Business Cycles

In this topic we explore the concept of the business cycle. A business cycle occurs due to the fluctuations that an economy experiences over time resulting from changes in economic growth. Understanding business cycles is the essence of a course in macroeconomics. Economists try to discern where the economy is located and more importantly where it is heading in order to deal with possibly adverse future economic events. When the economy is at or is heading in an undesirable direction, economists may apply fiscal or monetary policy tools to change the course of the economy. In general, a business cycle describes changes in the demand-side of the economy as measured by GDP, where: GDP = C + I + G + NX Over time, GDP does not remain constant and will change for many reasons, economic and noneconomic. Economic reasons include changes in government policies such as taxes and interest rates. The non-economic reasons are too many to even consider listing, but include factors such as war, drought, natural and man-made disasters. The defining part of the business cycle is a recession. Without a recession, the economy doesn't really experience a business cycle, just a period of a prolonged economic expansion. Between 1992 and 2000, the U.S. economy did not see a recession and set the record for the longest period of economic expansion without a recession. There were changes in real GDP growth during this time period, GDP even decreased in the first quarter of 2003, but no recession. The table above shows how the business cycle evolved in the 20th century. Prior to 1945, periods of recession were almost as common as days when the economy was growing. As we will discuss in Unit 9, until the Great Depression of the 1930s, economic policy makers generally did little to counteract the forces that drove the business cycle, choosing instead to allow the economy to take its own course. The result was long (typically almost 2 years) and frequent recessions that we usually much more severe than modern-day recessions. Modern economic thought is characterized by the use of both fiscal and monetary policies to counteract and smooth out the business cycle. As the table shows, economists have had success in using these policies to make the dealings of U.S. firms, as well as the life of Americans who work and save in financial markets less turbulent. To better understand the use of fiscal and monetary policies, take another look at the GDP equation: GDP = C + I + G + NX GDP is the sum of consumption + investment + government spending + net exports (exports imports). This equation can be written in further detail as: GDP = C(Y - T) + I(r) + G + NX

Y is equal to income and T represents taxes. (Y - T) gives us disposable income and thus consumption depends on the level of disposable income C(Y - T). r represents the interest rate and investment responds to changes in the interest rate.

As r increases, I will decrease. As r decreases, I will increase.

Fiscal Policy is represented by the executive and legislative branches of government and captures changes in taxes (T) and government spending (G). In the United States, the president and Congress make these decisions. As we can see from the equation, a decrease in T will increase disposable income (Y - T), increasing C and therefore increasing the growth rate of GDP. Government spending (G) directly affects GDP growth. If the economy is in a recession, a combination of tax cuts and increases in government spending can stimulate economic activity. For example, the U.S. economy saw its first recession in a decade in 2001. Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the 7% (at an annual rate) range. Monetary Policy is conducted by the central bank of a country - in the United States this is the Federal Reserve Board. Details will be present later in the class, but the Federal Reserve can increase and decrease interest rates to change business investment (I) in the equation above. Changes in interest rates will also influence consumption, but our focus in this class will be the effect on investment. For example, in the year 2000, the federal funds interest rate was 6.5% and by the summer of 2003, the interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal Reserve. Observers have concluded that economics is a somewhat imprecise field, especially when it comes to dealing with business cycles. Economic indicators such as GDP and the inflation rate are trailing indicators. They tell us a good deal about the economy, but importantly they tell us where the economy is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth in the current or following calendar quarter. Although there is often a correlation between future GDP growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly. Economists need to be able to identify changes in the growth trend and to spot these variations by using leading indicators such as changes in business inventories. Knowing current economic conditions is useful information for economists, but knowing where it is going is critical. As noted, economists use leading indicators to try to accurately predict future changes in GDP and the inflation rate. Interpreting the signals given by the leading indicators on

what direction the economy is taking is often weakly understood by economists, sometimes the indicators give conflicting signals and the conclusions made are often controversial. Before we go into the details of the business cycle, here is a summary of some important points to remember.

The policymakers desire to smooth out the business cycle by minimizing the magnitude of variations in economic growth over the course of the business cycle. It is crucial to understand where the economy is going in the future. If the path is not desired, then changes in economic policy can be made today to prevent that path from being realized. For example, assume that real GDP is growing at a desired 3% annual rate. If the Federal Reserve determines that GDP growth will soon slow down to a significantly lower growth rate, it can reduce interest rates today to stimulate future economic growth and try to maintain real GDP growth at 3% in the future. Leading economic indicators are the crystal ball for economic policymakers, and are used to predict the economy's future. Unlike your neighborhood fortuneteller, the economic crystal ball is usually cloudy. As a result, errors in judgment and public policy are possible. Economic policy errors include: o GDP growth is too rapid and inflation rates increase to uncomfortable levels,
o

GDP growth slows down too much, leading to an increase in the unemployment rate and possibly a recession.

