This course is a part of CFA Level I Economics section. You will learn the following:



<ul><li>Business cycles</li><li>Typical patterns of resource use fluctuation, housing sector activity, and external trade sector activity, as an economy moves through the business cycle</li><li>Theories of the business cycle</li><li>Types of unemployment and measures of unemployment</li><li>Inflation, hyperinflation, deflation and disinflation</li><li>The construction of indices used to measure inflation and its limitations</li><li>Cost-push vs. demand-pull inflation</li><li>Uses and limitations of economic indicators</li><li>Identifying past, current and future business cycle phase of an economy based on economic indicators</li></ul>

Understanding Business Cycles

Business cycles refer to the upward and downward movement of the economy. Real GDP and unemployment levels are used as indicators to assess in which phase of business cycles the economy is. Business cycles have four phases. They are peak, recession, trough, and recovery stage.



<h3>Peak</h3>



The peak stage is characterised by high real output, low unemployment and high inflation. Domestic output is usually at optimum capacity.



<h3>Recession</h3>



The recession stage sees a contraction of output as a result of lower demand. Unemployment rates also increase but inflation rates fall. If a downward trend persists prices start falling leading to deflation. If this trend continues for two or more quarters it is then officially a recessionary phase.



<h3>Trough</h3>



A prolonged recessionary phase is called a trough in the business cycle. Here real GDP reaches the lowest point, with low output and high unemployment.



<h3>Recovery</h3>



The economy at some point, with government intervention (raising demand through infrastructure projects for example) or other factors starts showing an increase in demand and there is a fall in unemployment rates. This phase is called a recovery phase.

Business Cycles

We will now learn about resource use fluctuation, housing sector activity and external trade in the context of the phases of the business cycle.



<h3>Resource Use Fluctuation</h3>



During the build-up to peak phase, production is high. Firms will keep inventory that is enough to meet the demand. They will not keep more as it will lock their capital. At the peak though, sales will slow down and a slow build-up of inventory will take place.



Once the recession phase starts, sales slow down drastically. Companies stop holding inventory, which further leads to a slowdown in the economy. In the recession stage companies keep low inventory. Once the cycle reaches trough stage, the next stage is an upward trend in the economy. Sales begin to improve and there is increased demand. This means the sales-inventory ratio will be low. Firms will start increasing inventory to meet growing demand and the sales-inventory levels will move back to normal.



Labour and capital in the context of business cycles can be adjusted theoretically. In real terms though it is impractical to reduce and increase workers and machinery during the varying stages of the business cycle. Instead companies will modulate the time both these factors are used. In the high demand phase workers and machines will work overtime and vice-versa in periods of low demand. In the case of machines, lesser maintenance and replacement will be done to reduce costs in times of low demand. Only in the case of a protracted downturn will workers be laid off.



<h3>Housing Activity</h3>



The housing sector is a big source of demand and behaves differently during the various stages of the business cycle. The housing market does well during the early phase of the business cycle. A growth in housing harbingers a further growth in the economy. Low interest rates stimulate growth in the housing market, while high interest rates reduce demand in the housing market.



In the recovery stage or growth stage of the economy when incomes are increasing, there is growth in the demand for housing as well. In the recession or trough stages there is a fall in the demand for housing and therefore a fall in construction related activity as well.



While housing boosts economic growth, by itself it does not result in the growth of the economy. In the upward movement to the peak, the demand for housing is high. With increase in prices, investors may seek to park their funds in housing, leading to a further increase in growth of the housing sector. As in the case of Ireland people borrowed from banks to invest in housing. Construction increases manifold – a pile up of inventory occurs. As the economy becomes sluggish there is a fall in prices and speculation in the housing sector ends. The housing bubble burst in Ireland resulted in banks sitting on a pile of bad debt. In Ireland’s case the housing activity was not real demand, but fuelled by speculative gains.



Another factor affecting housing activity is the demographic profile of the population. Growing economies, with high rural to city migration has resulted in an increase in demand for housing. Economies of populations with increasing numbers in the 25-40 age group also shows an increase in housing activity, as this age group seeks out housing options.



<h3>External Trade Sector Activity</h3>



The determinants of external trade sector activity during business cycles are currency rates, domestic GDP growth and the GDP of trading partners.



If the currency value of a country increases with respect to other currencies, this will lead to an increase in imports and decrease in exports. If the currency value decreases vis-a-vis others currencies, then imports will decrease and exports will increase. In these scenarios we are referring to continued trends rather than gains and losses in the currencies in the short term.



The GDP on the other hand usually reacts to a set of variables and behaves differently during different phases of the business cycles.



In the expansion stage the GDP growth rate increases. Unemployment reduces due to more recruitments; Inflation may be on the increase and investments particularly in housing and capital equipment increases. Imports will reduce.



In the peak stage the GDP starts slowing down. Investments start getting sluggish as does recruitment, though unemployment continues to stay low. Inflation continues to increase.



