Chapter 15

Business Cycles

© 2003 South-Western College Publishing

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The Business Cycle

The rise and fall of economic activity relative to the economy’s long-term growth trend

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Types and Lengths of Cycles Minor cycles

relatively mild intensity, noticeable but not severeshortnumerous

Major cycleswide fluctuations, serious contractions or

depressionswidespread unemploymentlower outputlow profits or net losses

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Other Types of Cycles

Long-wave building cyclesCommodity price fluctuationsStock market price fluctuations

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Duration of Business Cycles since WWII

Number 10Average duration 56 monthsLongest cycle 120 months (1991-2001)Shortest cycle 28 months (1980-1982)Average expansion 57 monthsShortest expansion 12 months (1980-1981)Longest expansion* 120 months (1991 - 2001)Average recession 11 monthsShortest recession 6 months (1980)Longest Recession 17 months (1981-1982)*as of February, 2000

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Phases of the Business Cycle

Time

Rea

l G

DP

Peak: highest level of economic activity in a particular cycle

Contraction: noticeable drop in the level of business activity

Trough: lowest level of business activity in a particular cycle

Expansion: rising level of economic activity

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Phases and Measurement of Cycles

TrendDirectional movement of the economy over an

extended time, usually 20-30 years Seasonal Variations

Recurring fluctuations in activity in a given period, usually 1 year

Random FluctuationsChanges in activity caused by unexpected events

Cyclical FluctuationsChanges in activity that occur regardless of trend,

seasonal variations, or random forces

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Patterns of Cycles

Two kinds of elements or forces bring about business cyclesInternal: elements within the very sphere of

business activity itself: production, income, demand, credit, interest rates, inventories

External: elements outside the normal scope of business activity: population growth, wars, basic changes in nation’s currency, national economic policies, natural disasters

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Trough

OutputEmployment IncomePriceCostsProfits Investment

LOW

PessimismHIGH

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Expansion

External factorsCost-price relationshipReplacement of depleted inventoriesLow interest ratesInvestment increasesDemand increasesEmployment and income increase

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Peak

OutputEmploymentIncomePriceProfitsInvestment

HIGH Optimism

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Contraction Output, employment, income at peak Consumer demand tapers off Prices level out, inventories increase Costs increase, profit margins diminish Demand slackens, firms reduce excess

inventories Output is cut, and so are income and

employment Investments discouraged & outlook

pessimistic

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Business Cycle Indicators Leading IndicatorsLeading Indicators

Group of 11 indexes whose upward and downward turning points generally precede the peaks and troughs in general business activity

Roughly Coincident IndicatorsRoughly Coincident IndicatorsGroup of 4 indexes whose turning points usually

correspond to the peaks and troughs of general business activity

Lagging IndicatorsLagging IndicatorsGroup of 7 indexes whose turning points occur after

the turning points for the general level of business activity have been reached

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Leading Indicators

Average work week for production workers in manufacturing

Rate of layoffs in manufacturing New orders for consumer goods and materials New business formations Contracts and orders for plant an equipment Vendor performance, measured as a % of

companies reporting slower deliveries from suppliers

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Number of new building permits issued for private housing units

Net change in inventories Change in sensitive prices Change in total liquid assets Changes in money supply

Leading Indicators (cont.)

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Coincident Indicators

Number of employees on nonagricultural payrolls

Personal income less transfer paymentsIndustrial productionManufacturing and trade sales volume

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Lagging Indicators

Average duration of employment Change in labor cost per unit of output Average prime rate charged by banks Commercial and industrial loans outstanding Ratio of consumer installment loans

outstanding to personal income Change in the CPI for services Ratio of manufacturing and trade inventories

to sales

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Real or Physical Causes of the Business Cycle

Innovation theoryBusiness cycles are caused by breakthroughs

in the form of new products, new methods, new machines, or new techniques

Agricultural theoriesBusiness cycles relate the general level of

business activity to the weather

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Psychological theoryWhen investors and consumers react according to

some belief about future conditions, their actions tend to transform their outlook into reality

Rational expectations theorySuggests that individuals and businesses act or react

according to what they think is going to happen in the future, after considering all available information

Psychological Causes of the Business Cycle

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Monetary theoryMonetary theoryBusiness cycle is caused by the free and easy

expansion of the money supply Spending and saving causesSpending and saving causes

Underconsumption theories: cycles are caused by the failure to spend all national income, resulting in unsold goods, reduced total production, and consequent reductions in employment and income

Underinvestment theories: recessions occur because of inadequate investment in the economy

Monetary, Spending & Saving Causes of the Business Cycle

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1991-2001 Business Cycle

Longest cyclical expansion in U.S. history & subsequent recession one of the mildest

Causes of expansionUsual ingredients for cyclical recoveryMonetary and fiscal policies conducive to economic

growthRapid introductions of new applications of

innovations in communication and computer technology, including Internet

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1991-2001 Business Cycle

Productivity gainsLow energy costs

Causes of contractionSeptember 11th and its impact on travel related

industriesCollapse of several major companies such as Enron,

WorldCom, etc.Declines in equity markets and their impact on

personal wealth