Economics - Understanding Business Cycles, CFA Level 1

Level I – Economics Understanding Business Cycles 1 Contents and Introduction 1. Introduction This reading focuses on short-term movements in economic activity 2. Overview of the Business Cycle 3. Theories of the Business Cycle 4. Unemployment and Inflation 5. Economic Indicators 2 2. Overview of the Business Cycle Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of events is recurrent but not periodic; in duration, business cycles vary from more than one year to 10 or 12 years. Burns and Mitchell (1946) 3 2.1 Phases of the Business Cycle Level of National Economic Activity Four stages of the business cycle: 1. Expansion: real GDP is increasing ▪ ▪ 2. 3. 4. Early Expansion Late Expansion Peak: real GDP stops increasing Contraction/recession: real GDP is decreasing Trough: real GDP stops decreasing Time 4 Exhibit 1: Business Cycle Characteristics Early Expansion (Recovery) Late Expansion Peak Contraction (Recession) At what stage of the cycle is labor productivity likely to be the highest? 5 Exhibit 1: Business Cycle Characteristics Early Expansion (Recovery) Late Expansion Peak Contraction (Recession) Example 1 6 2.2 Resource Use through the Business Cycle Economic downturn starts → AD down/left → Inventories accumulate → production down (low utilization) → idling workers (less overtime) Capital Spending If downturn is severe companies may take aggressive measures External Trade Sector Inventory Draw the recessionary output gap using the SRAS, LRAS and AD curves. Economic fluctuations Housing Sector Consumer Behavior 7 Fluctuations in Capital Spending Spending on new capital equipment is sensitive to the business cycle. Shifts in capital spending affect economic cycle in three stages: Stage 1: Businesses see demand falling Stage 2: Economy begins initial recovery Stage 3: Late in the cyclic upturn Reduce/cut maintenance cost; halt new orders; cancel existing orders if possible Small orders easily cancelled; cutbacks on large orders take longer Negative impact on economy Capital spending rises because: 1) Growth in earnings 2) Some cancelled orders are reinstated Capital spending focused on capacity expansion: complex equipment, warehouses, factories Major indicator: orders for capital equipment Example 2 8 Fluctuations in Inventory Levels Inventory increase and decrease happens very rapidly and has a major effect on economic growth despite small size. Inventory/sales (I/S) ratio is an important indicator. Stage 1: top of economic cycle; sales fall or slow Takes a while to cut back on production; inventory accumulates → I/S ratio up Cut production to reduce inventory Layoffs and cancelled orders might exaggerate downturn Stage 2: Production rate less than sales rate Stage 3: Sales begin cyclic upturn I/S ratio falls Initially production does not keep pace with sales → I/S falls Surge in production Turn in hiring patterns Once I/S is at a normal level production is increased even though sales might not be up Example 3 9 Consumer Behavior • 70% of U.S. economy • Patterns of household consumption determine overall economic direction of economy more than any other sector • Major indicator of household consumption: retail sales ▪ Some indicators make a distinction between durable goods, non-durable goods, services • Durables are more sensitive to the economic cycle (why?) • Growth in income provides an indication of consumption prospects ▪ Some analysts focus on ‘permanent’ income • Example 4 10 2.3 Housing Sector Behavior • Smaller part of overall economy compared with consumer spending, but can move up and down quickly; hence can count more in overall economic movements than the sector’s relatively small size might suggest • Generally statistics on housing are easily available in developed countries • Sector is particularly sensitive to interest rates • Housing sector might follow its own internal cycle • Sector is sensitive to demographics • Example 5 11 2.4 External Trade Sector Behavior • This sector varies in size and importance from one country to another • Imports rise with domestic GDP growth • Exports rise with growth in the rest of world • Currency value has a major impact on imports/exports • Example 6 12 3. Theories of the Business Cycle Until the 1930s economists believed that business cycles were a natural feature of the economy and recessions were temporary. The Great Depression changed that view and gave rise to new schools of economic thought. 