2015, Study Session # 5, Reading # 18

“UNDERSTANDING BUSINESS CYCLES”

18. a

Business cycle is defined by fluctuations in the economic activity.

Real GDP & unemployment rate are the key measures used to evaluate current
phase of business cycle.

Phase of Business Cycle

Expansion:
Real GDP Peak: Real GDP Begins Decreasing Contraction: Real GDP  Early expansion (recovery): Real
GDP Begins Increasing

Output
Output


Employment
Employment


Consumption & Investment
Consumptions & Investment


Inflation
Inflation

18. b

Inventories are an important business cycle indicator.

Inventory/Sales ratio typically increases in later stage of expansion.

Firms try to adjust their utilization of labor & physical capital in reaction to
fluctuations in business activity.

Firm lay (add) employee during contraction (expansion) slowly as it’s a high cost
activity, buying & selling plant and equipment is costly, firms adjust production
levels by their current physical capital.

Investment in new capacity is only made if expansion is likely to persist.

18. c Theories of the Business Cycle

Neoclassical Economists

Business cycles are temporary

Driven by ∆ in technology.

Economy moves toward full employment as a
result of rapid adjustment of wages & other input.

Keynesian Economists

Lowering interest rates may not reignite economic

growth and government intervention through fiscal
policy may be required.

Wages are slow to move downward ⇒ Contraction can
persist for long.

According to “New Keynesians” prices of input variables
other than labor also slowly move downward.

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 2015, Study Session # 5, Reading # 18

18. c Theories of the Business Cycle

Monetarists

Money supply needs to grow at a moderate rate

otherwise economic downturn may be severe or
inflation may accelerate. Business cycles may occur
due to exogenous shocks or govt. intervention.

Austrian School

Government intervention that drives interest rates

to be artificially low trigger’s business cycle.

Real Business Cycle Theory

Utility maximizing factors’ response to real economic

forces explains the business cycle.

18. d Types of Unemployment

Frictional Unemployment Structural Unemployment

Results from time lag between which Results from long-term economic changes.
employees & employers find each other.

Cyclical Unemployment

Result from changes in general level of

economic activity.

 



   =
    

An individual, who is actively seeking for work, is available for work
but not working is considered as “unemployed”.

Labor force includes all individuals who are working or are available for
work.

 

     =

  

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 2015, Study Session # 5, Reading # 18

18. e

Inflation: Sustained increase in price levels over a time period

referred as inflation.
భ
    = −1
బ

Deflation: Sustained decrease in price level over a time period is

referred as deflation.

18. f

.          &       భ

  =
.       &       .

CPI is one of the most widely used price index.

Percentage in prices index for all goods in the economy is known to as
Headline inflation.

Percentage change in price index excluding food & energy price is
referred as core inflation.

18. g

Laspeyres Price Index:

Price index created by keeping the composition of the consumption
basket constant.

Biases causing Laspeyres Price Index to be Biased Upward:

New goods Quality changes Substitution

Paasche Price Index:

Reduces substitution bias.

Uses current consumption weights for basket of goods/services for both
current & prior (base) period.

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 2015, Study Session # 5, Reading # 18

18. h Types of Inflation

Cost-push inflation: Demand-pull inflation:

Real price of an important factor ⇒ Persistent
in AD ⇒
P ⇒temporarily
aggregate supply. output > potential or full-employment level

Unemployment rate below which upward pressure wages is likely to develop is represented by
NAIRU (Non-Accelerating Inflation on Rate of Unemployment).

18. i Economic Indicators

Leading indicators: Coincident indicators:

They have turning points before peaks/ They have turning point at the same point as
trough in business cycle. the business cycle.

Lagging indication:
They have turning points that occur after that of
business cycle.

Limitation:

Relationship b/w various indicators & business cycle
is not exact.

Relationship varies over time.

18. j

Analysts should use variety of indicators

together rather than relying on any one
indicator.

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