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Understanding Business Cycles

2024 Curriculum CFA Program Level I Economics

Introduction

A typical economy’s output of goods and services fluctuates around its longer-term path. We now turn our attention to those recurring, cyclical fluctuations in economic output. Some of the factors that influence short-term changes in the economy—such as changes in population, technology, and capital—are the same as those that affect long-term sustainable economic growth. But forces that cause shifts in aggregate demand and aggregate supply curves—such as expectations, political developments, natural disasters, and fiscal and monetary policy decisions—influence economies particularly in the short run.

We first describe a typical business cycle and its phases. While each cycle is different, analysts and investors need to be familiar with the typical cycle phases and what they mean for the expectations and decisions of businesses and households that influence the performance of sectors and companies. These behaviors also impact financial conditions and risk appetite, thus impacting the setting of expectations and choices of portfolio exposures to different investment sectors or styles.

In the sections that follow, we describe credit cycles, introduce several theories of business cycles, and explain how different economic schools of thought interpret the business cycle and their recommendations with respect to it. We also discuss variables that demonstrate predictable relationships with the economy, focusing on those whose movements have value in predicting the future course of the economy. We then proceed to explain measures and features of unemployment and inflation.

Learning Outcomes

The member should be able to:

  • describe the business cycle and its phases;
  • describe credit cycles;
  • describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle;
  • describe theories of the business cycle;
  • interpret a set of economic indicators, and describe their uses and limitations;
  • describe types of unemployment, and compare measures of unemployment;
  • explain inflation, hyperinflation, disinflation, and deflation;
  • explain the construction of indexes used to measure inflation;
  • compare inflation measures, including their uses and limitations;
  • contrast cost-push and demand-pull inflation.

Summary

  • Business cycles are recurrent expansions and contractions in economic activity affecting broad segments of the economy.
  • Business cycles are a fundamental feature of market economies, but their amplitude and/or length vary considerably.
  • Business cycles can be split into many different phases. The investment industry typically refers to four phases of the cycle: recovery, expansion, slowdown, and contraction, with the peak output occurring during the slowdown phase and the trough in output occurring in the recovery phase.
  • Classical cycle refers to fluctuations in the level of economic activity when measured by GDP in volume terms.
  • Growth cycle refers to fluctuations in economic activity around the long-term potential trend growth level with focus on how much actual economic activity is below or above trend growth in economic activity.
  • Growth rate cycle refers to fluctuations in the growth rate of economic activity.
  • Credit cycles describe the changing availability—and pricing—of credit. When the economy is strong or improving, the willingness of lenders to extend credit, and on favorable terms, is high.
  • When the economy is weak or weakening, lenders pull back, or “tighten” credit, by making it less available and more expensive, contributing to asset values and further economic weakness and higher defaults.
  • Credit cycles are relevant due to the importance of credit in the financing of construction and the purchase of property.
  • The extent of business cycle fluctuations and the duration of recessions and recoveries are often shaped by linkages between business and credit cycles.
  • Key economic variables change through the business cycle. The level of business investment shows significant changes over the cycle.
  • Employment levels follow the cycle with a delay as companies initially use overtime before hiring after the onset of recovery and then reduce overtime before reducing employment as the economy passes its peak and enters contraction.
  • Consumer spending, the largest component of output, follows cyclical patterns as workers make decisions based on their levels of income, wage growth, and employment outlook.
  • Spending on consumer durables is the most cyclical consumer activity, followed by services and consumer staples, which are less affected by the cyclicality of the economy.
  • The size of inventories is small relative to the size of the economy, but they have a much greater effect on economic growth than justified by their relatively small aggregate size relative to the economy as a whole.
  • Inventory–sales ratio measures the inventories available for sale to the level of sales. Analysts pay attention to inventories to gauge the position of the economy in the cycle.
  • Neoclassical and Real Business Cycle (RBC) theories focus on fluctuations of aggregate supply (AS). If AS shifts left because of an input price increase or right because of a price decrease or technical progress, the economy will gradually converge to its new equilibrium. Government intervention is generally not necessary because it may exacerbate the fluctuation or delay the convergence to equilibrium.
  • Keynesian theories focus on fluctuations of aggregate demand (AD). If AD shifts left, Keynesians advocate government intervention to restore full employment and avoid a deflationary spiral.
  • Monetarists argue that the timing of the impact from government policies is uncertain, and it is generally better to let the economy find its new equilibrium unassisted while ensuring that the money supply is kept growing at an even pace.
  • Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle an economy is at. Of particular importance are the leading indicators, which suggest where the economy is likely to be in the near future. No economic indicator is perfect, and many of these statistics are subject to periodic revisions.
  • Leading economic indicators have turning points that usually precede those of the overall economy. They include survey-based indicators, such as (ISM), new orders, and average consumer expectations. They also include average weekly hours, initial claims for unemployment insurance, new building permits, the stock market index, and the difference between yields on short-term and long-term bonds.
  • Coincident economic indicators have turning points that are usually close to those of the overall economy. They are believed to have value for identifying the economy’s present state. They include industrial production indexes, manufacturing and trade sales indexes, aggregate real personal income, and non-agricultural employment.
  • Lagging economic indicators have turning points that take place later than those of the overall economy; they change after a trend has been established. They include average duration of unemployment, inventory–sales ratio, change in unit labor costs, average bank prime lending rate, commercial and industrial loans outstanding, ratio of consumer installment debt to income, and change in consumer price index for services.
  • Policy makers and market practitioners use real-time monitoring of economic and financial variables to continuously assess current conditions and produce a nowcast. Nowcasting produces an estimate of the present state of the economy. It is useful because the actual data on such measures as GDP are only published with delay, after the end of the time period under consideration.
  • Unemployed are those people who are actively seeking employment but are currently without a job.
  • Long-term unemployed are those who have been out of work for a long time (more than three to four months in many countries) but are still looking for a job.
  • Frictionally unemployed are those people who are not working at the time of filling out the statistical survey because they are taking time to search for a job that matches their skills, interests, and other preferences better than what is currently available, or people who have left one job and are about to start another job.
  • There are different types of inflation. Hyperinflation indicates a high (e.g., 100% annual) and increasing rate of inflation; deflation indicates a negative inflation rate (prices decrease); imported inflation is associated with increasing cost of inputs that come from abroad; demand inflation is caused by constraints in production that prevent companies from making as many goods as the market demands (it is sometimes called wartime inflation, because in times of war, goods tend to be rationed).
  • Inflation is measured by many indexes. Consumer price indexes reflect the prices of a basket of goods and services that is typically purchased by a normal household. Producer price indexes measure the cost of a basket of raw materials, intermediate inputs, and finished products. GDP deflators measure the price of the basket of goods and services produced within an economy in a given year. Core indexes exclude volatile items, such as agricultural products and energy, whose prices tend to vary more than other goods.
  • Price levels are affected by real factors and monetary factors. Real factors include aggregate supply (an increase in supply leads to lower prices) and aggregate demand (an increase in demand leads to higher prices). Monetary factors include the supply of money (i.e., more money circulating, if the economy is in equilibrium, will lead to higher prices) and the velocity of money (i.e., higher velocity, if the economy is in equilibrium, will lead to higher prices).
  • Economists describe two types of inflation: cost-push, in which rising costs, usually wages, compel businesses to raise prices generally; and demand-pull, in which increasing demand raises prices generally, which then are reflected in a business’s costs as workers demand wake hikes to catch up with the rising cost of living.

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