Chapter 15

1. Chapter 15 Business Cycles © 2001 South-Western College Publishing

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

3. Types and Lengths of Cycles • Minor cycles • relatively mild intensity, noticeable but not severe • short • numerous • Major cycles • wide fluctuations, serious contractions or depressions • widespread unemployment • lower output • low profits or net losses

4. Other Types of Cycles • Long-wave building cycles • Commodity price fluctuations • Stock market price fluctuations

5. Duration of Business Cycles since WWII Number 9 Average duration 56 months Longest cycle 118 months (1961-1970) Shortest cycle 28 months (1980-1982) Average expansion 48 months Shortest expansion 12 months (1980-1981) Longest expansion* 107 months (1991 - ?) Average recession 11 months Shortest recession 6 months (1980) Longest Recession 17 months (1981-1982) *as of February, 2000

6. Phases and Measurement of Cycles • Contraction - drop in level of business activity • Peak - highest level of activity in a cycle • Trough - lowest level of activity in a cycle • Expansion - rise in level of activity

7. Phases of the Business Cycle Peak Real GDP Expansion Contraction Trough Time

8. Phases and Measurement of Cycles • Trend - directional 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 Fluctuations - changes in activity caused by unexpected events • Cyclical Fluctuations - changes in activity that occur regardless of trend, seasonal variations, or random forces

9. Pattern of Cycles • Internal Forces • elements within the sphere of business activity • production • income • demand • credit • interest rates • inventories

10. Pattern of Cycles • External Forces • elements outside the normal scope of business activity • population growth • wars • basic changes in nation’s currency • national economic policies • floods, droughts, other catastrophes

11. Trough • Output • Employment • Income • Price • Costs • Profits • Investment PessimismHIGH LOW

12. Expansion • External factors • Cost-price relationship • Replacement of depleted inventories • Low interest rates • Investment increases • Demand increases • Employment and income increase

13. Peak • Output • Employment • Income • Price • Profits • Investment Optimism HIGH

14. 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

15. Business Cycle Indicators • Leading Indicators • Roughly Coincident Indicators • Lagging Indicators

16. 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

17. Leading Indicators (cont.) • 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

18. Coincident Indicators • Number of employees on nonagricultural payrolls • Personal income less transfer payments • Industrial production • Manufacturing and trade sales volume

19. 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

20. Causes of the Business Cycle • Real or physical causes • Innovation theory: business cycles are caused by breakthroughs in the form of new products, new methods, new machines, or new techniques • Agricultural theories: business cycles relate the general level of business activity to the weather

21. Causes of the Business Cycle (cont.) • Psychological causes • Psychological theory: when investors and consumers react according to some belief about future conditions, their actions tend to transform their outlook into reality • Rational expectations theory: suggests that individuals and businesses act or react according to what they think is going to happen in the future, after considering all available information

22. Causes of the Business Cycle (cont.) • Monetary theory: the business cycle is caused by the free and easy expansion of the money supply • Spending 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