Economic Cycle

1. Economic Cycle • Economic Cycle = one complete movement from peak to peak (or trough to trough) • Peak = height of economic prosperity. • Contraction = downturn in the economy. • Expansion = period of positive economic growth. • Recession = period when national economic growth is negative for 2 or more consecutive quarters. • Trough = lowest point in the cycle.

2. Economic Cycle % Nat. Econ Growth Peak Expansion Contraction Recession Trough Time ===>

3. Four Stages of an Economic Cycle Examples of historical cycles (trough to trough): 1959-1969, 1969-1975, 1975-1980, 1980-1989, 1989-1991, 1991-2001

4. Long-Term and Short-Term Interest Rates • What is “short term” and what is “long term?” • Short Term: U.S. T-Bills (8/20/12) 3-month 0.09 • 6-month 0.13 • 1-year 0.18

5. Long-Term and Short-Term Interest Rates • Longer-Term Investments: U.S. Treasury Bonds... • Time Period08/20/2012 Interest Rate • 5-year .79 • 10-year 1.81 • 30-year 2.93 • Interest rates on long-term investments can be thought of as the average of future short-term rates expected by investors.

6. The Spread - The difference between long-term and short-term interest rates. Source: Board of Governors of the Federal Reserve.

7. What does the difference between long-term and short-term interest rates tell us? • Large positive difference (i.e., long-term r minus short-term r is positive and large) • investors think that interest rates will rise in the future • short-term interest rates will rise at a faster pace than long-term interest rates

8. What does the difference between long-term and short-term interest rates tell us? • Large negative difference (i.e., long-term r minus short-term r is negative and large) • investors think that interest rates will fall in the future • short-term interest rates will fall at a faster pace than long-term interest rates fall

9. Since 1975... • In all instances where the spread was negative, interest rates subsequently fell. • The more negative the spread, the bigger the decline in interest rates that occurred. • In instances where there were large positive spreads, interest rates subsequently rose.

10. Other info the difference between long-term and short-term interest rates gives us... • The spread tells us something about what is likely to happen to national economic growth in the near future. • Important information regarding forecast for future employment • Important information regarding what is likely to happen to financial markets and interest rates • Important information regarding future inflation

11. Making Economic Forecasts • Why do families and households care about economic forecasts? • Implications for the costs of borrowing • Implications for the benefits of saving • Implications for the mix of human, physical, and financial capital families should hold • Implications for risk management

12. What indicators can/do help families make accurate forecasts? • Business cycle information - i.e., what is happening to real national economic growth. Where have we been recently? • Recent rates of inflation (look to CPI) • The spread between long- and short-term interest rates (comparison between 10-yr bonds and 3-6 month T-bills)