Professional bachelor’s study programme

“EUROPEAN BUSINESS STUDIES”

COURSE PAPER
IN ECONOMICS

Business Cycles

Evaluation: Full time student, year 1

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Commission:
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Supervisor:
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____________________ Asoc. profesore, Dr.sc.administr.
Ieva Brence

RĪGA, 2019
Table of Contents
Abstract.....................................................................................................................................................................3
List of abbreviations and conventional symbols.......................................................................................................4
1. Theories of business cycle................................................................................................................................6
1.1. Business cycle: essence, the evolution of views and reasons..................................................................6
1.2. Economic indicators..............................................................................................................................10
Abstract
List of abbreviations and conventional symbols

NBER – The National Bureau of Economic Research

RBC-models – Real business cycle models
HPI – House Price Index
Introduction
 1. Theories of business cycle
This section presents the study of literary and other sources regarding business cycles.
Further, significant episodes in the history of economic development are presented. To
conclude the chapter, some indicators that may reflect the existence of business cycles are
presented.

1.1. Business cycle: essence, the evolution of views and reasons

The instability of the economy has led to an increase in the relevance of questions
about the essence of economic growth, the appropriateness of its models as well as the
relationship between growth and cycle phenomena. The cyclical nature of economic
development is contrary to the theory of economic growth. The instability of the economy and
the risks associated with this have led many scientists to start studying the mechanisms of
economic development using the theory of cycles.
The Great Depression of 1929-1933 led to the emergence of many scientific papers on
cyclical crises, which were considered both in political, economic, and mathematical aspects
(McConnell et al., 2013). Among them: J. Keynes ("The General Theory of Employment,
Interest and Money", 1936), R. Harrod ("The Trade Cycle: An Essay", 1936), G. Haberler
("Prosperity and Depression: A theoretical analysis of cyclical movements", 1937), J.
Schumpeter (“Business cycles: a theoretical, historical, and statistical analysis of the capitalist
process”, 1939), P. Samuelson (“Interaction of the Multiplier Analysis and the Acceleration
Principle”, 1939), D. Hicks (“A Contribution to the Theory of the Trade Cycle”, 1950 g), E.
Hansen ("Business Cycles and National Income ", 1951), etc.
The generally admitted explanation of business cycles is Burns’ and Mitchell’s
definition "Business cycles are a type of fluctuation found in the aggregate economic activity
of nations that organize their work mainly in business enterprises" (Burns, 1946.)
According to Madhani, the business cycle is the downward and upward movement of
gross domestic product (GDP) around its long-term growth trend (2010).
The National Bureau of Economic Research (NBER) analyzes the processes that form
the basis of the theory of business cycles. The National Bureau of Economic Research is an
American private non-profit organization. It was founded in the United States in 1920 to
promote an objective quantitative analysis of the American economy. NBER analyzes the
micro, macro and international aspects of the US economy and studies business cycles. The
bureau also publishes research by third scientists and experts.
 The NBER defines a recession as a significant decline in economic activity spread
across the economy, lasting more than a few months, normally visible in real GDP, real
income, employment, industrial production, and wholesale-retail sales (Nber.org, 2010).
Thus, it is clear that the business cycle phenomenon refers to fluctuations in
production or economic activity across the entire national or global economy during a certain
period of time (for example, several months or years). Such fluctuations occur around the
main growth trend and usually include fluctuations between periods of economic growth and
periods of economic recession (O'Sullivan and Sheffrin, 2007).
The central long-term trend is the potential GDP with full employment. The economy
is in a growth phase when actual GDP is above potential value, and in a recession phase when
actual GDP is below potential one. The most critical points in economic development are the
peaks and trough, which reflect the highest and lowest values that the economy can reach in
the current economic conditions (Fregert and Jonung, 2016).
The entire business cycle is a period that includes all phases of the cycle, from one
peak to another (Figure 1.1).