13 3.1 Neoclassical and Austrian Schools • Basic premise of the neoclassical school: markets will reach equilibrium because of the “invisible hand or free markets” ▪ All resources used efficiently based on MR = MC ▪ If an economic shocks shifts the AD or SRAS curve, the economy will quickly readjust and reach equilibrium via lower interest rates and lower wages • The Austrian school largely agreed with the neoclassical model but is more focused on role of low interest rates and the resulting excessive credit growth ▪ Business cycles are the outcome of overinvestment in projects with low return; when interest rates rise these investments fail ▪ Government’s interference should be minimal because markets are self-stabilizing; 14 3.2 Keynesian and Monetarist Schools • Keynesian School ▪ Focus on AD fluctuations ▪ Wages are downward sticky, but even if lower wages accepted, consumption and hence AD will be lower ▪ Simply lowering interest rates would not ignite growth because of low business confidence and ‘animal instincts’ ▪ Government should use monetary AND fiscal policy to keep capital and labor employed even if this means a large fiscal deficit ▪ Agreed with Neoclassical and Austrian schools about economy self-correcting but ‘in the longrun we are all dead’ Example 7 15 Monetarist School • Monetarist school objected to Keynesian intervention for four reasons ▪ ▪ ▪ ▪ Keynesian model does not recognize importance of money supply Keynesian model lacks complete representation of utility-maximizing agents Keynesian model fails to consider long term costs of government intervention Timing of government’s economic policy response is uncertain • What do the monetarists say? ▪ ▪ ▪ ▪ Monetary and fiscal policy should be clear and consistent; limited role of government Grow money supply at steady predictable rate Business cycles occur because of exogenous shocks and government intervention Let AD and AS find own equilibrium rather than risking further economic fluctuation 16 3.3 The New Classical School • New classical macroeconomics models emphasize that economic agents should be represented with a utility function and a budget constraint ▪ Assume that all agents are roughly alike ▪ Two flavors: models without money and models with money • Models without Money: Real Business Cycle Theory ▪ Emphasizes effect of real economic variables such as changes in technology and external shocks ▪ Aggregate supply is an important part of the model ▪ Expansions and contractions represent efficient operation of the economy in response to external real shocks → government should not intervene with monetary and fiscal policy • Models with Money ▪ Build on RBC models but recognizing the role of monetary policy ▪ Neo-Keynesians (or New Keynesians) build models on microeconomic principles but say that frictions in the economy may prevent convergence and government intervention necessary Example 8 17 Summary of Business Cycle Schools School of Thought Comment Recommended Policy Neoclassical Invisible hand Do nothing Austrian Fluctuations caused by misguided government intervention Do nothing Keynesian Focus on the AD curve Economy does not automatically correct in the short-run Use fiscal and/or monetary policy because “in the long-run we are all dead” Monetarist Monetary policy Steady, predictable growth of money supply New Classical: RBC Expansions and contractions represent efficient operation of the economy in response to external real shocks Do nothing Example 9 18 4. Unemployment and Inflation Most governments try to limit unemployment and contain price inflation Unemployment at lowest level (tight labor market) Downturn Generally inflation is pro-cyclical Unemployment at highest level 19 4.1 Unemployment • Employed • Activity (participation) ratio • Labor force • Underemployed • Unemployed ▪ Long-term Unemployed ▪ Frictionally Unemployed ▪ Structurally Unemployed • Discouraged worker • Voluntarily unemployed 20 Unemployment (Cont…) • Unemployment rate = ratio of unemployed to labor force ▪ Most quoted measure of unemployment ▪ Measured differently in different countries ▪ Inaccurate at predicting direction of economy (lags the business cycle) ➢ Businesses reluctant to lay off people ➢ In difficult economic times discouraged workers stop looking for jobs (hence not counted as unemployed) • Overall Payroll Employment and Productivity Indicators ▪ ▪ ▪ ▪ To get a sense for the employment cycle analysts often look at payroll growth Other measures include overtime hours and number of temporary workers Drop in productivity precedes decrease in full-time payrolls Increase in productivity precedes increase in full-time payrolls Example 10 21 4.2 Inflation • Generally inflation is pro-cyclical (it goes up and down with the business cycle) • Inflation is the sustained rise in overall prices in an economy • Inflation rate is the percentage change in a price index • Inflation rates allow us to infer the state of the economy • Unexpected change in inflation my trigger a change in monetary policy which can impact asset prices • High inflation, fast economic growth and low unemployment indicate the economy is overheating 22 Deflation, Hyperinflation and Disinflation • Deflation: A sustained decrease in aggregate price level • Hyperinflation: An extremely fast increase