In the contraction state, growth rates fall to negative levels, unemployment increases; Imports fall as does consumer investments and purchases. Inflation starts falling.



In the trough stage the GDP growth rate climbs back to positive; unemployment continues to stay high with increased usage of contract labourers. Inflation starts to reduce. There is a spurt in consumer activity.

Economic Activities in Phases of Business Cycle

The&nbsp;Classical School&nbsp;derives its name from the school of Adam Smith, David Ricardo and John Stuart Mill. This theory states that the economy is self-regulating. It also assumes full employment. The&nbsp;neo-classical school&nbsp;feels that business cycles are in fact responses to shocks to the system, particularly technological changes.



Using the aggregate demand and supply concepts of the classical economists, the neo-classical economists have juxtaposed technological changes with respect to the same. A technological change that increases productivity results in an increase in aggregate demand since more firms will purchase new machineries. If the technology lengthens the life of current capital, aggregate demand falls, since the need for new equipment reduces. Technological changes have a direct impact on the GDP in the sense that rapid technological developments result in growth of potential GDP and later real GDP.



The classical theory believes that stimulation in any form by the government to the economy is not advisable. Taxes in fact lead to inefficiency by stunting incentives. Lower taxes are a better incentive for investment, employment, and technological innovation that help the economy grow.



Keynesian theory&nbsp;argues that the economy can never really achieve full employment without monetary and fiscal intervention. According to this theory aggregate demand is also impacted by how the population views the prospects of the economy. If the prospects are poor, then this leads to a fall in aggregate demand.



With regards to aggregate supply, this theory assumes that wage rates are sticky in nature. Once they are set at a rate, they will not go down even if the economy is in the recessionary phase. If it were not sticky, the short term aggregate supply would increase, pushing the economy back to full employment.



The&nbsp;new Keynesian economists&nbsp;have added that the prices of goods and services are sticky as well. The Keynesian economists believe that in times of recession, the government can intervene to increase demand in the system (by undertaking large infrastructure projects for instance). In this way the economy will tend back to full employment.



Economists following the&nbsp;monetary theory&nbsp;believe that the quantity of money is the single most important factor that impacts aggregate demand. If the central monetary authority keeps a steady flow of money, fluctuations in demand will reduce and the economy will tend to full employment. If it does not it will lead to a contraction in aggregate demand and result in recession like conditions. Like the Keynesian economists it believes wage rates are sticky; they too like the classical economists feel taxes deincentivise demand.

Theories of the Business Cycle

Unemployment falls into three categories:



<ol type="1"><li>Frictional unemployment</li><li>Structural unemployment</li><li>Cyclical Unemployment</li></ol>



Frictional unemployment&nbsp;refers to normal labour turnover that occurs when people leave jobs and with the creation and destruction of jobs. People leave jobs and look out for profiles that suit them. The time between jobs is called frictional unemployment. Companies too look for suitable candidates for roles designed in their company. One of the factors affecting frictional unemployment is unemployment compensation or welfare. If the unemployment benefit is large, the time people spend being frictionally unemployed tends to increase.



Structural unemployment&nbsp;comes into force when there is a change in technology or an outflow to competition. Workers need to retrain themselves to adjust to these structural changes, periods that tend to be longer than frictional unemployment. A growth in information technology means several workers were no longer required for some tasks that were automated; new job roles came into play such as project managers, logistics managers etc.



In the case of&nbsp;cyclical unemployment, it follows the patterns of the business cycles. Unemployment is low during expansion and high during contraction.



<h3>Measure of Unemployment</h3>



The participation ratio or the labour force participation rate refers to the percentage of persons in a population actively seeking employment. The participation ratio is usually greater during expansionary or growth phases and lower during recessionary phases due to lay-offs for example. When the cycle is in its early expansionary stage workers who lost jobs in the recessionary phase re-enter the job market rather than new entrants. It will therefore seem that despite increases in employment, the unemployment rates are high.



Another indicator of unemployment is productivity. As we discussed earlier during economy contraction stage while immediate lay-offs may not happen, companies may cut down on working time of employees. When the economy starts to expand unemployment will continue to stay at rates in the contraction stage, but will reduce as the economy expands further. Naturally all observations are made by using available data. Persons employed in illegal industries are not taken into account for.

Types and Measures of Unemployment

Inflation is a rise in the level of general goods and prices.



When the increase in prices is rapid, due to a war or any other upheaval it results in people holding lesser money. This scenario is called&nbsp;hyperinflation. These crises do not permit the government to collect taxes, leading to quick and large increases in prices in a short period of time.



Economies in the middle of a tough recession see their inflation rates go below 0%, that is in the negative. During a recession demand falls and with it prices of goods. People further wait to make purchases. This leads to a further decrease of aggregate demand. Such a situation when inflation rates go negative is called&nbsp;deflation.



When the inflation rate starts to reduce at a slow rate it is called&nbsp;disinflation. This fall in inflation rate occurs over a short term and does not necessarily herald a slowdown in the economy, unlike deflation.

