before layoffs start
productivity = output / labor
an increase in productivity precedes an increase in full-time payrolls
- ie firms are operating with very lean teams
Inflation
- inflation is the SUSTAINED RISE in the overall level of prices in an economy
- high inflation, fast economic growth, and low unemployment indicate the economy is overheating. this may trigger some policy movements to tame inflation
- equilibrium GDP is above potential GDP
- high inflation, high unemployment, and slow economic growth results in stagflation)
Deflation
- a sustained decrease in aggregate price levels
- price level comes down from 100 to 99 to 98 and so on
- the value of money increases in deflation
- deflation is not good (Great Depression)
falling prices = lower revenue for firms,
real debt borrowed by companies increases
cuts in spending and investment
economy declines further
Hyperinflation
- an extremely fast increase in aggregate price levels.
- ie over a 3 yr period, if the price level doubles, its hyperinflation
occurs when
- govt spending is greater than real tax revenue and there is an unlimited money supply
- usually after a war when the supply of G/S is limited and there is too much money supply
Disinflation
- a decline in the inflation rate, or decelerating inflation
- prices are still going up, but at a slower rate than earlier
Laspeyres index:
definition, characteristics and biases
- the most common type of index
- created by holding the consumption basket constant
- a base-weighted index
- the consumption basket is updated every 5 or so years
Biases: (all will cause the index to be overstated, upward)
- substitution bias: the index does not count on consumers choosing cheaper alternatives
- quality bias: G/S quality improves over time
- new product bias: new products entering the market are not included in the consumption basket
Paasche index
definition, characteristics
- allows for the composition of the basket to change
- uses the consumption in the current period
- measures the change in price of the consumption basket weighted by using the quantities in the current period
limitations:
- it is difficult to make comparisons on a periodic basis as different weights are used every time
Laspeyres index formula
over two years with two different goods
inflation rate for yr 2 = (good A base Q * current P) + (good B base Q * current P) /
(good A base Q * base P) + (good B base Q * base P)
then compare the inflation rate for yr 2 v yr 1 to find the delta
Paasche index formula
over two years with two different goods
inflation rate for yr 2 = (good A current Q * current P) + (good B current Q * current P) /
(good A current Q * base P) + (good B current Q * base P)
then compare inflation rate for yr 2 with yr 1 and find the delta
Fischer index
- uses the geometric mean of the Laspeyres index and the Passche index
Fisher index = squrt of (Laspeyres * Paasche)
Cost-push inflation:
- inflation that results from a decrease in aggregate supply
- caused by an increase in the real price of an important factor of production (wages / raw material)
- AKA wage-push inflation
Demand-pull inflation
- inflation that results from an increase in aggregate demand
- price levels increase and economic output increases above its potential or full-emp level
- there is an inflationary gap
an increase to AD may be caused by:
- increase in money supply
- increase in govt spending
- increased exports
Demand-pull inflation would least likely be caused by an increase in
- fuel prices
- govt spending
- money supply
fuel prices
Two analysts made the following statements:
Analyst 1: Inventories tend to rise when inventory-sales ratios are low.
Analyst 2: Inventories tend to rise when inventory-sales ratios are high.
Which analyst is most likely correct?
A. 1
B. 2
C. neither
A is correct. When the economy starts to recover, sales of inventories can outpace production, which results in low inventory-sales ratios. Companies then need to build inventory to meet demand.
Temporary earnings fluctuations least likely provide a guide to:
A. savings rate
B. spending on services
C. spending on durable goods
B. spending on services
B is correct. Households adjust services consumption based on perceived permanent income level rather than temporary earning fluctuations. 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. Savings rate and durable good consumption are more related to the short-term uncertainties caused by recession.