Figure 1.1. Business Cycle (Tunggal, 2018)

In addition, the business cycle can be viewed as a mechanism for the economy to
respond to various disturbances arising from both the supply side and the demand side. One
example may be transformations in production or a variation in the demand for investment
assets (Dornbusch, Fischer and Startz, 2018). Further improvement of the theory of business
cycles resulted in the emergence of classification of business cycles in accordance with their
periodicity. Some of business cycles were named after their discoverers or authors (Table
1.1.).
 Table 1.1.
Business cycles
Name Period, Explanations
years
The Kitchin 3-5 Overshoots and undershoots of business inventories. Changes in
inventory cycle working capital, i.e., in stocks of inventory items. Because of
market conditions, there is an imbalance between supply and
demand.
The Juglar cycle 7-11 Destructions of funds’ investments in active elements of fixed
capital;
The flow of capital from one industry to another, the influence
of inter-industry competition;
The impact of the production price formation in the long term;
Changes in monetary factors.
The Kuznets 15-25 Change of generations of equipment;
cycle Demographic change;
Features of the economic policy of the government.
The Kondratieff 45-60 The technical and scientific and technological revolution,
wave or cycle causing:
restructuring, radical changes in the technological base of
production;
changes in infrastructure investments;
changes in the preparation of labor, i.e. investments in human
capital.

Contemporary theories of the business cycle are based on the assumption that there are
two types of factors that influence the cyclical nature of an economy. Thus, GDP and other
economic indicators are changing slowly, and the duration of business cycles can last for
several years. At the same time, there are also random events that force the business cycle to
change direction sharply (Fregert & Jonung, 2016). Among such circumstances, it is possible
to single out monetary and financial crises, agrarian crises, wars, political upheavals,
revolutions, random events such as the decision of OPEC countries in 1973 or sanctions
against the Russian Federation in 2014, failures in the actions of regulatory authorities, etc.
In the second half of the twentieth century, two neoclassical theories offer answers to
the question about the sources of cyclical fluctuations. The first theory is called Lucas
imperfect-information model, and the second is known as the theory of the real business cycle
(Chen, 2011).
 The Lucas imperfect-information model is still one of the main macroeconomic
theories examining the microeconomic reasons for slow adjustment of nominal wages and
prices (ibid). Lucas argues that the commodity producer may not have real information about
the situation on the markets of other goods. Taking into account rational expectations,
producers may regard the price increase as a result of the general price increase, and partly as
a result of a change in the relative price of the goods. As a result, there is an increase in
production and some recovery in the economy. A criticism of this model is the fact that, under
current conditions, manufacturers have a sufficient amount of information. In addition,
economic agents usually make purchases during a certain period; therefore, knowledge of
price movements is ahead of information about their indices over this period. In addition,
economic agents usually make purchases during a certain time; therefore, knowledge of price
changes is leading to information about their indices over this period.
In accordance with the concept of the real business cycle, the sources of cyclical
fluctuations are real shocks, revealed to the real sector of the economy. The real business
cycle model studies both the effect and the degree of various factors on output. In addition,
the correlation between various factors is investigated. The model explains the causes of
business cycles occurrence, and the resulting calculations of it are the basis for the
development of the fiscal and monetary policy of the state. This model has a significant
disadvantage: capital is not considered as a factor of production in the investment sector and
does not use in the production of investment goods. In addition, the financial sector is not
sufficiently analyzed (Rebelo, 2010).
The analysis of the evolution of theories of business cycles resulted in the following
conclusions:
 the basic methodological approach is the dynamic economic development;
 the main indicator of the cyclical nature of economic development are periodic
changes in GDP;
 investments in fixed assets have a significant impact on the change in gross
production, and they are carried out on the basis of rational investors' expectations;
 shocks occurring in the real sector of the economy are the source of business
cycles.

