Business Cycles

Business cycles reflect fluctuations in economic activity as measured by the level of activity in such variables as the rate of unemployment and the GDP. Periods of economic expansion have been followed by periods of contraction and a pattern called the business cycle. Business cycles go through 4 stages:

• Expansion
• Peak
• Contraction
• Trough

Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time. To account for inflation, GDP in the United states is based on a constant dollar, currently the value in 2012.

Expansion, or recovery, is kissing business activity–in sales, manufacturing, and wages–throughout the economy. When GDP increases rapidly and businesses reach their productive capacity, the nation’s economy cannot expand further period at this point, the economy is said to have reached its peak. When business activity declines from its peak, the economy is contracting.

Economists call mild short term contractions recessions. Longer, more severe contractions are depressions. When business activity stops declining and levels off, the cycle makes a trough.

According to the U.S. Department of Commerce, the economy is in a recession when a decline in real output of goods and services–the GDP–continues for two or more consecutive quarters. It defines the depression as a decrease in GDP for six consecutive quarters.

The Four Stages of the Business Cycle

The Four Stages of the Business Cycle

To determine the economy’s overall direction, economists consider many trends in business activity.

Expansions are characterized by increasing consumer demand for goods and services, possibly leading to:

• And the increasing rate of inflation; and
• increasing industrial production, generally leading to
  • a decreasing unemployment rate as hiring accelerates,
  • falling inventories,
  • rising stock markets,
  • rising property values, and
  • increasing GDP.

Peaks are characterized by:

• a decrease to the GDP rate growth;
• a decrease to the unemployment rate, but a slowdown in hiring;
• a slower rate of growth in consumer spending and business investment; and
• an increase to the inflation rate.

Contractions/recessions in the business cycle tend to be characterized by:

• rising numbers of bankruptcies and bond defaults;
• decreasing working hours and increasing unemployment rate;
• decreasing consumer spending, home construction, and business investment;
• following stock markets;
• a decrease to the inflation rate;
• rising inventories (a sign of slackening consumer demand); and
• a negative growth rate for the GDP.

Troughs tend to be characterized by:

• a change from negative to positive GDP growth rate;
• a high unemployment rate and increasing use of overtime and temporary workers;
• a possible increase in spending on consumer durable goods and housing; and
• a moderate or decreasing inflation rate.

Barometers of Economic Activity

Certain aspects of economic activity service barometers, or indicators, of business cycle phases. There are three broad categories of economic indicators: leading, coincident, and lagging. These indicators are published on a monthly basis by The Conference Board, a non governmental, not-for-profit research organization.

Leading Indicators

Leading indicators are economic activities that tend to turn down before the beginning of a recession or turn up before the beginning of a business expansion. The generators are used by economists to predict the future direction of economic activity four to six months hence. The leading economic indicators include the following:

• Money supply
• Building permits (housing starts)
• Average weekly initial claims for unemployment insurance
• Average weekly working hours, manufacturing
• New orders for non defense capital goods
• Index of supplier deliveries–vendor performance
• Interest rate spread between 10 year treasury bonds and the federal funds rate
• Stock prices (e.g. S&P 500)
• Index consumer expectations

Not all leading indicators move in tandem. Positive changes in a majority of leading indicators point to increase spending, production, and employment. This will generally result in an increase to the rate of inflation period negative changes in a majority of indicators can forecast a recession.

Coincident (or Current) Indicators

Coincident, or current, indicators are economic measurements that change directly and simultaneously with the business cycle. Widely used coincident indicators include the following:

• Non agricultural employment
• Personal income minus Social Security, veterans benefits, and welfare payments
• Industrial production
• Manufacturing and trade sales in constant dollars

Lagging Indicators

Lagging indicators are measurements that change four to six months after the economy has begun a new trend and served to confirm the new trend. Lagging indicators help analysts differentiate long term trends from short term reversals that occur in any trend. Lagging indicators include the following:

• Average duration of unemployment
• Ratio of consumer installment credit to personal income
• Ratio of manufacturing and trade inventories to sales
• Average prime rate
• Change in the CPI for services
• Total amount of commercial and industrial loans outstanding
• Change in the index of Labor cost-per-unit of output (manufacturing)

Simply stated, these indicators attempt to tell us where we’re going (leading), where we are (coincident), and where we’ve been (lagging).

Terminology

Inflation is a general increase in prices as measured by an index such as the consumer price index (CPI). Mild inflation can encourage economic growth because gradually increasing prices tend to stimulate business investments. High inflation reduces a dollars buying power, which can reduce demand for goods and services.

Deflation, though rare, is a general decline in prices. Deflation usually occurs during severe recessions when unemployment is on the rise. Deflation is caused by conditions opposite those that cause inflation. Deflation is a severe shrinkage in the money supply. Deflation happens when the demand for goods and services is substantially below the supply of those goods and services. In a deflationary environment, prices tend to drift downward to encourage an increase in demand.

Gross Domestic Product (GDP) expresses the total value of all final goods and services produced within the United states during the year. GDP includes personal consumption (by far the largest component), government spending, gross private investment, foreign investment, and the total value of net exports. The GDP measures a country’s output produced within its borders regardless of who generated it when the GDP is negative, it is generally a sign of deflation.

The Consumer Price Index (CPI) is a major of the general retail price level. By comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago, we can get an indication of changes in the cost of living. The CPI attempts to measure the rate of increase or decrease in a broad range of prices, such as food, housing, transportation, medical care, clothing, electricity, entertainment, and services. The CPI is published on a monthly basis by the Bureau of Labor Statistics (BLS) and is the most commonly used measurement of the rate of inflation. The index for all items, less food and energy, is often unofficially referred to as the for CPI, a term created by the media and not the Bureau of Labor Statistics.