LEARNING MODULE 13: Understanding Business Cycles

LEARNING MODULE 13: Understanding Business Cycles

Business Cycles

4 phases

Peak
Real GDP reaches top and start decreasing

Contraction
Real GDP is decreasing, also output, employment, consumption, investment and inflation.

Trough
Real GDP reaches bottom and starts increasing

Expansion
Real GDP is increasing, also output, employment, consumption, investment and inflation.

Economic Activities during cycles

Inventory/ Sale ratios

Hiring/laying off employees
Slow to lay off employees early in contraction.
Slow to add more employees early in expansion.

Labor and Capital

Theory of business cycle
Keynesian: DO Something
Others: DON'T DO ANYTHING

Neoclassical

Cause of Business cycle: changes in technology.

Recommend: allowing wages and prices to adjust

Keynesian

Cause of business cycle: Excessive optimism/ pessimism among business causes Aggregate Demand to change

Contractions can persist because downward sticky wages

Austrian school

Cause of Business cycle: Government intervention in economy

Real Business Cycle Theory

Cause of Business cycle: Rational responses to external shocks, technology changes

Recommended Policy: Don't intervene to counteract business cycles

Unemployment

Types of unemployment

Frictional unemployment:
It takes time looking for employers and employees to meet each other.

Structural unemployment:
Longterm economic changes that requires workers to learn new skills to fill available jobs.

Cyclical unemployment
Unemployment results from changes in economic growth; equal zero at full employment

Measurement

A person is considered "unemployed" if: he is not working, is available for work, and is actively seeking job.

Labor force includes both the employed and unemployed.

Unemployment rate: the % of labor force that is unemployed

Inflation

Types

Inflation:
Persistent increase in price level over time.

Disinflation
Decrease in marginal POSITIVE inflation rate over time

Inflation rate
Annual percent increase in price index

Deflation
Negative inflation rate. Persistent decrease in price level.

Inflation indices

Price index
Measure the cost of a specific G&S baskets over time (relative to a base period).

GDP deflator

Wholesale Price index

Headline inflation
Percent change in price index for all goods

Core inflation
Excluding food and energy due to their high short-term volatility.

Adjustment for CPI bias

Laspeyres Index
basket weights from base period

Formula: (for goods C at time t)
$P_{Laspeyres}=\frac{\sum (p_{c,t_{n}}\times q_{c,t_{0}})}{\sum (p_{c,t_{0}}\times q_{c,t_{0}})}$

Cons: new goods, quality improvements, and consumer's substitution of lower-price goods for higher-price goods overtime cause bias upward.

Paasche Index
basket weights from current period

Formula: $ P_{Paasche}= \frac{\sum (p_{c,t_{n}}\times q_{c,t_{n}})}{\sum (p_{c,t_{0}}\times q_{c,t_{n}})}$

Fisher Index
Geometric means of Laspeyres and Passche

$ P_{Fisher}= \sqrt{P_{Laspeyres}\times P_{Paasche}}$

Factors affecting price levels

Cost-push inflation

Demand-pull inflation

Economic indicators

Leading indicators
Precede business cycle; PREDICT

Coincident indicators
Coincide with business cycle; CONFIRM

Lagging indicators
follow business cycle; CONFIRM

Early Expansion

Sale grows --> Inventory/ sale ratios decrease

Early Contraction

Sale slows --> Inventory/ sales ratios increase

Early Expansion

Labor and Capital are used more intensively

Early Contraction

Labor and Capital are use less extensively

Housing Sector
A highly cyclical sector of economy

Determined by

Mortgage rates: Higher the rate, Lower the activities

Income/ housing cost: More in come, more activities

Speculation: Home purchases based on expected price increases

Demographics Household formations, geographic shifts in population density

External Trade Sector

Import depend on domestic business cycle

Export depend on foreign business cycle

Foreign exchange rate

Domestic currency APPRECIATES

Import rises

Export falls

Domestic currency DEPRECIATES

Export rises

Import falls

Recommend: Use fiscal/ monetary policy to restore full employment

New Keynesian: other input prices are also downward sticky

Monetarist

Cause of business cycle: Inappropriate changes in money supply growth rate

Recommended Policy: Steady, predictable growth rate of money supply

Recommended policy: Don't force interest rate to artificially low level

Participation Ratio =Labor force / Working-age population (>16)

Discouraged worker: Available for work but not employed nor seeking employment --> NOT IN LABOR FORCE

Hyperinflation: Out-of-control high inflation

Consumer Price Index

Price index for personal consumption expenditures: Weights based on surveys of businesses instead of surveys of consumers

Producer price index: Crude materials, intermediate goods, finished goods prices

$ (CPI)=\frac{Cost_{current}}{Cost_{base}}\times 100 $

Limitation: overstate true rate of inflation

Biases

Consumer substitution of lower-priced products for higher-price ones

New goods replace older, lower-price ones

Price increases due to quality improvement

Money supply or government spending increases --> Aggregate Demand increase (AD moves to right), causing higher price and higher output level --> higher wage (may due to higher price) --> Short-run supply decreases (SRAS moves to left) --> output back to normal but at even higher price

Increase in wages or other producer input prices --> Decrease short-run aggregate supply (SRAS moves to left) --> Stagflation (higher price but lower output) --> Government intervenes --> increase aggregate demand (AD moves to right)--> move output back to previous level but with higher increased price level

Non-accelerating Inflation Rate of Unemployment
(NAIRU)

is the lowest unemployment rate that will not induce wage-push inflation

Aka. Natural rate of unemployement

Likely varies over time and across countries

Not neccessarily same as "full employment" or zero cyclical unemployment because wage pressure maybe in economic segments

Weekly hours, manufacturing

Producer's new order, consumer goods

ISM new orders index

Stock prices

Yield curve

New unemployment insurance claims

Manufacturers' new orders, non defense capital goods excluding aircrafts

Building permits

Leading Credit Index :

Consumer expectations

Employees on nonfarm payrolls

Industrial production

Personal income less transfer payments

Manufacturing and trade sales

Unemployment rate

Duration of unemployment

Inventory/sales ratio, manufacturing and trade

Consumer price index

Prime rate

Manufacturing labor cost per unit of input

Consumer credit/ personal income ratio

Stagflation

High inflation, slow economic growth and high unemployment

As there is no good short-term intervention, economy is left to self-correct