1. Chapter 6 Understanding business cycles
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2. Introduction
The study of business cycles is the study of short-term economic fluctuations.
Factors that may affect business cycles are some of the same factors that affect economic growth (e.g., labor productivity, money supply, inflation, and technology).
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3. Overview of the business cycle
A business cycle consists of an expansionary period and a contractionary period.
Characteristics of a business cycle:
They are typical in economies that rely on business enterprises.
There are alternating phases of expansion and contraction.
Phases occur throughout the economy, most often simultaneously.
Phases reoccur, but vary in duration and intensity.
An expansion occurs after a low point (the trough) and a contraction occurs after the highest point (the peak).
A contraction
is also referred to as a recession.
is referred to as a depression if severe and if aggregate activity declines.
LOS: Describe the business cycle and its phases.
Pages 280–284
A business cycle consists of an expansionary period and a contractionary period.
An expansion (or boom) occurs after a low point (the trough), and a contraction occurs after the highest point (the peak).
A contraction (or recession) is referred to as a depression if severe and if aggregate activity declines.
The business cycle can be described in terms of capital spending inventory levels, consumer behavior, housing sector behavior, and external trade.
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4. Typical scenario: recession
Aggregate demand declines
Inventories begin to accumulate
Companies slow production
Companies cut nonessential expenditures
Lower GDP
LOS: Describe the typical patterns of resource use fluctuation, housing sector activity, and external trade sector activity, as an economy moves through the business cycle.
Pages 280–284
In a recession
aggregate demand declines,
inventories begin to accumulate,
companies slow production, and
companies cut nonessential expenditures.
These actions result in a lower GDP.
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5. Typical scenario: Expansion
Wages grow and wages decline
Input prices fall
Consumers and companies purchase more
Companies increase capital spending
Increase GDP
LOS: Describe the typical patterns of resource use fluctuation, housing sector activity, and external trade sector activity, as an economy moves through the business cycle.
Pages 280–284
In an expansionary period
wage growth and wages decline,
input prices fall,
consumers and companies purchase more, and
companies increase capital spending.
These actions result in an increased GDP.
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6. Business cycle Summary
Characteristic
Early Expansion (Recovery)
Late Expansion
Peak
Contraction (Recession)
Economic activity
Economic activity changes from decline to expansion.
Accelerating rate of growth
Decelerating rate of growth
Declines
Employment
Layoffs slow, but new hiring does not yet occur and the unemployment rate remains high.
Unemployment rate falls to low levels.
Unemployment rate continues to fall.
Unemployment rate rises.
Consumer and business spending
Upturn is often most pronounced in housing, durable consumer items, and orders for light producer equipment.
Upturn becomes more broad based.
Capital spending expands rapidly, but the growth rate of spending starts to slow down.
Cutbacks appear most in industrial production, housing, consumer durable items, and orders for new business equipment, followed by a lag via cutbacks in other forms of capital spending.
Inflation
Inflation remains moderate and may continue to fall.
Inflation picks up modestly.
Inflation further accelerates.
Inflation decelerates but with a lag.
LOS: Describe the typical patterns of resource use fluctuation, housing sector activity, and external trade sector activity, as an economy moves through the business cycle.
Pages 287–290
The business cycle can be described in terms of capital spending inventory levels, consumer behavior, housing sector behavior, and external trade.
In an expansion, economic activity increases, unemployment rate falls, consumer and business spending increase, and inflation increases.
Around the peak, inventory levels will begin to accumulate and will be worked down through the recessionary period as production is slowed and sales begin to increase once again.
In a contraction, economic activity declines, unemployment rate increases, consumer and business spending declines, and inflation slows.
Notes to the presenter:
A hypothetical cycle is illustrated in Exhibit 6-1a (p. 281). An actual cycle would be “messier”—that is, not as easily defined.
The length of expansions and contractions vary.
The National Bureau of Economic Research identifies US expansions and contractions in their cycle dating service:
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7. Theories of business cycles
Different schools of economic thought are used to explain the causes of business cycles.
These schools of thought offer different prescriptions with regard to government actions that may affect the economy.
