Lecture Economics for investment decision makers: Chapter 6 - CFA In stitute

Chapter 6 - Understanding business cycles. This chapter describe the business cycle and its phases; describe the typical patterns of resource use fluctuation, housing sector activity, and external trade sector activity, as an economy moves through the business cycle; describe theories of the business cycle;...

Overview of the business cycle

• A business cycle consists of an expansionary period and a contractionary

period

• Characteristics of a business cycle:

- They are typical in economies that rely on business enterprises

- There are alternating phases of expansion and contraction

- Phases occur throughout the economy, most often simultaneously

- Phases reoccur, but vary in duration and intensity

• An expansion occurs after a low point (the trough) and a contraction occurs after the highest point (the peak).

• A contraction

- is also referred to as a recession

- is referred to as a depression if severe and if aggregate activity declines

Typical scenario: recession

Typical scenario: Expansion

Business cycle Summary

to expansion.

Accelerating rate of growth

Decelerating rate

of growth

Declines

hiring does not yet occur and the unemployment rate remains high

Unemployment rate falls to low levels.

Unemployment rate continues to fall.

Unemployment rate rises.

producer equipment.

Upturn becomes more broad based

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 by a lag via cutbacks in other forms of capital spending.

moderate and may continue to fall.

Inflation picks

up modestly. Inflation further accelerates. Inflation decelerates but with a lag.

Theories of business cycles

• Different schools of economic thought are used to explain the causes of business cycles

• These schools of thought offer different prescriptions with regard to

government actions that may affect the economy

Neoclassical and Austrian

• Neoclassical school of economic thought:

- The “invisible hand” (that is, free market) will result in a price for every good

for which there is supply and demand

demand

- This school cannot explain a prolonged depression Any declines in

aggregate demand would be temporary

• Austrian school of economic thought:

- This school is similar to neoclassical but considers the role of the money

supply and government actions

- Government intervention may cause a boom-and-bust cycle

Keynesian theory of business cycles

• In the event of lower aggregate demand, lower wages result in lower spending, hence affecting demand further

• Very low interest rates would not stimulate the economy because confidence would be too low

• Government should intervene in a crisis, running a deficit

• Criticisms of this theory:

- Government debt could get out of control

- Expansionary policy may cause the economy to grow too fast, resulting in inflation and other ills

- It takes time for fiscal policies to work, so they may be ill timed for a term crisis

• Those following the monetarist school of thought object to the Keynesian

approach because Keynesian theory

- does not consider the role of the money supply

- is not logical in light of utility-maximizing market participants

- ignores the long-term cost of government intervention

- does not consider the unpredictability of the timing of fiscal policy changes on the economy

• Monetarists advocate for a steady increase in the money supply and a limited role of government

New Classical School

• The new classical school uses the idea that utility-maximizing agents will seek

to maximize profits

• Real business cycle (RBC) theory:

- Business cycles are the result of the efficient operation of the economy in response to real shocks

- The RBC theory considers unemployment the result of persons wanting

wages that are too high

- It is criticized as being an unrealistic assumption

• Neo-Keynesians (new Keynesians):

- Neo-Keynesians assume slow-to-adjust wages and prices

- Government intervention is needed in the event of disequilibrium

Unemployment and inflation

• Types of unemployment:

looking

higher-paying job

voluntarily

• Measures describing the labor market:

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Productivity measures

Labor force indicators:

• The unemployment rate (the ratio of the number of unemployed persons to the labor force) lags the current environment

• Issues:

- Distortions from discouraged workers: The number of unemployed may drop because workers become discouraged and may increase when they rejoin the workforce to resume searching

- Reluctance of employers to lay off workers when business slows and to hire when business increases

• Payroll growth does not fully cover employment at small businesses

• Hours worked (including overtime) and use of temporary workers are indicators

of slowing and recovering businesses

- The inflation rate is the percentage change in a price index

- The purchasing power of money decreases

- The liability of the borrower decreases if the loan has fixed monetary terms

inflation rate)

- The purchasing power of money increases

- The liability of the borrower increases if the loan has fixed monetary terms

- It generally occurs when government spending is not backed with tax

Measuring inflation

- In the United States, the CPI covers only urban areas.

- It is used by US Treasury inflation protected securities (TIPS) and other contracts

- The personal consumption expenditures (PCE) price index covers all

consumption using surveys

- The producer price index (PPI), also known as the wholesale price index

(WPI), tracks inflation in prices of goods and services to domestic producers

Sources and measures of inflation expectations

• Sources of inflation

consumers

- Measure: Unit labor cost (ULC) = Total labor compensation per hour per

worker (W) divided by output per hour per worker (O) = W/O

- Measures: Money supply indicators and money supply growth compared with growth in the nominal GDP

- The velocity of money is the ratio of nominal GDP to the money supply and is a measure of the likelihood of inflationary pressures

• Measures of inflation expectations:

- Extrapolation of trends in inflation

- Surveys of inflation expectations

Economic indicators

An economic indicator is a measure that provides information about the state

of the overall economy

• A leading economic indicator is a measure that has turning points that

precede changes in the economy

• A coincident economic indicator has turning points that coincide with the

changes in the economy

• A lagging economic indicator has turning points that are later than changes

in the economy

Economic indicators, examples

Economic indicators and

the business cycle

Conclusions and Summary

• Business cycles are a fundamental feature of market economies and consist of four phases (trough, expansion, peak, and contraction), but their amplitude and length varies considerably

• Keynesian theories focus on fluctuations of aggregate demand (AD) and

advocate for government intervention

• Monetarists argue that the timing of government policies is uncertain, and it is generally better to let the economy find its new equilibrium unassisted but

ensure that the money supply keeps growing at an even pace

• New classical and real business cycle theories also consider fluctuations of aggregate supply (AS) Government intervention is generally not necessary because it may exacerbate the fluctuation or delay the convergence to

equilibrium

• New Keynesians argue that frictions in the economy may prevent convergence

to equilibrium and government policies may be needed

Conclusions and Summary

• The demand for factors of production may change in the short run as a result

of changes in all components of GDP: consumption, investment, government, and net exports Any shifts in AD and AS will affect the demand for the factors

of production (capital and labor) that are used to produce the new level of GDP

• Unemployment has different subcategories, including frictionally unemployed, long-term unemployed, discouraged workers, and voluntarily unemployed

• There are different types of price-level movements: inflation, disinflation,

deflation, and hyperinflation

• Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle is occurring

• Price levels are affected by real factors and monetary factors

• Inflation is measured by many indices, including consumer price indices and