Reading 18 LOS's

Question 1

LOS 18a: Describe the business cycle and its phases

Answer 1

Overview of Business Cycles

• Business cycles usually occur in economies that mainly rely on business enterprises
• There is a sequence of distinct phases that comprise a business cycle
• Almost all sectors of the economy undergo the phases of the business cycle at about the same time
• Business cycles are recurrent, but they are not periodic
• Business cycles typically last between 1 and 12 years

Phases of the Business Cycle

• The trough is the lowest point of the business cycle, as the economy comes out of a recession towards an expansion
• An expansion occurs after the trough and before the peak. It is a period during which aggregate economic activity is increasing
• the peak is the highest point of a business cycle, as the expansion slows down and the economy moves towards a recession
• A contraction ( or recession) occurs after the peak. It is a period during which aggregate economic activity is declining. A particularly sever recession is known as a depression

A boom generall occurs in the latter part of an expansion, when economic growth starts testing the limits of the economy

• Companies face a shortage of qualified workers so they start bidding wars to tempt employees away from competitors
• Companies borrow money to expand production capacity
• Excessive salary growth can lead to inflation, while excessive borrowing can result in cash flow problems. During the boom, the economy is said to be overheating, so typically central banks step in to cool it down

The peak occurs at the end of the expansion or boom and signals the onset of a contraction, which are characterized by rising unemployment and declining GDP growth

Resource use Through the Business Cycle

Fluctuations in inventory, employment, and investment are linked to fluctuations in the economy. For example suppose the economy is overheating so the central bank cools it down by raising interest rates. This leads to a decrease in demand, which leads to a decrease in price, which leads to a scale down in production. Workers receive less and the capital is not used fully, reducing AD and GDP. Here unemployment is above its natural rate, and wages and prices are low.

Eventually the central bank will cut interest rates to revive the economy. This will indicate the turning point of the business cycle, as increased production will increase demand. Companies will begin inventory rebuilding or restocking with old capital and then will eventually find new capital. As AD continues to grow, the economy will head back into expansion and possibly a boom.

Question 2

LOS 18b: Describe how resource use, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle

Answer 2

Changes in capital spending affect business cucles in three stages:

• Stage 1 - Spending on equipment falls off abruptly at the onset of an economic slowdown. Initially, orders for tech and light equipment are cut and then cuts on construction and installation of more complex pieces takes place later. These cutbacks add the the slowdown in the economy
• Stage 2 - In the inital stages of an economic recovery, orders begin to pick up due to the following
  
  • Increase in earnings and free cash flow encourages businesses to increase spending
  • The upturn in sales encourages managers to reverse order cancellations that were made hastily in the early stages of the preceeding downturn
• Stage 3 - Eventually after an extended expansion, businesses are unable to meet consumer demand with existing capacity, an therefore, look to expand. In this stage, orders focus on heavy and complex equipment, warehouses, and factories as businesses look to increase capacity. Therefore, this phase of capital spending can occur very soon after the initial recovery is underway

Fluctuation in Inventory Levels

Inventory levels tend to fluctuate dramatically over the business cycle. An important inventory indicator is the inventory - sales ratio and its interaction with the business cycle can be broken down in 3 stages:

• Stage 1 - Typically companies are slow to cut back on production, which leads to inventory build up in slow times. Because inventories are part of AD, this build-up masks the slow down, thus analysts also examine final sales. Firms will try to liquidate this excess inventory marking down prices, worsening the downturn
• Stage 2 - As business continue to cut back on production the inventory-sales ratio approaches normal levels. Then they eventually will start to increase production, a sing that marks the beginning of an upturn
• Stage 3- During the upturn, as sales rise, business will struggle to keep pace, leading to declines in inventory, and a very low inventory-sale ratio. This will encourage businesses to start hiring and increasing capital

Consumer Behavior

Household consumption is typically the largest single sector in almost every developed economy. 2 measures of household consumption are retail sales and a broad based indicator of consumer spending.

Sales data is usually presented in nominal terms so it is deflated to identify trends in real sales growth. Analysts break consumer spending into

• Durable goods
• Nondurable goods
• Services

Since durable goods typically have longer useful lives, households are more willing to defer purchases, therefore;

• A decrease in spending on durable goods relative to nondurable goods and services is an early indication of economic weakness

Surveys are also used to evaluate consumer confidence or sentiment and to gain insights into future spending patterns.

A better indicator of consumer spending is growth in disposable income. Another measure frequently used by analysts is permanent income, which adjusts for temporary unsustainable sources of income and estimates the income that households can rely on.