Schools of thought:
Neoclassical
Austrian
Keynesian
Monetarists
New classical
Real business cycle theory
Neo-Keynesian
LOS: Describe theories of the business cycle.
Pages 294–303
There are different schools of economic thought used to explain the causes of business cycles.
These schools of thought offer different prescriptions with regard to government actions that may affect the economy.
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8. Neoclassical and Austrian
Neoclassical school of economic thought:
The “invisible hand” (that is, free market) will result in a price for every good for which there is supply and demand.
Says’s law: All that is produced will sell because supply creates its own demand.
This school cannot explain a prolonged depression. Any declines in aggregate demand would be temporary.
Austrian school of economic thought:
This school is similar to neoclassical but considers the role of the money supply and government actions.
Government intervention may cause a boom-and-bust cycle.
LOS: Describe theories of the business cycle.
Pages 294–303
The neoclassical school of thought relies on the free market and supply and demand to ensure an equilibrium.
The Austrian school posits that misguided government intervention may cause the boom-and-bust cycle.
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9. Keynesian theory of business cycles
In the event of lower aggregate demand, lower wages result in lower spending, hence affecting demand further.
Very low interest rates would not stimulate the economy because confidence would be too low.
Government should intervene in a crisis, running a deficit.
Criticisms of this theory:
Government debt could get out of control.
Expansionary policy may cause the economy to grow too fast, resulting in inflation and other ills.
It takes time for fiscal policies to work, so they may be ill timed for a short- term crisis.
LOS: Describe theories of the business cycle.
Pages 294–303
The Keynesian theory of the business cycle encourages government intervention because the self-correcting mechanisms (e.g., wages) are not sufficient.
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10. Monetarists
Those following the monetarist school of thought object to the Keynesian approach because Keynesian theory
does not consider the role of the money supply.
is not logical in light of utility-maximizing market participants.
ignores the long-term cost of government intervention.
does not consider the unpredictability of the timing of fiscal policy changes on the economy.
Monetarists advocate for a steady increase in the money supply and a limited role of government.
LOS: Describe theories of the business cycle.
Pages 294–303
The monetarist theory of the business cycle advocates a steady increase in the money supply to stimulate the economy and a limited role of the government.
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11. New Classical School
The new classical school uses the idea that utility-maximizing agents will seek to maximize profits.
Real business cycle (RBC) theory:
Business cycles are the result of the efficient operation of the economy in response to real shocks.
The RBC theory considers unemployment the result of persons wanting wages that are too high.
It is criticized as being an unrealistic assumption.
Neo-Keynesians (new Keynesians):
Neo-Keynesians assume slow-to-adjust wages and prices.
Government intervention is needed in the event of disequilibrium.
LOS: Describe theories of the business cycle.
Pages 294–303
The new classical theories of the business cycle consist of the real business cycle theory, which suggests that business cycles are the result of an efficient response to shocks to the economy, and the neo-Keynesian theory, which advocates for government intervention because of the slowness of the response of the economy.
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12. Unemployment and inflation
Types of unemployment:
Unemployed: People who are actively seeking a job but do not have a job.
Frictionally unemployed are in the process of changing jobs.
Long-term unemployed have been out of work for a long time, but are still looking.
Underemployed: Employed people who have the qualifications to work a higher- paying job.
Discouraged worker: Unemployed person who stopped looking for a job.
Voluntarily unemployed: Person who is outside of the labor force voluntarily.
Measures describing the labor market:
Employed: Number of people with a job.
Labor force: Number of people with a job or actively seeking a job.
Unemployment rate: Ratio of the number of unemployed persons to the labor force.
Activity ratio (participation ratio): Ratio of labor force to total population of working age persons.
LOS: Describe types of unemployment and measures of unemployment.
Pages 303–307
Types of unemployment:
The unemployed are people who are actively seeking a job but do not have a job, and include the frictionally unemployed and long-term unemployed. The underemployed are employed people who have the qualifications to work a higher-paying job.
The discouraged worker is an unemployed person who stopped looking for a job.
The voluntarily unemployed is a person outside of the labor force voluntarily.