1.2. Economic indicators

 In order to analyze the impact of changes in GDP on the country's economy, it is
necessary to investigate various indicators that characterize it. Since this work has some
limitations (time and volume), the author has chosen the following indicators.
For business cycles analysis, it is necessary to investigate the real output (GDP) since
it is the best available measure of economic activity.
The financial cycle is best characterized in terms of credit and property prices. To
measure the financial sector, the author selected the Housing Index. Real HPI, an index that
measures the price of residential housing.
To study the labor market, the author has chosen the employment index.
GDP is the monetary value of all the finished goods and services produced within a
country's borders in a specific time period (Investopedia, 2019). Gross domestic product
(GDP) is the value of the goods and services produced by the nation’s economy less the value
of the goods and services used up in production. GDP is also equal to the sum of personal
consumption expenditures, gross private domestic investment, net exports of goods and
services, and government consumption expenditures and gross investment (Bea.gov, 2019).
A commonly used model in macroeconomics to describe GDP is defined as follow:

Y = C+G+I+N

Y is the demand for output in a country;

C – Consumption spending by households;
I – businesses and households investment expenses;
G – purchases of goods and services by the government;
N – net export (export minus iport).
Indicators measure different economic factors and have therefore connection to the
above formula (Dornbusch, Fischer, and Startz, 2011)
A House Price Index (HPI) is a tool that measures changes in single-family home
prices across a designated market (Discover Home Loans Blog, 2019). The HPI is a weighted,
repeat-sales index measures average price changes in repeat sales or refinancings on the same
properties. Since the HPI index only involves houses with mortgages within the conforming
amount limits, the index has a natural cap and does not estimate jumbo mortgages. The index
is determined based on the transaction prices registered in the Land Register by households
during the comparison period, whereas weights reflect the structure of the dwelling purchases
during the previous calendar year (Csb.gov.lv, 2019).
 HPI is a Laspeyres-type quality-adjusted price index. For the index calculation all
transactions are stratified into the following groups (strata):
 new flats;
 new single-dwelling houses (until 2008, including);
 existing flats in Riga;
 existing flats in the rest of the country;
 existing single-dwelling houses.
The group index is calculated as the ratio of geometric means of transaction prices in
comparison period and reference period.
In order to adjust structural (qualitative) dwelling transaction differences between the
comparison and reference periods, a hedonic regression method is used within each group. By
the method based on the most significant price determinants, a hypothetical value of dwelling
is calculated as follows:

Lntransaction price = ß0 + ß1X1+ ß2X2 + … + ßiXi (1.2)

i=1,…,n, where

Lntransaction price – a natural logarithm of transaction price;

xi – the price factors;
βi – the regression coefficients (factor impacts);
β0 – the constant.
The factors having the greatest impact on the dwelling price and taken into account in
the HPI calculations are geographical location of the property, property size (area) and
availability of amenities (Csb.gov.lv, 2019).
Employment rates are defined as a measure of the extent to which available labour
resources (people available to work) are being used. Employment rates are a measure of the
degree to which available labor assets (people available to work) are being used in this
economy (theOECD, 2019).

(1.3.)

Rates are determined as the proportion of the employed to the working age population.
Employment rates are susceptible to the business cycle in the short term. In long term
development, employment rates are influenced by governments' policies according to
education, social compensations, etc. Employed people are those failed 15 y. o. or over who
announce that they have worked in gainful employment for at least one hour in the previous
week or who had a job but were absent from work during the reference week. This indicator is
seasonally changed and it is estimated in terms of thousand personalities aged 15 and over and
as a percentage of working age population (theOECD, 2019).
 2. Research on Latvian economic indicators

In this section, the chosen research method will be presented. The author will describe
empirical methods, data collecting, and statistical methods. This section concludes by
statistical analysis of the data presented.

