Download Business Cycles

Business Cycles
Business cycles are irregular, non-periodic fluctuations in aggregate economic activity. Life is
good, and then it's bad. It's a roller coaster ride.
- Although we use the term 'cycle', we don't know how long an expansion or a contraction
will last. The economy might expand for a year or it might expand for a decade before it
declines
A. Expansionary good times are almost always good. But there is a bad side.
 The good side: The economy is growing, more goods are produced, living standards
rise, businesses are profitable, and scarcity problems are lessened.
 The bad side: Inflation and inefficiency.
 Inflation tends to worsen when the economy expands too rapidly because there is too
much money in circulation.
 Inefficiency is likely during an expansion. With the entire economy expanding, and
everyone becoming better off, the incentive to be efficient is reduced. We aren’t so
concerned with how we utilize our factors of production when they seem to be in
abundance.
Expansionary good times mean more production and rising living standards, but also
inflation and inefficiency problems
B. Contractionary bad times give us the most problems.
 First: Real GDP declines during a contraction.
 Second: Unemployment increases.
 Third: The incomes of employed resources also tend to fall, or at least not rise as much
as in an expansion.
 Fourth: Business profits decline and bankruptcies increase.
 Fifth: Social problems, including crime, poverty, and alcoholism, worsen.
 If prolonged, can become a recession or, if even longer, a depression
But contractions have some good:
 Inflation remains low or declines (deflation).
 Some resources are more efficiently allocated.
Since the 1930s Great Depression, when the modern study of economics was prompted,
economists have sought indicators of business cycles.
Some indicators are:
 Real GDP, the unemployment rate, and the inflation rate are useful measures, but
they measure only specific aspects of the economy. These may not be the best
indicators of overall business cycle activity. Economists have identified three sets of
indicators to track business cycles:
1. Leading economic indicators indicate business-cycle activity 3 or 12 months ahead. If
leading indicators decline now, then the economy is likely to decline in 3 to 12 months.
 Leading indicators are eleven statistics that precede changes in the economy.
 Three notable leading indicators are stock market prices, the money supply, and
consumer confidence.
2. Coincident economic indicators move along with the aggregate economy. They mark the
business cycle.
 The four coincident indicators are measures of production (GDP), employment,
income, and sales.
 The Composite Index of Coincident Indicators combines all four. Changes in this
index mark business cycle peaks and troughs.
3. Lagging economic indicators lag the turning points of business cycles by 3 to 12
months.
 Lagging indicators 'seal the deal' by certifying that a contraction or an expansion is
over.
 The next turning point (business cycle) usually doesn't begin until lagging indicators
confirm that the last one has happened.
 Seven statistics are used as lagging indicators, including in the inflation rate, consumer
debt, and the prime interest rate.
Major Economic Indicators:
I. Gross domestic product (GDP)
A. The total market value of all the final goods and services produced within an economic
unit (country, state) within a period of time
(normally a year)
B. Includes all productive marketed activities
- normal production of goods and services that are sold in regular markets
C. Excludes non-productive market activities
- Stock market sales
- Sale of used products
D. Includes estimates of some, but excludes other productive non-marketed activities
- Housework (not included)
- illegal activity (not included)
- Owner occupied housing (included)
- “in-kind” payments (included)
Calculating GDP
Two approaches to calculating GDP
1. Expenditure approach
a. GDP equals Personal Consumption plus Business Investment plus Government
Spending plus Net Exports
2. Income approach
a. GDP equals Rent plus Wages plus Interest plus Profits plus Depreciation plus
Indirect Business Taxes plus miscellaneous
b. GDP = R + W + I + P + Acc. Dep. + Ind. Bus. Taxes + Misc.
Nominal vs Real GDP
If GDP increases from one year to the next, it could be the result of an increase in production
or an increase in prices (inflation). To factor OUT inflation, REAL GDP is calculated. Real GDP
is a calculation that uses constant prices (or, the prices from the comparative year). When
GDP is calculated using current year dollars, it is called nominal GDP.
II. Unemployment rate = the percentage of the Labor Force who is out of work
Unemployment rate = 100 (# of people in the labor force seeking work /
# of people in labor force)
Labor Force = 16 yr.-olds and up who are employed or unemployed and looking for work
The Three Types of Unemployment
Economists break unemployment down into three distinct varieties - Structural, Frictional,
and Cyclical. Below we will examine each type of unemployment to see how they differ.