Measures of unemployment:
Employed: Number of people with a job.
Labor force: Number of people with a job or actively seeking a job.
Unemployment rate: Ratio of unemployed to labor force.
Activity ratio (participation ratio): Ratio of labor force to total population of working age persons.
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13. Productivity measures
Labor force indicators:
The unemployment rate (the ratio of the number of unemployed persons to the labor force) lags the current environment.
Issues:
Distortions from discouraged workers: The number of unemployed may drop because workers become discouraged and may increase when they rejoin the workforce to resume searching.
Reluctance of employers to lay off workers when business slows and to hire when business increases.
Payroll growth does not fully cover employment at small businesses.
Hours worked (including overtime) and use of temporary workers are indicators of slowing and recovering businesses.
LOS: Describe types of unemployment and measures of unemployment.
Pages 305–306
The unemployment rate (the ratio of the number of unemployed persons to the labor force) lags the current environment.
Payroll growth does not fully cover employment at small businesses.
Hours worked (including overtime) and use of temporary workers are indicators of slowing and recovering businesses.
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14. Inflation
Inflation is an increase in the level of prices in the economy.
The inflation rate is the percentage change in a price index.
The purchasing power of money decreases.
The liability of the borrower decreases if the loan has fixed monetary terms.
Deflation is a sustained decrease in the aggregate price level (negative inflation rate).
The purchasing power of money increases.
The liability of the borrower increases if the loan has fixed monetary terms.
Hyperinflation is an extremely fast increase in the aggregate price level.
It generally occurs when government spending is not backed with tax revenues and the money supply is increased (or unlimited).
Disinflation is a decline in the inflation rate.
LOS: Explain inflation, hyperinflation, disinflation, and deflation.
Pages 307–309
Inflation is the increase in the level of prices in the economy.
Disinflation is a decline in the inflation rate.
Deflation is a sustained decrease in the aggregate price level (negative inflation rate).
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15. Measuring inflation
A price index reflects the weighted average price of a basket of goods and services, with the index = 100 at a specified period of time (that is, base year).
Price index x = Value of basket of goods and services in Year X Value of basket of goods and services in base year
A Laspeyres index is a price index in which the basket of goods and services is held constant.
Biases in an index:
Substitution bias: People may substitute goods and services as prices change.
Addressed somewhat using a chained price index formula (e.g., Fisher index and Paasche index).
Quality bias: The utility of a good may improve over time, but this may be interpreted as a price increase.
New product bias: Not included in a fixed basket of goods and services.
LOS: Explain the construction of indexes used to measure inflation.
Pages 309–313
A price index reflects the weighted average price of a basket of goods and services, with the index = 100 at a specified period of time.
If the index is a Laspeyres index, the basket is held constant. If the index is a Fisher index or a Paasche index, the basket is not held constant, but the index includes chained prices.
Copyright © 2014 CFA Institute

16. Inflation indices
Price indices may differ with respect to scope and weights on goods and services.
Examples:
The consumer price index (CPI) is used to track inflation within a given economy.
In the United States, the CPI covers only urban areas.
It is used by US Treasury inflation protected securities (TIPS) and other contracts.
The personal consumption expenditures (PCE) price index covers all consumption using surveys.
The producer price index (PPI), also known as the wholesale price index (WPI), tracks inflation in prices of goods and services to domestic producers.
LOS: Compare inflation measures, including their uses and limitations.
Pages 311–313
Indices may differ with respect to scope and weights on goods and services.
The consumer price index (CPI) is used to track inflation within a given economy, and in the United States, it covers only urban areas.
The personal consumption expenditures (PCE) price index is broader than the CPI and covers all consumption using surveys.
The producer price index (PPI), also known as the wholesale price index (WPI), tracks inflation in prices of goods and services to domestic producers, and can be a predictor of the consumer price index.
Copyright © 2014 CFA Institute

17. Sources and measures of inflation expectations
Sources of inflation
Cost-push: Rising costs to businesses result in increased prices to consumers.
Measure: Unit labor cost (ULC) = Total labor compensation per hour per worker (W) divided by output per hour per worker (O) = W/O
Demand-pull: Prices increase because of an increase in demand.
