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Chapter 16
Cyclical Fluctuations in
Components of Aggregate
Demand
Cyclical Components of GDP in
Order of Importance
• Most cyclical fluctuations stem from changes in
capital spending. Credit terms and the stockadjustment principle are both important.
• Fluctuations in housing and consumer durables
are more closely related to credit terms; the
stock-adjustment principle in those sectors is not
very important.
• Inventory investment usually accounts for at
least half of the decline in real GDP during
recessions, but it usually drops in response to
lower sales and is not a cause of recessions.
The Stock-Adjustment Principle
• Net capital stock is proportional to output.
Suppose output were steady for a while, then
rose because of some exogenous development.
For a while, net capital spending would rise
rapidly until capital stock reached its new
equilibrium level. It would then stop increasing,
causing cyclical fluctuations.
• This relationship can also be measured by the
rate of capacity utilization; when excess capacity
appears, capital spending will drop even if
overall GDP is still rising.
Other Cyclical Factors Affecting
Capital Spending
• The stock adjustment principle is also just another way
of stating that investment will rise when the MPK is
above the cost of capital, and will fall when it is below.
• The focus here is on what cyclical factors affect these
terms. The main ones are:
Business sentiment and expectations
Stock market fluctuations (affect both the MPK and
cost of capital)
Until 1986, the tax laws were cyclically adjusted to
try and manipulate investment over the cycle
There is also some tendency for energy prices to
rise rapidly during periods of full employment, although
that term is largely exogenous.
How Important are the Cyclical
Fluctuations in Credit Variables?
• Interest rates invariably rise near business cycle
peaks, but the key variable is the expected real
rate of interest. Furthermore, if interest rates
rise in response to an increase in the MPK, that
will not initially reduce investment.
• Thus while interest rates are an important longrun determinant of capital spending, they are not
among the leading cyclical factors.
• For firms without unlimited access to credit and
capital markets, restricted availability of credit is
a more important cyclical variable.
Different Cyclical Patterns in
Capital Spending
• Industrial equipment is tied to rate of capacity
utilization
• Transportation equipment is tied to availability of
credit
• High-tech equipment is tied to the stock market
• Other equipment is tied to natural resource
prices
• Construction is tied to expected rate of price
appreciation
Cyclical Differences, Slide 2
• As high-tech investment becomes an
increasing proportion of total capital
spending, stock market fluctuations are
likely to have a greater impact on the
overall economy.
• Fluctuations in construction are less likely
to dominate capital spending has inflation
remains low and stable.
Residential Construction
• In the long run, housing starts are positively
related to demographic factors and negatively
related to the vacancy rate.
• In the short run, the cost and availability of credit
dominate cyclical fluctuations.
• Disposable income is not a very important
determinant of residential construction. When
income rises, people generally bid up prices of
land in desirable locations rather than buy more
houses.
Housing and Credit Terms
• In each recession from 1960 through 1991, housing
starts dropped sharply. However, they hardly fell at all
during the 2001 recession for several reasons.
• Interest rates did not rise very much
• Credit availability was not slashed
• For many would-be homebuyers, the single most
important factor is whether they can qualify for a
mortgage. That is usually determined by comparing the
monthly mortgage payment to monthly income, with the
maximum ratio set at 28% to 36%, depending on
creditworthiness. As mortgage rates drop, the number of
people who qualify rises, and so do housing starts.
Credit Terms, Slide 2
• Furthermore, when mortgage rates drop, more
creative forms of financing proliferate, including
interest-only loans and shared equity mortgages
(for people who cannot afford any down
payment).
• Real housing prices also have a strong negative
correlation with mortgage rates. So when rates
drop, housing prices rise faster. That
encourages more building because profits of
homebuilders rise.
Credit Terms, Slide 3
• For most consumer goods, higher prices
serve as a brake on purchases, but since
housing is viewed as an investment, rising
prices may actually spur demand because
of the likelihood of capital gains on the
house – which can then be cashed out
through refinancing.
• Thus lower mortgage rates spur both
demand and supply of housing.
Inventory Investment
• As previously noted, inventory investment
usually accounts for more than half of the
decline in real GDP during recessions.
