2015, Study Session # 5, Reading # 18

UNDERSTANDING BUSINESS CYCLES

18. a

Business cycle is defined by fluctuations in the economic activity.

Real GDP & unemployment rate are the key measures used to evaluate current
phase of business cycle.

Phase of Business Cycle

Expansion:
Real GDP

Contraction: Real GDP 

Peak: Real GDP Begins Decreasing

Output

Employment

Consumption & Investment

Inflation

Output
Employment
Consumptions & Investment
Inflation

18. b

Inventories are an important business cycle indicator.

Inventory/Sales ratio typically increases in later stage of expansion.

Firms try to adjust their utilization of labor & physical capital in reaction to
fluctuations in business activity.

Firm lay (add) employee during contraction (expansion) slowly as its a high cost
activity, buying & selling plant and equipment is costly, firms adjust production
levels by their current physical capital.

Investment in new capacity is only made if expansion is likely to persist.

18. c

Theories of the Business Cycle

Neoclassical Economists

Business cycles are temporary

Driven by in technology.

Economy moves toward full employment as a
result of rapid adjustment of wages & other input.

Keynesian Economists

Lowering interest rates may not reignite economic
growth and government intervention through fiscal
policy may be required.

Wages are slow to move downward Contraction can
persist for long.

According to New Keynesians prices of input variables
other than labor also slowly move downward.

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Early expansion (recovery): Real

GDP Begins Increasing

2015, Study Session # 5, Reading # 18

18. c

Theories of the Business Cycle

Monetarists
Money supply needs to grow at a moderate rate
otherwise economic downturn may be severe or
inflation may accelerate. Business cycles may occur
due to exogenous shocks or govt. intervention.

Austrian School
Government intervention that drives interest rates
to be artificially low triggers business cycle.

Real Business Cycle Theory

Utility maximizing factors response to real economic
forces explains the business cycle.

18. d

Types of Unemployment

Frictional Unemployment

Structural Unemployment

Results from time lag between which

employees & employers find each other.

Results from long-term economic changes.

Cyclical Unemployment

Result from changes in general level of

economic activity.

 

    

An individual, who is actively seeking for work, is available for work
but not working is considered as unemployed.


   =

Labor force includes all individuals who are working or are available for
work.

     =

 

  

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2015, Study Session # 5, Reading # 18

18. e

Inflation: Sustained increase in price levels over a time period

referred as inflation.
    =




Deflation: Sustained decrease in price level over a time period is

referred as deflation.

18. f

  =

.          &       

.       &       .

CPI is one of the most widely used price index.

Percentage in prices index for all goods in the economy is known to as
Headline inflation.

Percentage change in price index excluding food & energy price is
referred as core inflation.

18. g

Laspeyres Price Index:

Price index created by keeping the composition of the consumption
basket constant.

Biases causing Laspeyres Price Index to be Biased Upward:

New goods

Quality changes

Substitution

Paasche Price Index:

Reduces substitution bias.

Uses current consumption weights for basket of goods/services for both
current & prior (base) period.

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2015, Study Session # 5, Reading # 18

18. h

Types of Inflation

Cost-push inflation:

Real price of an important factor 
aggregate supply.

Demand-pull inflation:
Persistent
in AD
P temporarily
output > potential or full-employment level

Unemployment rate below which upward pressure wages is likely to develop is represented by
NAIRU (Non-Accelerating Inflation on Rate of Unemployment).

18. i

Economic Indicators

Leading indicators:
They have turning points before peaks/
trough in business cycle.

Coincident indicators:
They have turning point at the same point as
the business cycle.

Lagging indication:
They have turning points that occur after that of
business cycle.

Limitation:

Relationship b/w various indicators & business cycle
is not exact.

Relationship varies over time.

18. j

Analysts should use variety of indicators

together rather than relying on any one
indicator.

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