In an attempt to reduce inflationary pressures, economic policymakers will attempt to slow economic growth. The reduction in the growth rate of real GDP corresponds to an economic downturn, where GDP growth has fallen from its peak level. Are economic policymakers stupid? Historically, economic downturns are eventually followed by a recession when real GDP growth actually becomes negative. Recessions are often synonymous with rising rates of unemployment. Rising unemployment rates certainly get the attention of economic policy makers who furiously enact expansionary policies (the durations of recessions tend to be much shorter than positive growth periods). The closest that economic policymakers come to nirvana is during the expansionary phase. The worst is over, economic growth is increasing (often very quickly), jobs are being created, and inflation remains muted. Everyone deserves their day in the sun, but after a brief interlude of happiness, rising inflation causes a storm of tears for even the most optimistic economists. Leading Economic Indicators As noted earlier, economic policymakers try to predict where the economy is heading in the near future based on leading economic indicators. The Fed follows many economic indicators which can give signs regarding changes in future economic growth and inflation. For example, as these economic indicators reach the danger zone, there is increasing likelihood that the economy is overheating and increasing the danger of rising inflation in the near future. Important leading economic variables that the Fed closely monitors include:

1) The unemployment rate: in relation to full-employment. On average, labor comprises roughly 2/3 of total production costs for businesses. When the unemployment rate reaches and then falls below full-employment, labor shortages build. As producers trying to expand production find new workers becoming increasingly scarce, they are forced to add costly overtime and offer higher wages to entice non-labor force members to work. The result is upward wage pressures. Wage increases translate into higher production costs, higher prices for goods and services and an increase in the inflation rate. Another important indicator related to employment is new jobless claims. Released every Thursday, new jobless claims give the number of people who are making an initial claim for unemployment benefits. If the number of new jobless claims is rising over time, the indication is that firms are increasingly laying off workers who then are filing for unemployment. A persistent increase in claims indicates that demand for goods and services is falling and unemployment rates will be rising. On the other hand, if new jobless claims remain constant or are falling, then labor markets are in good shape. Currently, economists consider 400,000 new weekly jobless claims to be the dividing line between a labor market to is adding jobs (on a net basis) and one that is experiencing net job losses. Even in the best of times, workers lose jobs and a number of 300,000, for example, signifies that the economy and labor market are doing very well. The lower the number of new jobless claims, the better for the labor market and people seeking employment. 2) The Labor Cost Index: measures what the title indicates the cost in terms of wages, salaries and benefits paid by firms to their employees. This is a very important indicator since even in the high technology US economy, labor still comprises about 2/3 of the total production costs to a firm. If the index is rising at a fairly rapid pace, and consumer demand is strong, firms are likely to pass on their higher production costs to the consumer by raising prices. In contrast, if the index remains steady, then strong consumer demand may not lead to higher prices and inflation. 3) The utilization of productive capacity: capacity utilization refers to the amount of physical capital available to firms that is in use. At any time, firms have a given stock of capital equipment such as machinery, office space, factories, computers and telecommunications infrastructure available to assist workers in the production of goods and services. In the short run, a firm's, industry's or economy's capital stock is considered fixed, as it often takes awhile to invest in additional capital equipment, especially when new office or factory space is required to increase output to meet growing demand. The Fed regularly surveys different producers to estimate how much of the capital stock in place is actually being used. As various producers within an industry reach full-capacity (100% use of the capital available) due to high demand for their product, firms are likely to begin charging customers higher prices to satisfy additional demand. This is the result of higher production costs resulting from additional shifts, overtime and other costs relating to increased use of the available capital. For the economy as a whole, the Fed becomes cautious as the capacity utilization rate approaches 84%. The Fed considers this to be the threshold at which inflationary pressures will build in some parts of the manufacturing sector. Although 84% is well below 100%, at this point the Fed judges that some important industries will be approaching 100% capacity utilization. Industries that are likely to reach full capacity before the economy as a whole include

manufacturers of basic commodities such as steel, aluminum and paperboard used in shipping final goods. As an example, consider the auto industry. When demand for autos is growing due to robust economic growth, auto manufacturers increase their output and the use of their capacity. Excess capital equipment and factory space, which had previously been idled, is put into production. Steel is an important input in automobile production and as auto manufacturers increase their output they order more steel used in production. At first, steel producers may also have some spare capacity (also known as slack) or unused capital equipment. However, as orders from the auto producers continue to grow, soon all available capital used in steel production is put into use. Adding extra capital would take several years, so the only way steel firms can boost production to meet additional demands is to add overtime and extra shifts - using the capital more intensively. In most cases, workers are paid higher wages for working overtime or extra shifts, and these higher production costs are passed on to the auto manufacturers. As auto producers pay higher prices for their steel inputs, they pass on the higher cost to the consumer by raising the prices of their final goods. 4) Commodity prices: as noted above, higher raw material and commodity prices (e.g., steel, copper, aluminum, paperboard) are often passed on to the final product. 5) Changes in business inventories: rapid growth in demand for goods and services will deplete business inventories. As businesses increase production to meet additional demand and to rebuild inventories to desired levels, inflationary pressures may build. Of course, falling inventories can also be a sign of weak consumer demand. The trend has to be placed in the context of overall economic conditions. 6) Worker productivity gains: worker productivity refers to output per worker, or how much of a good or service a worker produces during a given time period (e.g. per hour or day). As workers gain job experience, knowledge and skills, they become better at their jobs and their productivity improves. Increases in worker productivity helps to dampen inflationary pressures by decreasing production costs. Rates of change in worker productivity vary only slightly from year-to-year and significant changes are due to long-run economic dynamics. Presently, U.S. worker productivity improves by about 2.0% annually. The above leading indicators: the unemployment rate, capacity utilization, commodity prices, changes in business inventories and gains in worker productivity all help to give economists a picture of where the economy is going. Consider the U.S. economy in the beginning of 1994. The unemployment rate had fallen into a range consistent with what the Federal Reserve considers to be full employment (a shade below 6%). Capacity utilization had run up past 84%, commodity prices were beginning to show upward spikes and business inventories continued to fall. Combined with other economic indicators followed by the Fed, these conditions signaled an increase in the inflation rate in the near future. Consequently, by raising interest rates, the Fed took action to slow economic growth before inflation rates actually increased.