Business cycle

1. Business cycle

2. The term business cycle or economic cycle refers to economy-wide fluctuations in production or economic activity over several months or years, around a long-term growth trend.

5. Phases of business cycle • peak (boom) - the upper turning of a business cycle • contraction (slowdown) - A slowdown in the pace of economic activity • recession ->trough - the lower turning point of a business cycle, where a contraction turns into an expansion • expansion - a speedup in the pace of economic activity

6. Phases of business cycle - expansion • In an economic expansion, businesses experience record sales and profits. They can hardly keep up with demand. In anticipation of a continued sales growth, inventories are built up and production facilities are expanded. • This creates demand for suppliers of raw material and equipment. The equipment takes time to be built and installed. Banks are willing to lend given the bright predictions of continued cash flows. A large number of loan applications pushes banks to raise interest rates which companies can afford to pay. • Companies find it difficult to hire all the employees they need, and are forced to pay higher wages, for instance, for overtime hours. But, that is not a serious problem in light of healthy sales and profits.

7. Phases of business cycle - peak • Furthermore, a strong consumer demand justifies raising prices for many products. With higher wages, employees are still able to buy in spite of higher prices; moreover, anticipation of continued employment encourages them to use consumer credit if their income is insufficient. • The overheating of the economy is evident in shortages of employees, materials, equipment, loanable funds and products. • These shortages imply inflation. Because of difficulties in obtaining resources, this is no longer a good time to start a business even if sales appear encouraging. Prices, wages and interest rates continued rise puts eventually a stop to further expanding product demand, new hiring and new lending. The economy has reached its peak.

8. Phases of business cycle – slow down (contraction) • Sales are no longer expanding. The economy starts slowing down. The slow down is mild at first. As sales stop increasing, inventories pile up. • Companies can adjust to that by reducing orders for raw materials, avoiding overtime and resorting to sales promotions. • Suppliers start to feel the pinch and are forced to lay off a few workers. These lay-offs are seen as a signal of potential hard times ahead. • Employees prefer to set aside some wages, and reduce their consumption. Sales start to drop as consumer demand shies away. • Companies are now burdened by the loans they took out to install new equipment. Their profits shrink with decreasing revenues, still high employee salaries, and a large overhead. • The hardest hit are the manufacturers of equipment who see their orders dwindle. Fewer and fewer businesses are started. Often, plans to open business are cancelled. Some firms go out of business.

9. slow down -> recession • The slow down becomes a serious contraction. Surpluses are everywhere: product inventories are bulging, excess capacity causes newly purchased equipment to turn idle, banks have loanable moneys that no project justifies, raw materials are not needed, and employees are too many. • Lay-offs become widespread. Shrinking revenues force companies to replace full-time employees by lower paid part time and temporary workers (if labour unions do not intervene), or even to ask for wage concessions from the existing staff. • Decreasing disposable income causes even more reduction in product demand. Companies are forced to cut prices. • Revenues disappear and profits turn to losses. Businesses default on their loans. • Highly leverages companies close down. These are bankruptcies of large operations. In turn, these bankruptcies can cause some banks to close as well.

10. Phases of business cycle – recession • Pessimism and hardship are widespread. If the loss of income is not too severe it is called a recession, otherwise it is branded a depression. • Firms try to survive as they can selling off the inventory on hand. More bankruptcies are observed, but the number and the size of the bankrupt firms are bottoming out. • All prices, interest rates and wages are at their lowest. • Unemployment is ubiquitous. The unemployed are ready to take any job. • The contraction has run its course. The economy has reached its trough.

11. recession -> expansion • The recovery starts. Having sold off their inventories, companies start to place orders for new supplies. • Consumers have postponed some purchases and made do with cars or appliance by repairing them. But this has gone long enough, it is time to buy at least the indispensable; moreover credit is cheap. • Families have saved up in hard times. Bank reserves are plentiful and bankers are eager to lend anew, even at very low rates. • Interest rates are indeed so low that some company projects become attractive again. • New sales are observed in all sectors. • Companies start rehiring at the low wages first. • New businesses are started. Bankruptcies are less noticeable. The economy is approaching expansion.

12. Expansion • In expansion, attitudes turn optimistic. Manufacturers of durable goods see their order books fill up. • Employees are more secure in their jobs, and start planning for vacations and renewed consumption. • Businesses no longer need to mark down their inventory. The newly received merchandise from suppliers reflects new fashion and attracts customers. • Sales continue to pick up, and healthy profit margins bring back profits. Rehiring employees pushes the unemployment rate down. • As the expansion becomes more and more entrenched, memories of hard times vanish with their warning, and anticipation of continued growth is about to cause the economy to overheat anew.

13. Reasons of business cycle • Internal reasons – in economy • changes in consumption and investments • changes in economic policy (monetary policy and fiscal policy) • External • demographic changes • political reasons • inventions and innovations

14. Reasons of business cycle • Real Business Cycle Theory (or RBC Theory)Unlike other leading theories of the business cycle, it sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment: • fuel prices grows rapidly • important invention (e.g. computer, internet, just-in-time inventory model etc.) • wars • dynamic increase of the birth rate

15. TheAustrianSchooltheory • The Austrian Schoolsaysthatrecessionsare caused mainly by central government intervention in the money supply. • Austrian School economists conclude that, if the interest rate is held artificially low by the government or central bank, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. • This pricing misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects.

16. The Austrian School theory cont. • In Austrian theory, depressions and recessions are positive forces in-so-much that they are the market's natural mechanism of undoing the misallocation of resources present during the “boom” or inflationary phase. • Austrian School economists point to the dot-com investment frenzy and the U.S. housing bubble as modern examples of artificially abundant credit subsidizing unsustainable malinvestment.

17. Unemployment Rate and Recessions Source: http://www.econlib.org/library/Enc/BusinessCycles.html#lfHendersonCEE2-017_figure_003

18. Recession and depression • Recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters. • A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.

19. Politically-based business cycle • Another set of models tries to derive the business cycle from political decisions. The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.

20. Business cycleindicators Leading Indicators • Hours of production workers in manufacturing • New claims for unemployment insurance • Value of new orders for consumer goods • S&P 500 Composite Stock Index • New orders for plant and equipment • Building permits for private houses • Fraction of companies reporting slower deliveries • Index of consumer confidence • Change in commodity prices • Money growth rate (M2)

21. Consumer Confidence Index • Consumer confidence, measured by the Consumer Confidence Index (CCI), is defined as the degree of optimism on the state of the economy that consumers (like you and me) are expressing through their activities of savings and spending.  • The CCI is prepared by the Conference Board, and was first calculated in 1985.

22. CCI cont. • Each month the Conference Board surveys 5,000 U.S. households. The survey consists of five questions that ask the respondents' opinions about the following: • Current business conditions. • Business conditions for the next six months. • Current employment conditions. • Employment conditions for the next six months. • Total family income for the next six months. • Survey participants are asked to answer each question as "positive", "negative" or "neutral".

23. Bibliography • http://www.peoi.org/Courses/finanal/ch/ch15b2.html • http://economics.about.com/cs/businesscycles/a/depressions.htm • Czarny B. „Podstawy ekonomii”, PWE, 2002 • www.wikipedia.org • http://www.investopedia.com/articles/05/010604.asp • http://pages.stern.nyu.edu/~nroubini/bci/bciintroduction.htm