Measures: Money supply indicators and money supply growth compared with growth in the nominal GDP
The velocity of money is the ratio of nominal GDP to the money supply and is a measure of the likelihood of inflationary pressures.
Measures of inflation expectations:
Extrapolation of trends in inflation
Surveys of inflation expectations
Comparison of yields on inflation-adjusted securities with non-inflation- adjusted securities
LOS: Distinguish between cost-push and demand-pull inflation.
Pages 314–318
Price levels may be affected by rising costs of inputs to businesses, which are then passed along to consumers (cost push), or they may be affected by an increase in demand (demand pull).
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18. Economic indicators
An economic indicator is a measure that provides information about the state of the overall economy.
A leading economic indicator is a measure that has turning points that precede changes in the economy.
A coincident economic indicator has turning points that coincide with the changes in the economy.
A lagging economic indicator has turning points that are later than changes in the economy.
LOS: Describe economic indicators, including their uses and limitations.
Pages 319–320
An economic indicator is a measure that provides information about the state of the overall economy.
A leading economic indicator is a measure that has turning points that precede changes in the economy.
A coincident economic indicator has turning points that coincide with the changes in the economy.
A lagging economic indicator has turning points that are later than changes in the economy.
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19. Economic indicators, examples
Leading Economic Indicators
Average weekly hours
Average weekly initial claims for unemployment insurance
Manufacturers’ new orders for consumer good and materials
Vendor performance, slower deliveries diffusion index
Manufacturers’ new orders for nondefense capital goods
Building permits for new private housing units
S&P 500 Index
Money supply, real M2
Interest rate spread between 10-year Treasury yields and the federal funds rate
Index of Consumer Expectations
Coincident Economic Indicators
Aggregate real personal income
Employees on nonfarm payrolls
Industrial Production Index
Manufacturing and trade sales
Lagging Economic Indicators
Average duration of unemployment
Inventory-to-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
LOS: Describe economic indicators, including their uses and limitations.
Pages 319–320
There are a number of economic indicators that reflect different dimensions of economic activity (that is, income, spending, money supply, hours worked, borrowing, and unemployment).
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20. Economic indicators and the business cycle
Increase in weekly hours, manufacturing
Leads an expansion
Increase in the Index of Consumer Expectations
Leads an expansion
Increase in the money supply not accounted for by inflation
Leads an expansion
Increase in Industrial Production Index
Coincides with a contractionary phase
LOS: Identify the past, current, or expected future business cycle phase of an economy based on economic indicators.
Pages 319–327
The relationship between an economic indicator and the phase of a business cycle depends on whether the indicator is a leading, coincident, or lagging indicator.
Increase in the average duration of unemployment
Follows contractionary phase
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21. Conclusions and Summary
Business cycles are a fundamental feature of market economies and consist of four phases (trough, expansion, peak, and contraction), but their amplitude and length varies considerably.
Keynesian theories focus on fluctuations of aggregate demand (AD) and advocate for government intervention.
Monetarists argue that the timing of government policies is uncertain, and it is generally better to let the economy find its new equilibrium unassisted but ensure that the money supply keeps growing at an even pace.
New classical and real business cycle theories also consider fluctuations of aggregate supply (AS). Government intervention is generally not necessary because it may exacerbate the fluctuation or delay the convergence to equilibrium.
New Keynesians argue that frictions in the economy may prevent convergence to equilibrium and government policies may be needed.
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22. Conclusions and Summary
The demand for factors of production may change in the short run as a result of changes in all components of GDP: consumption, investment, government, and net exports. Any shifts in AD and AS will affect the demand for the factors of production (capital and labor) that are used to produce the new level of GDP.
Unemployment has different subcategories, including frictionally unemployed, long-term unemployed, discouraged workers, and voluntarily unemployed.
There are different types of price-level movements: inflation, disinflation, deflation, and hyperinflation.
Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle is occurring.
Price levels are affected by real factors and monetary factors.
Inflation is measured by many indices, including consumer price indices and producer price indices.
Copyright © 2014 CFA Institute