• During the 2001 recession, it accounted for
more than 100%, which means real final sales
kept rising during the downturn.
• Yet it is not necessarily the case that fluctuations
in inventory investment cause recessions. They
often reflect the decline in final sales that occur
for other reasons.
Inventory Investment in 2001
• This argument needs some fine tuning, for if changes in
inventory investment simply reflect previous sales in final
sales, how could inventories decline in 2001 if final sales
kept increasing?
• 1. Final sales of goods did decline; it is just that services
kept rising.
• 2. The decline in profit margins intensified cost
pressures and squeezed inventories.
• 3. More excess capacity meant less need to order
ahead
• 4. Diminished expectations: businesses thought sales
would be weaker.
Additional Determinants of
Inventory Investment
• Thus in addition to reacting to previous changes
in final sales, we see that inventory investment
also depends on:
• Rate of capacity utilization
• Expectations of how much sales will change in
the near future. Although the stock market is not
a perfect indicator, it often serves as a
measuring stick for these expectations.
• It is unlikely that shortages will develop in the
near future, but if they are believed to be likely,
additional stockpiling would occur.
Cyclical Components of Consumer
Spending and Saving
• Business cycle economists used to think that sales of
cars and housing would provide an accurate indication of
the phase of the business cycle.
• Like so many other theories of the cycle, that fell by the
wayside in late 2001, when “zero-interest” financing on
new motor vehicles sent sales to an all-time record even
though the economy was still in recession.
• In previous recessions, new motor vehicle sales had
always dipped sharply. Yet even before these new
incentives were put in place, sales had remained fairly
strong during the 2001 downturn.
Interest Rates and Motor Vehicle
Sales
• In 1981, when bemoaning the possible demise
of Chrysler, Lee Iacocca said the three major
problems with auto sales were “interest rates,
interest rates, and interest rates”. Since then,
changes in interest rates have been the major
factor determining fluctuations in car sales.
• Why does it make so much difference? “Zero
interest rate” financing in late 2001 lowered the
overall cost of new cars by only about 2%, yet
sales zoomed by 30%. It seems obvious that
announcing a 2% price reduction would have
had a much smaller impact on sales.
Motor Vehicle Sales, Slide 2
• The answer lies with the peculiarities of
time payments. Given the choice between
driving a 3-year old car that costs $350 per
month and a brand-new car of the same
make and model that also costs $350 per
month, “everyone” will choose the newer
car. Lower interest rates make it profitable
for auto manufacturers and dealers to
“swallow” the unpaid balances on existing
time and lease payments.
Motor Vehicle Sales, Slide 3
• No one knows for sure what will happen to
interest rates in the future. However, given a
logical long-term forecast of about 3% growth
and 2% inflation, it would not be unreasonable to
assume that the Federal funds rate would climb
back from 1% to 5%. It will not be possible for
auto companies to profitably renew leases on
existing terms, so even slight rises in interest
rates may have a major impact on car sales in
the future.
Motor Vehicle Sales, Slide 4
• It is probably overstating the case to say
that income, prices, and consumer
expectations don’t have any impact on
new motor vehicle sales.
• However, it does seem increasingly likely
that in the future, fluctuations in these
sales will be dominated by changes in the
cost and availability of credit.
Other Consumption
• What about the other cyclical components of
consumption, where the monthly payment is not
as important?
• Computers and home electronic equipment are
tied more to new products than to economic
conditions
• Furniture and household appliances are tied to
residential construction
• Clothing and jewelry are probably the most
sensitive to income. But even this category did
not decline during the 2001 recession.
The Personal Saving Rate
• What about the personal saving rate, which theoretically
takes all components of consumption into account?
• Published figures are distorted because they do not
include realized capital gains income and cashing out
the increased value of homes.
• Abstracting from the data problems, most consumers
spend whatever money they have and, except for
pension plans, save very little. People who do save
usually make that decision independently of the interest
rate, putting their money in stocks or real estate.
• To the extent that lower interest rates offer more creative
financing for homes and cars, the published personal
saving rate will be negatively related to interest rates