Inflation, Hyperinflation, Deflation and Disinflation

We use the Consumer Price Index or CPI to measure inflation. It is a fixed-weight price index, which takes the quantities in some base year as being the typical goods bought by the average consumer during that base year, and then uses those quantities (same basket) as weights to calculate the index in each year.



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/cpi-1-1024x133.png" alt="" class="wp-image-28584" width="666" height="86"/></figure></div>



CPI helps calculate the cost of living and the value of money. We can arrive at the inflation rate by calculating the annual percentage change in price levels.



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/cpi-2.png" alt="" class="wp-image-28585" width="624" height="101"/></figure></div>



<h3>Limitations of CPI</h3>



The CPI is not an altogether accurate measure of inflation rates as it tends to inflate it. It has inherent biases, some of which are:



New Goods Bias:&nbsp;If we decide to compare the inflation rates today with those say 20 years back we need to compare similar goods. For instance, if we compare phones, the new touch phones would be more expensive than the old rotary dial phones. This would get factored into the CPI making the current CPI more expensive.



Quality Change Bias:&nbsp;Newer products come in with more technological innovation and are hence more expensive. However, the increase in prices is due to innovation rather than inflation. CPI sees it as inflation and states it such.



Commodity Substitution Bias:&nbsp;When consumers switch from one product to a similar product due to increase in prices, CPI records inflation rates as high in that product. If consumers derive the same amount of satisfaction or utility by the switch this is not factored by CPI. Only the increased usage of the substitute product is documented.



Outlet Substitution Bias:&nbsp;In times of increased prices people shopping from supermarkets may choose to go to discount stores. CPI does not factor in outlet substitutions.

Consumer Price Index (CPI) to measure inflation

Demand pull inflation&nbsp;is caused by an initial increase in aggregate demand. Aggregate demand can increase due to a variety of factors. An interest rate cut can boost consumption; government generates demand by increased infrastructure projects or by cutting tax rates. Aggregate demand can also increase due to an increase in exports, or an increase in investment stimulated by an increase in expected future profits.



In a demand-pull inflation, initially



<ul><li>Aggregate demand increases</li><li>Real GDP increases above potential GDP and the price level rises. This leads to an inflationary gap.</li><li>Money wages rates begin to rise.</li><li>The price level rises further and real GDP decreases toward potential GDP.</li><li>This process repeats in an unending price-wage spiral.</li></ul>



A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation. For demand pull inflation to occur, aggregate demand must persistently increase. The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.



Cost push inflation&nbsp;is a result of an initial increase in costs. Increasing costs can be due to an increase in the cost of raw materials, e.g., oil, and an increase in the money wage rates. It can also increase due to a rise in prices of the raw material or products in the rest of the world.



In a cost-push inflation, initially:



<ul><li>Short-run aggregate supply decreases</li><li>Real GDP decreases below potential GDP and the price level rises (Stagflation)</li><li>The economy could become stuck in this stagflation situation for some time.</li></ul>



The key difference between the two is that while GDP rises in demand-pull inflation it falls in Cost-push inflation in the initial phase.

Cost-Push vs. Demand-Pull Inflation

Different economic indicators are used in different stages of assessing the business cycle of an economy. There are three broad categories of indicators, namely, leading indicators, lagging indicators, and coincident indicators.



Leading indicators&nbsp;tend to change direction before the cycle goes into expansion at the trough or before contraction at the peak. They can be used to make predictions about events in economy and tend to change ahead of that event. The housing market, retail activity, inventory levels and sales are some examples of leading indicators.



A&nbsp;lagging indicator&nbsp;is an indicator that follows an event. Lagging indicators can only give insights using historical patterns. CPI, unemployment rates, balance of trade, interest rates, income and wages and the value of the currency are examples of lagging indicators. Unemployment rate (lagging) indicates that the economy has been doing poorly. Similarly, financial statements are lagging indicators.&nbsp;&nbsp;They show the result of spending.



Coincident indicators&nbsp;change at about the same time as peaks and troughs. Industrial production, personal income less transfer payments are examples of coincident indicators.



The uses of economic indicators are that they give some criteria, based on which we can arrive at current and future growth patterns of the economy. Their limitation is the same too, in that they can at best indicate not tell for sure which way the economy will move.



<h3>Identifying past, current and future business cycle phase of an economy based on economic indicators</h3>



Leading, lagging and coincident indicators must be used in conjunction before the phase of the business cycle is identified and predictions made.



For example, in the US, the Leading Economic Indicator Index, comprised of a weighted average that indicates cyclical peaks and troughs, showed expansion of eight of the ten indicators. Leading the pack were interest rate spreads, credit availability, stock prices and new home permits. The coincident index rose by few percentage points and the lagging indicator index reduced by a few. Put together they all indicate a period of expansion of the US economy for that year.

Uses and Limitations of Economic Indicators

This quiz is a part of the CFA Level 1 reading 'Understanding Business Cycles'. 

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