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 Number10 Average duration56 months Longest cycle120 months ( ) Shortest cycle28 months ( ) Average expansion57 months Shortest expansion12 months ( ) Longest expansion*120 months ( ) Average recession11 months Shortest recession6 months (1980) Longest Recession17 months ( ) * as of February, 2000

6 Phases of the Business Cycle Time Real GDP 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

7 Phases and Measurement of Cycles  Trend  Directional movement of the economy over an extended time, usually 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 LOW Pessimism HIGH

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 HIGH Optimism

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  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.)

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 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 Psychological Causes of the Business Cycle

20  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 Monetary, Spending & Saving Causes of the Business Cycle

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

Business Cycle  Productivity gains  Low energy costs  Causes of contraction  September 11 th 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