Unfortunately, consumer spending frequently diverges from income, making it difficult to predict consumer spending patterns based on estimates of income alone. Analysus of the savings rate can also be useful:

• Fluctuations in the savings rate capture changes in consumers willingness to reduce spending out of current income
• the savings rate is also a good indicator of consumer’s expectations regarding future income

Housing Sector Behavior

Although the housing sector forms a relatively small part of the economy, fluctuations in the sector occur so rapidly that is makes a significant contribution to overall economic movements.

• Since most home sales are usually financed by mortgage loans, housing sector activity is particularly sensitive to the level of interest rates
• Home sales are also affected by income levels relative to housing prices

Typicalls towards the end of an expansion, housing prices are relatively high to wage prices. The resulting slowdown normally indicates the end of the expansion, unless something like 2008 is experienced again, with speculative home buying.

External Trade Sector Behavior

The contribtuion of the external sector to GDP varies considerably from country to country. So Generally speaking:

• An increase in domestic GDP leads to an increase in demand for imports. Domestic exports usually tend to rise with an increase in GDP of major trading partners even if the domestic economy is weak. Therefore. patterns of external trade balances are not directly linke to domestic economic cycles
• An appreciation of the domestic currency makes imports cheaper and at the same time makes domestic goods more expensive for trading partners
• GDP growth differentials have a more immediate and straightforward impact on the external trade balance
• Currency Movements have a more complex and gradual impact on the trade balance

Question 3

LOS 18c: Describe theories of the business cycle

Answer 3

Neoclassical School of Thought

Assertions

• The invisible hand will lead the market toward general equilibrium
• Resources are allocated efficiently when MC = MR and there is no voluntary unemployment of labor and capital
• All that is produced will be sold as supply creates its own demand

Criticisms

• Great depression would not have occured if assertions were true
• There is no theory on business cycles. It only mentions Schumpeter’s creative destruction theory
• Treats economy-wide business cycles merely as short-term disequilibria which self-adjust

Austrian School of Thought

Assertions

• Shares some views with neoclassical but focuses more on money and governemtn
• They argue that when governments try to increase employment and GDP through expansionary monetary policies, interest rates fall below their natural level, which leads to overinvestment. This leads companies to cut back and causes a recession. Conclusion is that government only causes a “boom and bust” cycle

Criticisms

• Again the Great Depression, especially how government got economy out of it
• Attributes entire blame for business cycle on government

Keynesian School of Thought

Assertions

• The general price and wage reduction are hard to attain
• If nominal wages were reduced, that would result in a further decline in AD and actually exacerbate a recession
• Lower interest rates will not necessarily reignite growth due to weak business confidence
• The economy’s self correcting mechanisms will work in the long-run, but shold not be relied up on the short run, which is what really matters
• The government should step in during a recession and stimulate AD to keep labor and capital employed
• Note that Keynes did not encourage the government to be ever-present in fine-tuning the economy

Criticisms

• Fiscal deficits imply higher government debt, which must be serviced and repaid. The gov may lose control over finances trying to stimulate AD
• while the gov can try to fix the economy in the short run, its actions may result in the economy overheating in the long run
• There is a time lag until fiscal action take effect in the economy
• Does not give any importance to money supply

Monetarist School of Thought

Assertions

• Money supply is supremely important. The gov should maintain a steady growth rate of money supply
• If it grows too fast, there will be inflation and a boom. If too slow there will be recession
• The gov’s expansionary fiscal actions may take effect once the recession is over and actually do more harm than good
• Business cycles can be caused by exogenous shocks or gov actions

Criticism

• If everyone knows that the gov will lwoer interest rates in a recession, a company would not invest outside of a recession unless it had to. Therefore companies would stop investing until they cause a recession

The New Classical School (RBC Theory)
This school of thought is based on new classical macroeconomics. When an economic agent faces an external shock, its behaviour is governed by the aim of max utility. Further, the approach assumes that all economic agents are very similar, so thay all behave in a similar manner and markets gradually adjust towards equilibrium

Real Business Cycle (RBC) Theory

Assertions

• Business cycles have real causes. Monetary variables are assumed to have no impact on GDP and unemployment
• The gov should not intervene in the economy
• Unemployment is only short term
• Aggregate supply plays a more prominent role in bringing about business cycles

Criticisms:

• During recessions, people are eagerly looking for jobs and unable to find employment despite reducing their wage demands

Neo-Keynesian or New Keynesian Theory

Assertions

• Like the New Classical School, this theory seeks to draw macro conclusions based on mirco reasoning
• Market do not self-adjust seamlessly if they find themselves in disequilibrium. This is because :
  
  • Prices and wages are “downwardly sticky”
  • It is costly for companies to constantly update prices to clear markets
  • Companies need time to reorganize production in response to economic shocks