1. Structural Unemployment:
- Structural unemployment is unemployment that comes from there being an
absence of demand for the workers that are available because their skills do not
match available jobs.
There are two major reasons that cause an absence of demand for workers in a
particular industry:
1. Changes in Technology: As personal computers replaced typewriters, typewriter
factories shut down. Workers in typewriter factories became unemployed and had to
find other industries to be employed in.
2. Changes in Tastes: If bagpipes become unpopular, bagpipe companies will go
bankrupt and their workers will be unemployed.
2. Frictional Unemployment:
-Frictional unemployment is unemployment that comes from people moving
between jobs, careers, and locations.
Sources of frictional unemployment include the following:
1. People entering the workforce from school.
2. People re-entering the workforce after raising children.
3. People changing employers due to quitting or being fired (for reasons beyond
structural ones).
4. People changing careers due to changing interests.
5. People moving to a new city (for non-structural reasons) and being unemployed
when they arrive.
3. Cyclical Unemployment:
- Cyclical unemployment occurs when the unemployment rate moves in the
opposite direction as the GDP growth rate. So when GDP growth is small (or
negative) unemployment is high. This unemployment reflects a contracting
business cycle.
Getting laid off due to a recession is the classic case of cyclical unemployment. This is
why the unemployment rate is a key economic indicator.
What About Seasonal Unemployment?:
Seasonal unemployment is unemployment due to changes in the season - such as a lack of
demand for department store Santa Clauses in January. Seasonal unemployment is a form
of structural unemployment, as the structure of the economy changes from month to
month.
III. INFLATION
- inflation is defined as a persistent increase in the level of consumer prices or a
persistent decline in the purchasing power of money, caused by an increase in the
money supply (because of available currency and credit beyond the proportion of
available goods and services.)
Calculating Inflation
The calculation of inflation relies on the Consumer Price Index (CPI)
- Each month, the BLS surveys prices for a “market basket” of goods and services in
order to
create an economic “snapshot” of the average consumer’s spending, which is quantified as the
CPI. Because the CPI looks at expenditures in these fixed categories, this index is a valuable
tool for
comparing the current prices of goods and services to costs last month or one year ago.
- the CPI is compiled by the Bureau of Labor Statistics monthly and is based upon a
1984 base of 100. An Index of 185 indicates 85% inflation since 1984 (actually the average of
1982-1984). Since this is an index it only tells you the total inflation since the base year.
inflation =
CPI2-CPI1
* 100
CPI1
Causes of Inflation
A. Cost-push Inflation
Cost-push Inflation occurs when a firm passes on an increase in production costs to the
consumer. The inflationary effect of increased costs can be the result of:
 Increased wages, leading to
1. a wage-price spiral, which occurs when price increases spark off a series of
wage demands which lead to further price increases and so on;
2. a wage-wage spiral, which occurs when one group of workers receive a wage
increase which sparks off a series of wage demands from other workers.
 Increased import prices which can be the result of:
1. a rise in world prices for imported raw materials;
 Increased indirect taxation
B. Demand-pull Inflation
Demand-pull inflation occurs when there is 'too much money chasing too few goods'
because the demand for current output exceeds supply.
Remedies for Inflation
Cost-push Remedies
 Introduce a prices and incomes policy to free price and wage increases.
 Reduce indirect taxation.
Demand-pull Remedies
 Reduce government spending.
 Increase income tax to reduce consumer spending.
 Reduce peoples' ability to borrow money by increasing interest rates and tightening
credit regulations.
 Control the supply of money.
Effects of Inflation
Advantages of Inflation
Not everyone suffers from inflation. Some parts of society actually benefit:
 The government finds that people earn more and so pay more income tax.
 Firms are able to increase prices and profits before they pay out higher wages.
 Debtors (homeowners, businesses, government) are helped by high inflation because
they pay back with dollars
worth less than those borrowed.
 Both income and resource allocations are affected by inflation as the market tries to
adjust to the loss in value
caused by inflation.
1. High gas prices in the 1970's caused a switch to small cars and many
people bought wood stoves.
2. Low gas prices in the 1990's made RV's less expensive to run.
Disadvantages of Inflation
 People on fixed incomes are unable to buy so many goods. (COLAs)
 Creditors (savers) lose because the loan will have reduced purchasing power when it
is repaid.
 US goods may become more expensive than foreign-made products so the balance
of payments suffers.
 Industrial disputes may occur if workers are unable to secure wage increases to
restore their standard of living.