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Chapter 15
Business Cycles
© 2003 South-Western College Publishing
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The Business Cycle
The rise and fall of economic activity relative to the economy’s long-term growth trend
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Types and Lengths of Cycles Minor cycles
relatively mild intensity, noticeable but not severeshortnumerous
Major cycleswide fluctuations, serious contractions or
depressionswidespread unemploymentlower outputlow profits or net losses
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Other Types of Cycles
Long-wave building cyclesCommodity price fluctuationsStock market price fluctuations
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Duration of Business Cycles since WWII
Number 10Average duration 56 monthsLongest cycle 120 months (1991-2001)Shortest cycle 28 months (1980-1982)Average expansion 57 monthsShortest expansion 12 months (1980-1981)Longest expansion* 120 months (1991 - 2001)Average recession 11 monthsShortest recession 6 months (1980)Longest Recession 17 months (1981-1982)*as of February, 2000
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Phases of the Business Cycle
Time
Rea
l G
DP
Peak: highest level of economic activity in a particular cycle
Contraction: noticeable drop in the level of business activity
Trough: lowest level of business activity in a particular cycle
Expansion: rising level of economic activity
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Phases and Measurement of Cycles
TrendDirectional movement of the economy over an
extended time, usually 20-30 years Seasonal Variations
Recurring fluctuations in activity in a given period, usually 1 year
Random FluctuationsChanges in activity caused by unexpected events
Cyclical FluctuationsChanges in activity that occur regardless of trend,
seasonal variations, or random forces
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Patterns of Cycles
Two kinds of elements or forces bring about business cyclesInternal: elements within the very sphere of
business activity itself: production, income, demand, credit, interest rates, inventories
External: elements outside the normal scope of business activity: population growth, wars, basic changes in nation’s currency, national economic policies, natural disasters
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Trough
OutputEmployment IncomePriceCostsProfits Investment
LOW
PessimismHIGH
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Expansion
External factorsCost-price relationshipReplacement of depleted inventoriesLow interest ratesInvestment increasesDemand increasesEmployment and income increase
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Peak
OutputEmploymentIncomePriceProfitsInvestment
HIGH Optimism
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Contraction Output, employment, income at peak Consumer demand tapers off Prices level out, inventories increase Costs increase, profit margins diminish Demand slackens, firms reduce excess
inventories Output is cut, and so are income and
employment Investments discouraged & outlook
pessimistic
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Business Cycle Indicators Leading IndicatorsLeading Indicators
Group of 11 indexes whose upward and downward turning points generally precede the peaks and troughs in general business activity
Roughly Coincident IndicatorsRoughly Coincident IndicatorsGroup of 4 indexes whose turning points usually
correspond to the peaks and troughs of general business activity
Lagging IndicatorsLagging IndicatorsGroup of 7 indexes whose turning points occur after
the turning points for the general level of business activity have been reached
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Leading Indicators
Average work week for production workers in manufacturing
Rate of layoffs in manufacturing New orders for consumer goods and materials New business formations Contracts and orders for plant an equipment Vendor performance, measured as a % of
companies reporting slower deliveries from suppliers
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Number of new building permits issued for private housing units
Net change in inventories Change in sensitive prices Change in total liquid assets Changes in money supply
Leading Indicators (cont.)
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Coincident Indicators
Number of employees on nonagricultural payrolls
Personal income less transfer paymentsIndustrial productionManufacturing and trade sales volume
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Lagging Indicators
Average duration of employment Change in labor cost per unit of output Average prime rate charged by banks Commercial and industrial loans outstanding Ratio of consumer installment loans
outstanding to personal income Change in the CPI for services Ratio of manufacturing and trade inventories
to sales
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Real or Physical Causes of the Business Cycle
Innovation theoryBusiness cycles are caused by breakthroughs
in the form of new products, new methods, new machines, or new techniques
Agricultural theoriesBusiness cycles relate the general level of
business activity to the weather
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Psychological theoryWhen investors and consumers react according to
some belief about future conditions, their actions tend to transform their outlook into reality
Rational expectations theorySuggests that individuals and businesses act or react
according to what they think is going to happen in the future, after considering all available information
Psychological Causes of the Business Cycle
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Monetary theoryMonetary theoryBusiness cycle is caused by the free and easy
expansion of the money supply Spending and saving causesSpending and saving causes
Underconsumption theories: cycles are caused by the failure to spend all national income, resulting in unsold goods, reduced total production, and consequent reductions in employment and income
Underinvestment theories: recessions occur because of inadequate investment in the economy
Monetary, Spending & Saving Causes of the Business Cycle
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1991-2001 Business Cycle
Longest cyclical expansion in U.S. history & subsequent recession one of the mildest
Causes of expansionUsual ingredients for cyclical recoveryMonetary and fiscal policies conducive to economic
growthRapid introductions of new applications of
innovations in communication and computer technology, including Internet
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1991-2001 Business Cycle
Productivity gainsLow energy costs
Causes of contractionSeptember 11th and its impact on travel related
industriesCollapse of several major companies such as Enron,
WorldCom, etc.Declines in equity markets and their impact on
personal wealth