Question 4

LOS 18d: Describe types of unemployment and measures of unemployment

Answer 4

• Employed- Number of people with a job. This excludes those working in the informal sector
• Labor Force- Number of people who either have a job or are actively looking for one. This excludes the discouraged worker (not looking for a job)
• Unemployed - People who are currently without a job, but are actively looking for one
  
  • Long-term unemployed- people out of work for more than 3-4 months and still looking
  • Frictionally unemployed- people who have just left a job and are about ti start another one
• Unemployment Rate- ratio of the number of unemployed to the labor force
• Activity ratio- ratio of labor force to total working age population
• Underemployed- People who currently have jobs, but have qualifications to do significantly higher-paying jobs
• Discouraged Worker- a person who has stopped looking for a job. The official unemployment rate may decrease in a recession as a lot of people stop looking for work, and therefore are discouraged and not counted in unemployment
• Voluntarily unemployed- These are people who choose to remain outside the labor force

The unemployment Rate

Countries around the world use different calculations to compute the unemployment rate, which makes comparisons difficult. They are not useful in prediciting an economy’s cyclical direction as they are l_agging economic indicators._

• The size of the labor force responds to changes in economic conditions. Further during recessions, when people stop looking, the unemployment rate is lower than it actually should be due to performance of economy. Then when expansion starts, those who were discouraged may reenter the labor force, increasing unemployment, when it actually should be decreasing due to production of economy
• Busines are reluctant to lay off workers at the first sign of weakness and are timid to hire back at the first sign of improvement

Overall Payroll Employment and Productivity Indicators

• Size of payrolls- This measure is not biased by the number of discouraged workers. generally speaking, payrolls tend to shrink in recession and expand in expansions
• The number of hours worked and the use of temporary workers tend to increase at the first sign of a recovery
• An economy’s productivity is measured by dividing total output by the number of hours worked. it measures the intensity of workflow of existing employees. These measures can identify an economy’s cyclical direction even before a change in the number of hours worked is noticed

Question 5

LOS 18e: Explain inflation, hyperinflation, disinflation, and deflation

Answer 5

Inflation

Generally speaking inflation is procyclical but with a lad of around one year. It is defined as a persistent increase in the overall level of prices in an economy over a period of time. The inflation rate measures the speed of overall price movements by calculating the rate of change in a price index.

Investors watch the inflation rate of an economy very closely because:

• The inflation rate helps assess the state of the economy
• It can be used to predict changed in monetary policy, which have a significant impact on asset prices
• Very high inflation rates can lead to social unrest and political risk for investments in those economies

Policy makers pay a lot of attention to the inflation rate in conducting monetart policy

• If the economy is experiencing high inflation along with high economic growth and low unemployment, it is overheating
• If an economy is experiencing high inflation along with high unemployment and slow economic growth, it is said to be suffering stagflation.

Deflation

Is defined as a persisten decrease in the aggregate level of prices in an economy over a period of time. The value of money actually rises in a deflationary environment. This increases the liabilities of most companies. This means that companies now have a lowered valued asset and a higher valued liabilities. This is why deflation is rather bad

Hyperinflation

Refers to a situation when the inflation rate is extremely high. It typicalls occurs when, instead of being backed by real tax revenue, large-scale government spending is supported by an increase in money supply. With an increase in supply of money the value falls. People prefer to hold on to real goods instead of the fastly devaluing money, therefore money changes hands very quickly.

Disinflation

Is defined as a fall in the inflation rate. Disinflation is very different from delation in the sense that deflation refers to a situation when the inflation rate is negative, while disinflation refers to a situation when the inflation rate falls, but remains positive.

Question 6

LOS 18f: Explain the construction of indices used to measure inflation

LOS 18g: Compare inflation measures, including their uses and limitations

Answer 6

The inflation rate is calculated as the percentage change in a price index over a period. A price index represents the average prices of a basket of goods and services

A price index that holds quantities of goods in the consumption basket constant is called a Laspeyres Index. Using a fixed basket of goods and services to measure the cost of living gives rise to three biases:

1. Substitution bias- changes in the relative prices of goods motivate consumers to replace expensive goods with cheaper substitutes. Use of a fixed basket results in an upward bias in the computed inflation rate
2. Quality Bias- Improvements in product quality sometimes come at the cost of higher prices. This again will result in an upward bias.
3. New Product Bias- recently introduced products are not included in the price index if the consumption basket is fixed. This usually creates an upward bias

Price Indices and theis Usage

In the US:

• The CPI only covers urban areas, which is why it is known as the CPI- U
• the Personal Consumption Expenditures (PCE) price index uses business surveys to cover personal consumption
• The Producer Price Index (PPI) tracks price changes experienced by domestic producers and includes items such as fuels, farm products, machinery, and equipment. Since higher production costs may eventually be passed on to consumers, the PPI is a good indicator of future changes in the CPI
• Headline inflation is based on an index that includes all goods and services in the economy
• Core inflation is based on an index that exludes food and energy prices from the basket. Core inflation is a better predictor of domestic inflation

