Chapter 15

1. Chapter 15 Business Cycles © 2003 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 10 Average duration 56 months Longest cycle 120 months (1991-2001) Shortest cycle 28 months (1980-1982) Average expansion 57 months Shortest expansion 12 months (1980-1981) Longest expansion* 120 months (1991 - 2001) Average recession 11 months Shortest recession 6 months (1980) Longest Recession 17 months (1981-1982) *as of February, 2000

6. Phases of the Business Cycle Peak: highest level of economic activity in a particular cycle Expansion: rising level of economic activity Real GDP Contraction: noticeable drop in the level of business activity Trough: lowest level of business activity in a particular cycle Time

7. 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

8. Patterns of Cycles • Two kinds of elements or forces bring about business cycles • Internal: 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

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

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

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

12. 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

13. Business Cycle Indicators • Leading Indicators • Group of 11 indexes whose upward and downward turning points generally precede the peaks and troughs in general business activity • Roughly Coincident Indicators • Group of 4 indexes whose turning points usually correspond to the peaks and troughs of general business activity • Lagging Indicators • Group of 7 indexes whose turning points occur after the turning points for the general level of business activity have been reached

14. 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

15. 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

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

17. 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

18. Real or Physical Causes of the Business Cycle • 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

19. Psychological Causes of the Business Cycle • 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

20. Monetary, Spending & Saving Causes of the Business Cycle • Monetary theory • 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

21. 1991-2001 Business Cycle • Longest cyclical expansion in U.S. history & subsequent recession one of the mildest • Causes of expansion • Usual ingredients for cyclical recovery • Monetary and fiscal policies conducive to economic growth • Rapid introductions of new applications of innovations in communication and computer technology, including Internet

22. 1991-2001 Business Cycle • Productivity gains • Low energy costs • Causes of contraction • September 11th and its impact on travel related industries • Collapse of several major companies such as Enron, WorldCom, etc. • Declines in equity markets and their impact on personal wealth