Harcourt

BUSINESS CYCLE

UNIT 7

Harcourt

BUSINESS CYCLE

The short-term variations in economic activity are known as BUSINESS CYCLE.

Economic history shows that the economy never grows in a smooth and even pattern.

Upward and downward movements in output, inflation, interest rates, and employment form the Business Cycles that characterizes all market economies.

Harcourt

BUSINESS CYCLE

Business Cycles are the irregular expansions and contractions in economic activity.

Business Cycles are economy-wide fluctuations in total National Output, Income, and Employment, usually last for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy.

Harcourt

FEATURES OF THE BUSINESS CYCLE

Economists divide Business Cycle into two phases:

1. Recession: The downturn of a business cycle is called Recession.

A period of decline in output, income & employment.

Usually lasts from 6 months to a year.

Harcourt

BUSINESS CYCLE

2. Expansion: Upward turn of Business Cycle is called Expansion.

A period of rapid growth in output, national income, and employment.

Factories work overtime and earn fabulous profit.

Harcourt

DEPRESSION

The contraction in business cycle persists for a decade and causes widespread economic hardships.

Harcourt

BUSINESS CYCLE American History

History of American Capitalism witnessed fabulous boom in 1990s.

Recession begin in March, 2001 and ended in November, 2001.

Great Depression in 1930s.

Harcourt

PEAKS and TROUGHS

Peaks and troughs mark the turning points of the cycle.

Peaks turn downward towards contractions, and

Troughs lead upward towards expansions.

Harcourt

CHARACTERISICS OF A RECESSION

Often consumer’s purchases decline sharply.

Business inventories of automobiles & other durable goods increase unexpectedly.

Production/Output decline – real GDP falls Business investment in plants &

equipments also fall sharply.

Harcourt

CHARACTERISICS OF A RECESSION

The demand for labour falls – first seen in a drop in the average workweek followed by layoff & higher unemployment.

Inflation slows. Demand for raw materials decline – price

tumble. Wages & prices of services are unlikely to

decline.

Harcourt

CHARACTERISICS OF A RECESSION

Business profit falls sharply. Price of common-stock usually fall as

investors sniff the scent of a business cycle downturn.

Because demand for credit falls – interest rates generally fall in recession.

Harcourt

Business Cycle Theories

Economists classify different sources of Business Cycle into two categories.

1. Exogenous2. Internal cycle

Harcourt

EXOGENOUS

The exogenous theories find the sources of the Business Cycle in the fluctuations of factors outside the economic system, i.e.

Wars Revolutions Elections Change in Oil Prices Discoveries of gold, land, resources Scientific breakthroughs Technological innovations Migration Climate or weather changes etc.

Harcourt

INTERNAL CYCLE

Internal cycle theories look for mechanism within the economic system itself – give rise to self-generating Business Cycles.

In this approach, every expansion breeds recession and contraction.

And every contraction breeds revival and expansion – repeating chain.

Internal theory of the business cycle shows a mechanism, like the motion of pendulum.

Harcourt

Role of Multiplier-accelerator Theory in Business-Cycle.

According to this principle, rapid output growth stimulates investment.

High investment in turn stimulates more output growth – this process continues until the capacity of economy is reached – at this point, economy growth rate slows.

The slower growth rate in turn reduces investment spending and inventory accumulation, which tend to send economy into a recession.

Harcourt

Role of Multiplier-accelerator Theory in Business-Cycle.

The process then work in reverse as reached to trough, and the economy then stabilizes and turn up again.

Harcourt

Business Cycle vs Aggregate Demand

What causes Business Cycles/fluctuations? How can govt. policies reduce their

virulence? Keynes pointed out the importance of the

forces of Aggregate Demand in determining Business Cycle.

Harcourt

KEYNESIAN ECONOMICS SUGGESTS

Changes in Aggregate Demand can have a powerful impact on the overall level of output, employment, and price in the short-run.

Business cycle fluctuations in output, employment and prices are often caused by shift in aggregate demand.

These shifts occur as consumers, businesses and governments change total spending relative to the economy’s potential productive capacity.

FORECASTING BUSINESS CYCLES

Economists have developed forecasting tools to help them foresee changes in the economy.

In an earlier era: economists try to look at easily available data on items like money, boxcar loadings & steel production

If steel production is dropped, it means business purchases are reduced – economy would soon slow down.

FORECASTING BUSINESS CYCLES

This process combines with several different statistics into an “index of leading indicators”.

The index does give an early & mechanical warring on whether the economy is heading up or down.