Also note that:

• Countries around the world specialize in different industries so the differences in weights of different categories of goods and services in the PPI across countries are even more significatn than differences in CPI weights
• Some countries refer to the PPI as the Wholesale Price Index (WPI) and use it to track the overall level of inflation in the domestic economy

Question 7

LOS 18h: Distinguish between cost-push and demand-pull inflation

Answer 7

Cost-Push Inflation occurs when rising costs compel businesses to raise prices. Costs of production may increase in money wage rates or an increase in the price of raw materials. Since labor is the biggest cost for most businesses, analysts tend to focus on the labor market

• the lower the unemployment rate, the higher the probability of labor shortage, which may exert an upward pressure on wages

The effect of labor market constraints on wage rates is usually overserved relative to the natural rate of unemployment (NARU). It is at the NARU that the economy begins to experience bottlenecks in the labor market and feel wage-push inflationary pressures.

It is preferred to combine trends in labor costs with productivity measures to evaluate the state of the labor market. Labor productivity is important because it determines the number of units across which business can spread their labor costs. Unit labor cost (ULC) is calculated as:

• ULC = W/O
• Where
• O= output per hour per worker
• W= Total labor compensation per hour per worker
• If wage rates grows at a fast rate than labor productivity, businesses ULC increases. Businesses then look to increase output prices
• If wage rates increase at a slower rate than labor productivity, ULC falls and this eases inflationary pressures

Demand-Pull Inflation is caused by increasing demand, which causes higher prices and eventually results in higher wages to compensate for the rise in cost of living. Demand-pull inflation may be analyzed based on the economy’s capacity utilization levels:

• As the economy’s actual GDP approaches its potential GDP, there is an increase in the probability of shortages and bottlenecks occurring, so prices tend to rise
• The further the economy operates below its potential output, the greater the probability of a slowdown in inflation

Monetarists’ View on Inflation

They believe that inflation occurs when the growth rate of money supply in the economy outpaces growth in GDP. They explicitly place the blame for demand-pull inflation on excess money growth.

• If money growth exceeds nominal GDP growth, there is a possibility of inflation
• If money growth is slower than nominal GDP growth, there could be disinflationary or deflationary pressures in the economy

The ratio of nominal GDP to money supply equals the “velocity of money” The velocity of money may decline due to :

• A fall in nominal GDP. In this case the economy is more likely to soon enter an upswing than to experience inflationary pressures
• A rise in the money supply. In this case the economy is more likely to experience inflationary pressures than to witness an upturn

Inflation Expectations

These also play an important role in policy-making. Once economic agents start ecpecting prices to continue to rise going forward, they change their actions in line with those expectations. This can lead to higher inflation and cause it to persist in the economy even after its real underlying cause is no longer present. Economists try to measure inflation expectations by:

• Observing past inflation trends
• Conducting surveys of inflation expectations
• Comparing the nominal yield on gov bonds to TIPS whose yields adjust with inflation

Question 8

LOs 18i: Describe economic indicators, including their uses and limitations

Answer 8

An economic indicator is a variable that provides information on the state of the broader economy:

• Leading economic indicators have turning points that usually precede the turning points of the broader economy. Economists use them to predict the economy’s future state
  
  • Examples - Average Weekly Hours, S&P500 stock index, Money Supply, Interest rate spread between 10-year Treasury yields and overnight borrowing rates, Building permits for new private housing units, manufacturers’ new orders
• Coincident economic indicators - have turning points that usually occur close to the turning points of the broader economy. Economists use them to identify the current state of the economy
  
  • Examples - Employees on payrolls, Aggregate real personal income, Industrial Production Index, manufacturing and trade sales
• Lagging Economic indicators have turning points that usually occur after the turning points of the broader economy. Economists use them to identify the economy’s past condition
  
  • Examples - Average Duration of Unemployement, Inventory-sale ratio, change in ULC, Average bank prime lending rate, Change in CPI, commercial and industrial loans outstanding

Practitioners take an aggregate perspective when interpreting various economic indicators. The US composite of leading economic indicators is known as Index of Leading Economic Indicators.

The relationship between an indicator and the business cycle can be quite uncertain. For example, some leading indicators may be excellent predictors of expansions but poor predictors of recessions. This is why analysts combine different indicators with common factors among them when constructing indicator indicies. A diffusion index measures the proportion of the index’s components that have moved in the same direction as the overall index. The more than do move in the same direction, the more confident the analyst can be