in aggregate price level • Disinflation: A decline in the inflation rate 23 Measuring Inflation: The Construction of Price Indices • A price index represents the average prices of a basket of goods and services • Laspeyres index is the most common type of index and is created by holding consumption basket constant; this strategy introduces a few biases ▪ Substitution bias ▪ Quality bias ▪ New product bias • Paasche index allows for the composition of the basket to change • Fisher index uses the geometric mean of the above two indices 24 Example Date January 2012 February 2012 Goods Quantity Price Quantity Price Sugar 7 kg 90/kg 9 kg 110/kg Milk 10 Liters 100/Liter 12 Liters 120/Liter Assume the base period is January 2012. The price level for the base period is set to 100. Calculate the December price index as a: 1) Laspeyres index 2) Paasche index 3) Fisher index 25 Price Indices and Their Usage • Most countries use their own CPI to track inflation in the domestic economy • Weights of different categories vary across countries (Exhibit 6) • Scope of each index is different ▪ CPI-U ▪ PCE ▪ PPI • Many economic activities are indexed to a certain price index ▪ Treasury Inflation Protected Securities (TIPS) adjust bond’s par value based on CPI-U • • • • Central banks use CPI to monitor inflation Example 11 – Headline and Core Inflation Example 12 – Sub-Indices and Relative Prices Example 13 - Inflation 26 Explaining Inflation Cost-push inflation results from a decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as labor or energy • Commodity prices • Non-accelerating inflation rate of unemployment • Natural rate of unemployment • Productivity and unit labor cost • Example 14 Demand-pull inflation results from persistent increases in aggregate demand that increase the price level and temporarily increase economic output above its potential or full-employment level • If actual GDP is close to potential → shortages and bottlenecks → prices rise • Monetarist perspective: inflation is a monetary phenomenon ▪ Compare money growth with growth of nominal economy • Example 15 27 Inflation Expectations • Inflation expectations can be self-sustaining • Some analysts gauge inflation expectations based on past trends • Example 16 28 5. Economic Indicators We use economic indicators to assess the current state of the economy and for insights into future economic activity • Leading indicators have turning points that tend to precede those of the business cycle ▪ Weekly hours in manufacturing, S&P 500 return, private building permits • Coincident indicators have turning points that tend to coincide with those of the business cycle and are used to indicate the current phase of the business cycle ▪ Manufacturing activity, personal income, number of non-agricultural employees • Lagging indicators have turning points that tend to occur after those of the business cycle ▪ Bank prime lending rate, inventory-to-sales ratio, average duration of unemployment 29 Leading Indicators Leading Indicators 1. 2. 3. Average weekly hours, manufacturing Average weekly initial claims for unemployment insurance Manufacturers’ new orders for consumer goods and materials 4. Vendor performance, slower deliveries diffusion index 5. Manufacturers’ new orders for non-defense capital goods 6. Building permits for new private housing units 7. S&P 500 Stock Index 8. Money supply, real M2 9. Interest rate spread between 10-year treasury yields and overnight borrowing rates 10. Index of Consumer Expectations, University of Michigan In the U.S. the composite leading indicator is called the Index of Leading Economic Indicators (LEI) Different countries will have different composite indices Diffusion index reflects the proportion of the index’s components that are moving in a pattern consistent with the overall index 30 Coincident and Lagging Indicators Coincident Indicators Lagging Indicators 1. 2. 3. 4. 1. 2. 3. 4. 5. Employees on non-agricultural payrolls Aggregate real personal income Industrial Production Index Manufacturing and trade sales Coincident and lagging indicators can help confirm what leading indicators are telling us 6. 7. Trade associations and public agencies also provide aggregate cyclical measures Average duration of unemployment Inventory–sales ratio Change in unit labor costs Average bank prime lending rate Commercial and industrial loans outstanding Ratio of consumer installment debt to income Change in consumer price index for services Examples 17, 18, 19 31 Summary • Business cycle and its phases ▪ Inventory levels, labor and capital utilization at different phases of the cycle • • • • Classical, Keynesian, Monetarist and RBC theories Types and measures of unemployment Price levels and inflation Economic indicators 32 Conclusion • Read summary • Review learning objectives • Examples • Practice problems • Practice questions from other sources 33