FORECASTING MODELS

For a more detailed look into the future, economists turn to computerized econometric forecasting models.

Econometric model is a set of equations, representing the behavior of the economy, that has been estimated using historical data.

Pioneers in this area were Jan Tinbergen of Netherlands & Lawrence Klein of University of Pennsylvania.

Harcourt

FORECASTING MODELS

Today, there is an entire industry of econometricians estimating macroeconomics models & forecasting future of the economy.

Generally, modellers start with an analytical framework containing equations both aggregate demand & aggregate supply.

In small models there are one or two dozen equations.

While, large systems forecast from a few hundred to 10,000 variables.

Harcourt

FORECASTING MODELS

Using modern techniques, each equation is “fitted” to the historical data to obtain parameter estimates (MPC, the slop of the investment demand function, etc.).

Once the exogenous and policy variables are specified (population, govt. spending & tax rates, monetary policy, etc.), the system of equations can project important economic variables into the future.

Harcourt

Aggregate Demand (AD)

Ad is the total or aggregate quantity of output that is willingly bought at a given level of price, other things hold constant.

AD is the desired spending in all product sectors:

1. Consumption ( C )2. Private Domestic Investment ( I )3. Govt. Purchases of good & services ( G )4. Net Exports ( X ) AD = C + I + G + X

Harcourt

Major Components of AD

AD has 4 major components:

1. Consumption ( C )2. Private Domestic Investment ( I )3. Govt. Purchases of good & services ( G )4. Net Exports ( X ) AD = C + I + G + X

Harcourt

CONSUMPTION ( C ).

Consumption primarily determined by disposable income i.e. personal income-taxes.

Other factors affect consumption are: Long-term trends in income (permanent income)

Household wealth & Aggregate price level.AD Analysis focuses on the determinants of real

consumption i.e. nominal or dollar consumption divided by the price index for consumption.

Harcourt

INVESTMENT ( I )

Spending includes purchases of buildings, software, & equipments and accumulation of inventories.

Major determinants of investment are: Level of output Cost of capital (as determined by tax policies,

interest rates & other financial conditions). The major channel by which economic policy can

affect investment is monetary policy.

Harcourt

GOVERNMENT PURCHASES ( G )

Govt. purchases of goods & services. Purchases of goods like: tanks or road

building equipments. Purchases of services like: services of

judges & public school teachers. This component of AD is determined

directly by govt. spending decisions.

Harcourt

NET EXPORTS

Net exports are equal to the money value of exports minus money value of imports.

Export value determined by foreign incomes & outputs, by relative prices & by foreign exchange rates.

Net export, then determined by domestic & foreign income, relative prices and exchange rates.

Harcourt

Movements along the AD Curve

Holding other things constant, the level of real spending declines as the overall price level in the economy rises---AD Curve slopes downward.

The reason of downward slope is that---there are some elements of income or wealth that do not rise when price level rises. (i.e. personal income, govt. transfer payments, minimum wages, company’s pension etc.).

Harcourt

Movements along the AD Curve

When price level goes up, real disposable income falls---leads to a declined in real consumption expenditures.

Some elements of wealth may be fixed in nominal terms, e.g. saving certificates or bonds purchases on promises to pay a certain amount for a fixed period---if price level rises, the real wealth declines---leads to lower level of real consumptions.

Harcourt

Movements along the AD Curve

A rise in price level with a fixed money supply causes a decline in investment & consumption.

The AD curve slopes downward---real spending declines as the price level rises, other things remain constant.

Real spending with a higher price level decreases because of the effect of higher prices on real incomes, real wealth & real money supply.

Harcourt

Shift in AD Curve

Macroeconomic policy variables under govt. control, i.e. monetary policy & fiscal policy.

Monetary Policy: Supply of money & interest rates.

Fiscal Policy: Taxes & govt. expenditures Exogenous variable: wars, revolutions,

foreign economic activity.

Harcourt

Assignment

Find annual data on real GDP for the United States for the period of 1948-2003 (see the web site of the Bureau of Economics Analysis, www.bea.gov )

A. define “recessions” as years in which real GDP declined. Which years were recessions?

Calculate the average growth rate of real GDP for the year 1948, 1973, 1988, 1998 & 2003.

Harcourt

Assignment

Collect data of real growth rate (GDP) of Pakistan from Bureau of Statistics of Pakistan, and show recession & expansion in a business cycle through a table and graph.

Suggest possible measures to reduce the intensity of the present recession occur in our economy.

Harcourt

Harcourt