Business Cycles
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Why Should I Care?
Our economy is not always stable. It grows and shrinks, sometimes violently, wreaking havoc on families and communities through inflation or unemployment. There is a silver lining; business cycles can provide opportunities to those who understand the system. It’s all about people’s feelings about risk, investment and profits.
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This Lecture Has 6 Parts
- Phases of Economic Fluctuation
- Triggers
- The Catalyst
- The Correction
- Cyclical Products
- Predicting the Cycle
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What is aare Business Cycle?Cycles?
As a general observation, government spending habits seem to be relatively stable over time. The government provides military, police, justice, education, and healthcare services which are not cyclical in nature. We have stable needs in terms of schools and hospitals.
However, the private sector thrives on risky investments and profit-seeking ventures. Many business owners will wait for the whole economy to be doing well before they venture their savings in a risky new investment. The “business” sector is more likely to act in waves, or cycles, to reduce the risk of their ventures.
Using aggregate measurements of the economy, we can identify phases of economic fluctuations. Not only can we use the usual data from GDP, unemployment, and inflation, but we will also use data like business bankruptcies, aggregate income, average hours worked, average wages paid, manufacturing orders and sales, and many others.
Of course the main measure of economic activity is Real GDP (Y or output). The fluctuating “business” component of Real GDP is measured through several accounting categories. On the expenditure side, demand for personal consumption and business investments are both private market operations that can fluctuate. On the income side, profits, rent, and interest payments are the most volatile components of Real GDP.
If Y goes up, it must be because of a change in one of the components: C, I, G, X, or M.
Theoretically, there should not be cycles. Remember the Circular Flow Diagram: one person’s spending is another person’s income. The diagram should be in a steady-state.
The key is risk. People reduce their spending in a downturn, to increase savings and feel safer about their prosperity. This slows the economy. In a growth period, business people risk their savings in profit-seeking ventures, and increase investments, which grow GDP. Karl Marx called these cycles’ booms and busts. He believed they were inevitable and would only impoverish workers in the long run. Fortunately, in the last 200 years, the booms have generally been bigger than the busts. Overall, one can argue that, on average, the market economy has produced more wealth than poverty.
Keep in mind that a business cycle is a change in production flow. This flow starts with the stocks of resources, and moves them into stocks of product. For example, the first stock might represent materials in a lumber yard. The flow is consumers buying lumber. The end stock is a nice patio in someone's yard, which is a stock of final production. The problem for us is that sometimes people buy more lumber, sometimes less. That change in the flow of production can create important social ills like unemployment and poverty.
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Phases of Economic Fluctuation
As measured by Real GDP, the economy either grows or shrinks. When Real GDP expands, aggregate demand may exceed the capacity of production. This is called the over-heating phase and usually leads to a peak, and maybe a downturn of economic activity. Expect high prices in factor markets such as minerals and labour production, more jobs, more demand, and steady prices on product markets.
When Real GDP shrinks, we call that a recession. Expect less production, less jobs, less demand, and lower prices on both factor and product markets. Technically, economists won’t call a recession (the R-Word) until Real GDP has decreased for six consecutive months in a row (or two quarters). Economists also measure the low-point in Real GDP, called the trough. This is used to measure the length, and depth of the recession.
When Real GDP grows, the economy enters a recovery phase. Expect more production, but jobs, and prices will take time to increase as factories use up idle machines and piled-up inventory before hiring new workers and ordering more inputs. Once Real GDP grows past the previous peak, the recovery is over and the economy is in expansion phase. Expect more production, more jobs, more demand, and growing prices on factor markets.
When Real GDP expands too much, aggregate demand may exceed the capacity of production. This is called the over-heating phase and usually leads to a peak, and maybe a downturn of economic activity. Expect high prices in factor markets such as minerals and labour production, more jobs, more demand, and steady prices on product markets.
Graph - The phases of the business cycle
The following table depicts the behaviour of the big 3 macro variables during the four phases of the business cycle. Consider that these figures would probably occur in a situation with no government intervention. We will discuss government intervention later in the course.