2.1. Method

There are, according to Bryman and Bell, two different types of methods, which is
used in research projects, either a quantitative strategy or a qualitative strategy (2015).
Quantitative method is selected as the research design for this study.
The quantitative research aims to examine the phenomenon with mathematical
demonstrating and factual estimation or measurable derivation. The quantitative aspect of this
study is linked with the statistical outcomes obtained from the survey.
According to Cooper and Schindler, the selected research method will define data
collection techniques (2006). Moreover, Yin demonstrates that the decision about this
procedure depends on different types of research questions.
A quantitative research method with secondary data will be conducted. This research
method investigates the relationship between variables (Maddala, Lahiri and Maddala, 2010).
Secondary data are used in this study.The data collected should be relevant and able to
provide the research a conclusion . Secondary data is usually attributed to as previous
empirical data in research, government publications or census records (Saunders et al., 2012).
The list of significant economic indicators has been revised over the years. The author
of this paper will use previous research as a basis for indicators choosing. Further information
with respect to the Central Statistical Bureau of Latvia, which publishes and summarize
information of the most frequently used indicators. In relation to this, indicators were selected
from the financial and real economy categories.
The sample period will be based on publically available data. As Latvia became an EU
member since 2004, the 2005 years was chosen as the first period. GDP will be used as a
dependent variable and indicators as independent variables. The test will include a maximum
of 10 years.
The authors gathered information from the original sources. Seasonally adjusted GDP,
HPI, UR are collected from the Central Statistical Bureau of Latvia.
Logarithmic Transformation, with natural logarithm, will be conducted on the data of
indicators and for GDP. In developing economies it is common to use logarithmic
transformation to get GDP growth (Stock & Watson, 2012).
 (2.1.)

yt – this year volume;

yt-1 – previous year volume.

To examine the chosen economic indicators’ development connected with GDP

growth, the correlation between them will be analyzed. Correlation is a non-unit judgment
that shows the strength and direction of a relationship between two variables. The measure of
correlation is revealed as values between -1 and 1. The value of 0 means no association
between variables, -1 indicates a maximum negative relationship and 1 show a maximum
positive relationship. This analysis will present information about the linear relationship
between indicators and GDP growth. A high positive correlation will show that two variables
progress in the same direction, whereas the opposite is true for a negative correlation.

2.2. Data analysis

The author presents the progression of the GDP in Latvia (table 2.1).
Table 2.1.
GDP 2005-2018 in Latvia (countryeconomy.com, 2019)
 Year  GDP, Logarithmic
th. euro Transformation
2018 29524 0,088
2017 27033 0,077
2016 25038 0,029
2015 24320 0,029
2014 23618 0,034
2013 22829 0,034
2012 22058 0,088
2011 20202 0,127
2010 17789 -0,053
2009 18749 -0,262
2008 24355 0,071
2007 22679 0,273
2006 17264 0,229
2005 13726
 For a visual representation of the dynamics of GDP, we present the values of table 2.1
in Figure 2.1.

Figure 2.1. – Logarithmic Transformation of GDP in Latvia

The next indicator is HPI. The progression of it is presented in table 2.2.

Table 2.2.
HPI 2006-2018 in Latvia (Ycharts.com, 2019)
 Year  HPI Logarithmic
Transformation
2006 119.19
2007 146.78 0,208216
2008 120.71 -0,19554
2009 85.34 -0,34675
2010 83.25 -0,0248
2011 88.05 0,056057
2012 93.41 0,059094
2013 101.0 0,078122
2014 96.57 -0,04485
2015 102.91  0,063587
2016 110.90 0,074774
2017 119.69 0,076276
2018 133.87 0,111964

For a visual representation of the dynamics of HPI, we present the values of table 2.2
in Figure 2.2.
 Figure 2.2. – Logarithmic Transformation of HPI in Latvia

The next indicator is HPI. The progression of it is presented in table 2.3.

Table 2.3.
Employment rate 2005-2018 in Latvia (Statistikas datubāzes, 2019)
Year Employment Logarithmic
rate, %
Transformation
2005 57
2006 60,1 0,053
2007 63 0,047
2008 60,1 -0,047
2009 51,5 -0,154
2010 52,7 0,023
2011 55 0,043
2012 57,2 0,039
2013 58,6 0,024
2014 59,3 0,012
2015 61,4 0,035
2016 61,7 0,005
2017 63,7 0,032
2018 64,7 0,016

For a visual representation of the dynamics of employment rate, we present the values
of table 2.3 in Figure 2.3.
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