Business Cycles

The Economic Fluctuations

Main Textbook Reference: Mankiw and Taylor CH26

Learning objectives
v Definition of business cycles
v The features of the four phases
v Cyclical indicators
v Application: invest using the business cycle
v The possible causes of business cycle
vBusiness cycle models

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Figure 1a. UK GDP, measured in current US dollars on the vertical axis over the period 1961 – 2017.

Data Resources : The World bank

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Figure 1b. GDP across the EU over the period 1961 – 2017.

Similarity?
-trend
-fluctuation
 Figure 2. UK GDP Growth Rate, 1961 – 2017 (%)

Varies in
-the amplitude*
-the length
between peaks
and troughs

*Amplitude is the difference between a peak and a trough in the business cycle and trend output.
1. The description of business cycles
 What is a Business Cycle?
These periods of expansion and slowdown of the level of
economic activity are referred to as the business cycle.
o Economic activity: the rise and fall in production output of goods and
services. (i.e. The amount of buying and selling changes over time)
o Measured using the changes in the real GDP.

Business Cycle is the study of the fluctuations in economic

growth around the long-term trend growth.
Long term: due to population, productivity growth..
GDP growth rate: 2-3%; unemployment: 4-4.5%; inflation 2% Reference: Office
for budget responsibility Economic and fiscal outlook

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Question What does a flattening long
term trend line mean?

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Phases of a Business Cycle
²Contraction: when real output is lower than the previous time
period.
§ Recession : two successive quarters of negative economic growth.
§ Depression : is a severe recession.

²Trough is where economic activity reaches a low and the

decline ends.

²Expansion : when real output is higher than the previous time

period.

²A peak is where economic activity reaches a high and real

output begins to decline.
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 Features of the four phases
Peak: Growth of economic activity peaking, credit growth strong, profit growth peaks, higher
tax revenue, policy neutral; Inventories and sales grow, reaching equilibrium relative to each
other. capacity becomes constrained, which leads to rising inflationary pressures and a tight
labour market .
Beginning of contraction: Policy contractionary, growth moderating, confidence drops, lower
AD, credit tightens, earning under pressure. Sales falls.
Recession phase: Falling activity, profits decline and credit is scarce for all economic actors.
Policy eases (e.g.low interest rate); inventories, sales fall, unemployment increases.
Expansion: recovery, economic activity (AD/GDP, industrial production, consumption,
employment) and confidence (house prices, investment) rebounds. Credit conditions stop
tightening, policy still simulative (e.g. easy monetary policy), profits grow. Business
inventories are low, sales improve

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Business winners and losers during different
phases of business cycles
When making strategic business plans: be aware of the published GDP growth data, and factor it
into your economic forecast and plans.

Businesses that sell normal goods...

- expand with the economy

Businesses that sell inferior goods...

- opposite!
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The Three Points About Economic Fluctuations
① Economic fluctuations are irregular and unpredictable.
② Most macroeconomic variables fluctuate together.
③ As output falls, unemployment rises.

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Different recession/recovery shapes
Economic fluctuations are irregular and hard to predict. [1st point]

V- Shaped
U-Shaped
W-Shaped
L-Shaped

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2. Cyclical indicators
Cyclical Indicators
Most macroeconomic variables that measure some type of
income or production fluctuate closely together. [2nd point]
The leading indicator can be used to foretell future changes in
economic activity. [point towards possible future events]
The lagging indicator occurs after changes in economic activity
have occurred. [Q: why its useful?]
The coincident indicator occurs at the same time as changes in
economic activity. [clarify the state of the economy]

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 Are these variables leading,
lagging or coincident indicators?
qStock index (FTSE-250);
Question qBond yields / yield curve
qPurchasing Manager’s index;
qConsumer confidence/expectation (?)
qGDP
qPersonal income
qUnemployment
qQuantity of loans / Consumer Debt to Income Ratio

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Yield Curve
What Is a Yield Curve?
A yield curve is a line that plots yields
(interest rates) of bonds having equal credit
quality but differing maturity dates.
The slope of the yield curve gives an idea of
future interest rate changes and economic
activity.
There are three main types of yield curve
shapes: normal (upward sloping curve),
inverted (downward sloping curve) and flat.

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Example: the yield curve of the U.S. Treasury debt
on December 4, 2018 (source: Haver Analytics/US Treasury Department)

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Question Why Does The (normal) Yield
Curve Slope Upwards?