Table - Phases of the Business Cycle
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Phase |
Real GDP |
Unemployment Rate |
Inflation |
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Growth |
UP UP (+4 %) |
DOWN (6 %) |
FLAT (0-2 %) |
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Over-heating |
UP (4 %) |
DOWN (3-5 %) |
UP UP (4+ %) |
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Recession |
DOWN (-2 %) |
UP (10+ %) |
DOWN (-2 %) |
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Recovery |
UP (+1%) |
FLAT & HIGH |
FLAT & LOW |
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Theories of Economic Fluctuation
Many economic theories exist concerning fluctuations; they all deal with risk.
Volatile Investments: Investments often need loans, and are sensitive to interest rates. Also, suppliers will wait for expansionary period to reduce the risks of their own expansion plans. Suppliers end up running their factories and stores as they would feed wood in a hot-stove, either too hot, or too cold, but never just right.
Lags in supply chains: An important factor is that economic activity can build up due to lack of coordination between the suppliers of a supply chain. For example, every company has an order book, which allows it to manage production over the next weeks, months, and years. As orders come in, firms themselves order inputs such as materials and equipment. This network of dependent actors can actually load too many orders than are possible to produce, which then creates lags in production. Adjusting orders across complex systems can explain why the economy tends to slow down, or accelerate beyond it's optimal level.
Demand Shocks: Aggregate Demand may fluctuate. If people are scared, they may reduce consumption to increase their savings. Also, foreign demand may decrease, reducing exports. This may be due to lower overall activity in the foreign country, or to new competitive substitutes from somewhere else.
Innovations: Suppliers wait for an expansionary period before marketing new products, which are risky ventures. This boosts investment and consumption. Innovation can also create new substitutes to local production which can reduce economic activity.
GDP data has shown that diverse economies tend to fluctuate less wildly than economies that are specialized and dominated by an export sector such as minerals, or manufacturing.
One reason may be that diversification reduces the cyclical risk of specific industries. When one industry declines, others may be doing well, so the overall level of production does not necessarily decline, or if it does, the recession is not as deep.
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Triggers
Economists don’t agree on the existence of a “cycle”, which is inevitable. Economists do agree that historically these cycles reoccur regularly. We will present a consensus theory that explains how fluctuations work, and why they end.
Our cycle needs a trigger: a social, natural, or economic event that changes people’s feelings about risk, wealth and the future. A trigger is a micro-economic event that can have macro-economic consequences.
Examples:
Natural catastrophes Political unrest & War
Hyperinflation Increase in input prices
Negative expectations Decrease in demographics
Shifts in foreign demand Labour saving technology
Some of these triggers can play on aggregate demand. For example, a decrease in the population will reduce overall planned expenditures for goods and services. Other triggers will effect aggregate supply. For example, a natural catastrophe that destroys industrial assets such as plants and hydro dams will reduce an economy’s capacity to produce.
Two examples: in 2008, a price bubble blew up in the US housing market and sent the world economy into recession. The following stock market crash reduced aggregate demand.
In 1972, a sudden increase in oil prices sent the Western world in a recession. This reduced increased costs of production across the economic system and reduced aggregate supply. The triggers are game changers because they generate feelings about economic risk. A trigger can increase optimism, which is driven by profit-seeking and greed. Or the trigger can increase pessimism, which is driven by risk aversion and fear.
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The “production – jobs – demand” Catalyst
If a “trigger” event is contained, and limited to one microeconomic market, it cannot create a macroeconomic phenomenon. But if the feelings are strong enough, the initial trigger, however small it seemed, may not be contained to one market, because of a built-in catalyst in the economic system.
A catalyst is something that accelerates the speed, or increases the energy, provided by a smaller phenomenon such as a trigger. For example, a gun has a finger activated trigger, and the explosive gun powder acts as a catalyst to increase the energy from the trigger. The explosion accelerates the speed of the bullet. Economists don’t agree on everything, but they do agree that a series of accelerating domino effects can come into play. The “production-jobs-demand” catalyst is a self-reinforcing feedback loop that is built-in to the economy.
Virtuous cycle:cycle
In an expansion period, a series of positive effects that feed into more positive effects.
Vicious cycle:
In a recession period, a series of negative effects that feed into more negative effects.
Growth phase
Optimism More inventory
Suppliers increase production More jobs
More demand for consumer goods More sales
Increasing business confidence More production
More jobs, higher wages Higher prices More optimism
Recession phase
Pessimism Less inventory
Suppliers decrease production Less jobs
Less demand for consumer goods Less sales
Decreasing business confidence Less production
Less jobs, lower wages Lower prices More pessimism
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The Correction
What can reverse a vicious cycle from continuing forever? Well, every recession has “bottomed-out” at some time, and every phase of “over-heating” has stopped eventually. Our economies go through downturns, but they usually bounce back.
