Download LECTURE 5. The Business Cycle

ABSE 102
The Business Cycle
1. Definition and phases
The Business cycle is defined as periodical fluctuations of aggregate demand
around the level of the potential GDP.
The aggregate demand is measured by the level of real GDP and presents the
economic activity in the country.
The Business cycles trace out a wavelike pattern with a length between 3.5 and 8 years.
The business cycle is identified as a sequence of four phases:

Contraction (a slowdown in the pace of economic activity)

Trough (The lower turning point of a business cycle, where a contraction turns
into an expansion)

Expansion (A speedup in the pace of economic activity. It has two parts recovery and boom. The boom starts when the level of real GDP rises above the level of
its previous peak)

Peak (The upper turning of a business cycle)
A recession occurs if the level of the real GDP declines during the contraction. The
standard definition of a recession is a decline in the Gross Domestic Product for two or more
consecutive quarters. A deep trough is called a slump or a depression. The difference
between a recession and a depression is marked by the change in the level of real GDP. While
during the recession it falls, during the depression the decline in aggregate demand stops and
stays at a low level for more than two consecutive quarters.1
The standard phases are presented on Figure 1.
GDP (AD)
peak
recession
peak
boom
recession
recovery
trough
trough
time
Fig. 1. The phases of the business cycle.
2. Economic indicators of the business cycle
The phases of the business cycle describe the behaviour of a variety of economic
indicators which reflect basic business conditions. To achieve precision these data are taken
weekly or monthly; together they trace out a reference cycle which maps the congruence of
peaks and troughs in an attempt to indicate average business cycle behaviour.
The business cycle indicators are classified into three groups:
1
There is an old joke among economists that states: A recession is when your neighbor loses his job. A
depression is when you lose your job.
a) Leading: Leading economic indicators are indicators which change before the
economy changes. Stock market returns are a leading indicator, as the stock
market usually begins to decline before the economy declines and they
improve before the economy begins to pull out of a recession. Leading
economic indicators are the most important type for investors as they help
predict what the economy will be like in the future.
b) Coincident: A coincident economic indicator is one that simply moves at the
same time the economy does. The Gross Domestic Product is a coincident
indicator.
c) Lagged: A lagged economic indicator is one that does not change direction
until a few quarters after the economy does. The unemployment rate is a
lagged economic indicator as unemployment tends to increase for 2 or 3
quarters after the economy starts to improve.
Main Leading Indicators

Hours of production workers in manufacturing

New claims for unemployment insurance

New orders for plant and equipment

Building permits for private houses

Car sales

Change in inventories

Change in commodity prices

Money growth rate
Main Coincident Indicators

Real GDP

Consumption

Exports

GDP defaltor

Nonagricultural employment

Index of industrial production

Personal income

Personal savings rate

Manufacturing and trade sales
Main Lagging Indicators

Unemployment rate

Commercial and industrial loans

Ratio of consumer debt to personal income
In Cyprus exports and construction contracts are the most important indicators because of
the export orientation of the economy and the important role played by the construction
industry in the economy.
3. The business cycle in the real sector and in the financial markets
During the recovery and the boom, aggregate demand is greater than aggregate supply.
Firms are happy to sell more and make greater profits. They increase production and order
more raw materials from their suppliers. Everybody has optimistic expectations about the
future, unemployment falls, income rises and aggregate demand rises even further.
The higher profitability in the real sector raises prices of the firms and their shares
become more expensive. The increase in production and income raises the demand for
durables (machines, equipment, housing, etc.) and the demand for credit rises too. The
optimistic expectations push upwards the prices of securities in the financial markets. This
is a bull market. Everyone expects the demand to increase further and securities increase
in price. Everyone is trying to make money on speculation – buy now in order to sell later
at a higher price. Everyone wants to invest more in such deals in order to get greater
profits. Often, the money invested is borrowed from the banks. Thus, the prices of the
financial assets go much beyond the value of the real goods, presented by the securities.
The increase in aggregate demand drives up the aggregate supply. However, supply
cannot grow forever. Resources are scarce. Firms have limited production capacity and
when they operate above their full capacity, the cost of production starts rising. Because
of the high demand for labor and high employment rate workers would work more if only
their wages and salaries are raised. Any further increase in production involves greater
costs and prices start rising faster than production and income. Aggregate demand falls
below aggregate supply. Firms cannot sell as much as they have expected and their
inventories increase. They reduce their orders of new supplies and all firms start
producing less. Unemployment rises, income falls and demand decreases even more. This
is the recession.
The first signals for the recession come usually from the financial markets. The
increase in the cost of production and oversupply creates pessimistic expectations about
the future and prices of securities fall sharply. This is a bear market. Investors loose
money and they are not able to pay for the losses. Everyone needs money from the banks.
The banks have difficulties to collect the credits and to serve their clients. This could lead
to bankruptcy. Since banks offer and borrow money from each other, the bankruptcy of
one bank creates risks for the entire financial system. The confidence in the financial
markets is lost. Everyone is reluctant to put money in the financial system. Everyone
prefers liquidity (real money), not securities.
Shortly, this is the picture in the financial markets today. It started with the inability of
many American households to pay for their mortgage loans. It is not a big deal for the
society if some people cannot pay back their loans. They lose their houses, cars, etc.
However, when it comes to many households and firms, which cannot pay, the financial
institutions that have landed the money cannot survive either. Here comes the crisis.
The current situation in the financial markets is so critical, because during the boom
period money was too cheap. It was very easy and cheap to borrow and optimistic
expectations pumped the financial balloon too much. If the central banks had raised the
price of the money a few years ago, the speculative demand for securities and real estate
would have not gone that away from the real value of the assets and the losses would be
much lower. Anyway, the contraction could not have been prevented, but the slow down
in the level of economic activity might have been quite smaller.
The recession is the most important phase of the business cycle. It sweeps away the
inefficient businesses and motivates technological progress.