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The Predictive Powers of the Bond Yield Curve
HOW THE YIELD CURVE PREDICTED EVERY RECESSION FOR THE PAST 50 YEARS
KEY TAKEAWAYS
1. A normal yield curve shows bond yields increasing steadily with the length of
time until they mature, but flattening a little for the longest terms.
2. A steep yield curve doesn't flatten out at the end. This suggests a growing
economy and, possibly, higher inflation to come.
3. A flat yield curve shows little difference in yields from the shortest-term bonds
to the longest-term. This indicates uncertainty.
4. The rare inverted yield curve signals trouble ahead. Short-term bonds pay
better than longer-term bonds.

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Purchasing Managers' Index (PMI)
The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends
in the manufacturing and service sectors.
It consists of a diffusion index that summarizes whether market conditions, as viewed by
purchasing managers, are expanding, staying the same, or contracting.
The purpose of the PMI is to provide information about current and future business conditions
to company decision makers, analysts, and investors.
The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when
compared with the previous month. A PMI reading under 50 represents a contraction, and a
reading at 50 indicates no change. The further away from 50 the greater the level of change.
à Leading indicator of overall economic activity

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 Cyclical Indicators
qStock index (FTSE-250);
qBond yields / Yield curve
qPurchasing Manager’s index;
qConsumer confidence/expectation (?)
qGDP
qPersonal income
qUnemployment (?)
qQuantity of loans / Consumer Debt to Income Ratio
Conference Board Indicators - one of the most comprehensive list of useful indicators
that economists follow.

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 GDP and Unemployment - Okun’s law
As output falls, unemployment rises. [3rd point]
Okun’s law states that in order to keep the unemployment rate steady, real
GDP needs to grow at or close to its potential.

When firms choose to produce a smaller amounts, they lay off

workers.
o If there is a time-lag between any downturn in economic activity and a
rise in unemployment and vice versa. à Unemployment is a lagged
indicator.

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Composite Leading Indicators
The Organisation for Economic Cooperation and Development (OECD) uses an index of cyclical
indicators – composite leading indicators (CLI), to try to identify potential turning points in
economic activity relative to trend six to nine months ahead.

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Understanding Composite Leading Indicators

More on Forecasting methods and analytical tools

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 Figure 3. OECD Area CLI, Dec 2020

Source: OECD

Q: What does the CLI tell us?

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3. Investment over The Business Cycle
Steps
1. Identify the phases and the direction of the business cycle
2. Make asset allocation decisions according to the probability
that assets may outperform or underperform
 Steps 1: Identify the Phases and direction
A. The GDP equation:
GDP= C + I + G+ (X-M)

B. Cyclical indicators
 A. GDP= C + I + G+ (X-M) : Causes Of Changes In
The Business Cycle
Changes can be caused by:
① Household spending decisions. (w, r, T .. )
② Firms’ decision making. ( demand, PPI, w, productivity, T, exchange rate, …)

And their Confidence and expectations

① External sources.
② Government policy

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Summary of the causes
Demand side : real wage, interest rates, taxes,
exchange rate, asset prices, confidence, credit cycles
(banking/housing/currency crisis) ..
Supply side: population, technological/productivity
shock, commodity prices (cost), business taxes,
exchange rate, inventory cycles
**Multiplier Effect : G….AD…unemployment…C…AD (GDP)
**Accelerator Effect: GDP…I….GDP…

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 B: Using cyclical indicators
Choose the cyclical indicators
a) Economically Significant
b) Good Cyclical Behaviour
c) High Data Quality.
Leading, Lagging And Coincident Indicators: Composite Leading
Indicators; Stock Index (FTSE-250); Bond Yields; Yield Curve
Consumer Confidence/Expectation, New Home Sales, Retail
Sales, Personal Income; Unemployment, Average Prime Rate; CPI
& PPI; Quantity Of Loans / Consumer Debt To Income Ratio;
Purchasing Manager’s Index; Housing Permits;…
Steps 2: Choose the sectors to invest

◦The early expansion : a sharp economic recovery. Sectors

that typically benefit most from a backdrop of low interest
rates and the first signs of economic improvement à
interest-rate-sensitive and economically sensitive assets
[equity, housing, industrials]
◦late expansion / Peak : defensive and inflation resistant
sectors [oil?]
◦Recession : most defensive, historically stable sectors
[consumer staples]
Sector performance in each stage of the business cycle (reference:
Fidelity)