Why? It’s confusing. Prices play a double role. As we have just seen, high prices can create more optimism. Why reduce production when prices and profits are soaring? But prices also affect workers, and families, and anyone else who is a consumer in the economy. Prices can therefore create a second feedback mechanism. It usually takes a while to activate, but this self-correcting feedback loop never fails.
A recession usually drives prices down, as surpluses appear on all sorts of markets. The surplus of labour, natural resources, and final goods is due to disequilibrium of demand and supply. Suppliers have left resources idle. These low prices change the rules of the economy and create opportunities to buy assets and reduce the risk of profit-seeking ventures. The most important prices in an economy are wages. When wages drop, the cost of labour is reduced. This can convince employers to start hiring again and thus the recession is corrected.
Inversely, an expansion period usually drives prices up, as shortages appear in resource markets. These higher prices for labour and land work their way into the price of final goods. Shortages and higher prices act as a natural “cooling” agent on the economy by reducing demand for these products.
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Cyclical Products
The sales of goods and services will vary according to the economic cycle. But some products don’t vary much at all. In fact, some products will sell even better during a recession.
Pro-cyclical products:
“Normal goods”. Anything luxurious and expensive, big-ticket durable goods (furniture, homes, cars), also discretionary non-durable consumer goods (movies, restaurants, clothes, home decorations, ice-cream)
Non-cyclical products:
daily necessities, milk, bread, cheese, gasoline, health services.
Counter-cyclical products:
“Inferior Goods”, such as car parts, pasta, cheap candy, home hardware, home entertainment, cheap substitutes to non-durables.
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Predicting the Cycle
You wouldn’t know if the economy is overheating because you saw your neighbour buy an expensive car. But you can predict Real GDP with some accuracy using the right data. Keep in mind the statistic must refer to a phenomenon that happens before a final sale will be registered into Real GDP.
- Durable Goods Orders
- Net business formation
- New building permits
- Transportation company sales reports
- Raw materials prices
- Average hours worked, and paid
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Wrap-Up
Business cycles are economic phenomena that arise from how much risk people feel is prevalent in the economy.
Changes in consumption and investment spending affect Real GDP which grows during expansion periods, and contracts during recessions. Expansions are associated to inflation, whereas recessions are associated to high unemployment rates.
The interconnected nature of economic flows between people mean that one person’s reduction in spending becomes another person’s lost income. These domino effects generate vicious or virtuous cycles, which are called self-reinforcing feedback loops.
The cycle ends when people change their mindset about risk. New price levels help people assess the macroeconomic environment.
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Cheat Sheet
Trigger:Trigger
A micro-economic event that can have macro-economic consequences.
Catalyst:Catalyst
A system that, in reaction to a change, acts to increase the magnitude of that change. Also known as positive feedback: A produces more of B, which in turn produces more of A. Self-reinforcing feedback loop.
Correction:Correction
An event that sends a system into a negative feedback. A produces less of B, which in turn produces less of A. Self-correcting feedback loop.
Expansion: Expansion
A period of increasing economic activity, Real GDP is surpassing past peaks. Also called growth phase.
Over-heating:heating
A period of increasing economic activity, Real GDP is surpassing Potential GDP. Inflation accelerates. Unemployment at historical lows. Factor shortages.
Recession:Recession
A period of decreasing economic activity, Real GDP below Potential. Associated to low prices, high unemployment rates and factor surpluses.
Recovery:Recovery
A period of increasing economic activity, Real GDP is growing, but has not reached its previous peak.
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References and Further Reading
James, E., Wellman, S. J. & Aberra, W. (2012) Macroeconomics, 2nd ed. Pearson Canada. Chapter 12.
Mankiw, N. G. (2018). Principles of Macroeconomics, Eighth Edition. Cengage Learning. Chapter 22 - The Short-Run Trade-off between Inflation and Unemployment.
Stiglitz, J. E. & Walsh, C. E. (2006). Economics, Fourth Edition. WW Norton. Chapter 29 - Introduction to Macroeconomic Fluctuations.