Financial sector
Equity / Bonds
Real estate
Industrials
Transportation
Consumer discretionary
Information Tech
Energy
Commodity
Consumer Staples
Health Care
Utilities
Other assets
1.Would you buy or sell bonds or short the
bond market in anticipation of recession?
2.How about Gold?
a) Holds value during inflationary periods
b) Gold prices rise with inflationary expectations
c) Gold’s industrial applications mean gold prices rise during
economic expansions

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4. Business Cycle Models
Business Cycle Models
1. Neoclassical / New Classical Model
2. Real Business Cycle Model / New Classical
3. Keynesian School
4. New Keynesian Model
5. Monetarist School
6. Austrian School

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Neoclassical /New classical (according to M&T)
Labour market
-imperfect information, unanticipated price changes,
Inflation fallacy :
Price increases à real wage falls à labour demand
increases à labour demand > labour supply à nominal
wage increases but less than price rise à real wage fall ;
output rise above trend GDP
Cyclical implications : Unemployment is countercyclical, inflation is pro-cyclical,
real wages is countercyclical ß output rises when real wages fall
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Real Business Cycles
Real business cycle theories –Kydland and Prescott (1982) – emphasise supply-
side causes of the business cycle: productivity /technology shock is the major
cause of the business cycle fluctuations, the economic agents have correct
expectations. The GDP growth is not considered to be deterministic but
stochastic. RBC tend to assume rates of unemployment reflects changes in
people’s willingness to work.

- no market imperfection
- no role for stabilization policies
In RBC, employment, labour productivity and real wages are pro-cyclical.

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New Classical
1. Shifts in AD and AS are driven by changes in shocks (demand or
supply side)
2. Business cycles result from temporary deviations from equilibrium
and economy will move towards full employment equilibrium by
adjusting the money wage rate
3. Introduced real business cycle theory (RBC), which focuses on the
effect of real economic variables rather than monetary variables,
RBC applies utility theory, arguing that policy makers should not
intervene business cycles because markets are efficient

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Keynesian
1. Business cycles result from changes in expectations, which tends to overinvest when
optimistic and underinvest when pessimistic
2. Wages are downward sticky and increase AD is the best way

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 New Keynesian
1. Rational expectation
2. Sticky prices with microfoundation – contracts ; menu costs…
3. Demand side policy is needed

The speed with which the economy returns to trend after an AD shock will depend on the time it takes for prices and
wages to adjust to the changed economic conditions. In this model, employment, real wages and inflation are pro-
cyclical, and unemployment is countercyclical.

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Monetarism
Monetary neutrality implies that an increase in the money supply will,
over a period, lead to an increase in the price level, but not in real
variables such as output, consumption and relative prices
1. Business cycles result from variations in the rate of
growth in M
2. Central bank should follow a policy of steady and
predictable increases in M to keep AD stable and
growing.

Policy makers in the 1980s focused on controlling growth in the money supply.

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Austrian
The Power of Free Markets

The fundamental beliefs associated with the Austrian School are those of
the power of free markets, private property, property rights and individual
choice.
◦ Only individuals make choices which generate unintended consequences.
◦ Prices are determined by subjective factors like an individual’s preference.
1. Business cycles result from government intervention
2. When government forces interest rates down to artificially low levels, firms will invest too
much to cause the boom

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 Business Cycle Models
1. Are there deviations from equilibrium?
2. Reasons of the deviation?
3. How fast can variables adjust?

Incomplete information / inflation fallacy.

Sticky prices / sticky wages.

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The Austrian School VS Keynesian
 Contrasting Business Cycle Theories:
Keynesian vs. Austrian
Keynesian Austrian

Shape Bust-Boom Boom-Bust

Cause & Problem Insufficient Aggregate Demand Artificial Credit Expansion
Mal-investment/Consumption

Prescription Expansionary policies Let bust run its course

Decision maker Policy makers steer the market Let consumer demand dictate prices and
resource allocation

Prevention Give the government control of Don’t give money production authority
money production & spending to non-market institutions

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Other important economic/business cycles
Credit cycle / Debt cycle –interest rates, asset prices
Inventory cycle : more volatile

References:
Business Cycles, Lars Tvede
Big Debt Crises, Ray Dalio
"Fear the Boom and Bust": Keynes vs. Hayek